All-time high Treasury short positions by hedge funds last week were a “disaster waiting to happen,” as massive short-covering occurred, pushing yields. “Basic business” at him again

But now, the 10-year yield will jump 15 basis points as of Friday. Has the short veil gone its way?

By Wolf Richter for WOLF STREET.

The fireworks in the US Treasury market over the past few weeks have been, as you’d expect, creating liquidity and then covering highly leveraged short positions.

Commodity Futures Trading Commission figures reported by Bloomberg this morning show that On October 31, 2006

In the midst of these short positions, the 10-year Treasury yield rose to 5% on October 23, and the rise in yields meant falling prices in the cash Treasury market, and they were making short bets on Treasuries, but that 5% glory period followed. . Insta-plunge in same day products, then more product drops. Dropping a product means raising prices. And during that week, hedge funds continued to pile into this backed short trade until October 31.

And on Oct. 31, net short positions in Treasury futures reached an all-time high, and this extremely high position was “a disaster waiting to happen,” Macquarie Group strategist Gareth Berry told Bloomberg.

Then on November 1st, the Treasury Department’s announcement of quarterly refunds, designed to weaken long-term yields, completely pulled the rug out from that short trade. And those trades unfolded.

“A compelling story of price action in Treasuries over the past few months fed price action until it went too far, causing the overshoot that is now being corrected,” Gareth Berry told Bloomberg.

These short trades also include “basis trading”: selling Treasury futures and buying bonds in the Treasury money market and making a small profit on the difference between them, but multiplied by a large margin.

The foundation business has come under the supervision of the SEC, which regulates hedge funds; And the bank regulators are worried about because the banks provide some of the financial support for this business funds and may be hit with the support. And the Fed is worried because hedge funds are also borrowing in the repo market, and the backed bets have destroyed the repo market in 2019, when the Fed ends up stepping in to free up those goal balls. It’s a bet that contributed to the crazy volatility in the Treasury market in March 2020 when the Fed threw sky and earth.

In the year In August 2023, Fed researchers found that hedge funds were back at it: Short positions in 2-year, 5-year and 10-year Treasury contracts rose by $411 billion in 10 months, to $715 billion, and that total use of Treasuries Shorts rose to $860 billion — but that’s based on May 9 data. And the business has ballooned ever since. No one knows how big this business is.

And the Fed’s researchers pointed out that trade is a risk to financial stability.

“A cash-futures-based trade is an arbitrage trade that involves a short Treasury futures position, a long Treasury cash position, and borrowing in the repo market to finance and supply the trade. This trade presents financial stability risks because the trade is generally highly leveraged and in both futures It is exposed to changes in margins and changes in repo spreads.The hedge fund’s cash-based futures trading contributed to the volatility in the Treasury market in March 2020.

In today’s speech on financial stability, Fed Governor Lisa Cook pointed to hedge fund and underlying trading:

“For example, many indicators suggest that Treasury futures—the sale of Treasury futures and the purchase of Treasury securities for futures contracts—may gain popularity in the near future. Because the underlying business is often highly leveraged, a financial shock or a downturn in the Treasury markets Volatility can force hedge funds to suddenly liquidate positions with high volatility.

“I will monitor how these supported businesses interact with Treasury market liquidity.”

The SEC has proposed new rules to improve the Treasury market to regulate these leveraged bets. Among other things, those laws treat hedge funds as the broker-dealer arm of banks.

Ken Griffin, the CEO of the hedge fund Citadel, who is up to his ears in the fundamental business, has pushed back on the SEC investigation, and regulators should focus on the lending of banks and financial hedges, to reduce the risk to the financial system, he told the FT yesterday.

“If regulators are really worried about the underlying trading volume, they can ask banks to do stress tests to see if they have enough collateral from their counterparties,” he told the FT.

Meanwhile, in the Treasury market, the massive short-covering that helped push the 10-year yield lower last week appears to have run its course, and today the 10-year yield jumped 15 basis points from Friday’s low. Currently 4.65%

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