Heavy U.S. Treasury Market Leverage Poses Market Risks

U.S. asset managers anticipating a possible recession have loaded up on short positions in futures contracts for U.S. Treasury securities—a type of leveraged trade that went awry in March 2020 and could again, if some impromptu event, such as a U.S. government shutdown, triggers it.

In 2020, a global pandemic sparked a financial market dislocation that roiled bond markets and spiked U.S. Treasury yields. Such dislocations happen when financial markets, operating under stressful conditions, cease to price assets correctly on a widespread basis. Could a potential U.S. government budget shutdown in coming weeks do the same?

The Bank of International Settlements (BIS), in a recent publication, seems to think so.

“Given these experiences, the current build-up of leveraged short positions in U.S. Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger,”  the BIS said in its Quarterly Review published in this week.

On the Margin

Traders and asset managers have amassed $600 billion in net short positions in U.S. Treasury futures, the most since late 2019, with most of those positions tied to an arbitrage trade versus underlying U.S. Treasury securities. Most have borrowed money on margin to initiate the trade and must routinely post margin to maintain it.

In this so-called cash basis trade, traders try to make money on the difference between the futures and cash securities involved—in this case, mostly 2-, 5- or 10-year Treasury securities. The trade works as long as traders don’t need to come up with substantially more amounts of margin.

But sometimes, broker-dealers supplying the leverage traders need to implement the trade will require additional margin. That can force traders to either come up with more money or close out their trade, partly because they use Treasury securities as collateral for the money they borrow.

In this case, closing out the trade means selling U.S. Treasury securities. And if too many traders try to do it at once, chaos can ensue.

2020’s Dash for Cash

That’s what happened when the pandemic hit in March 2020. At the same time many traders tried to sell Treasury securities to close out positions, demand for those securities dried up, with investors selling securities in an episode now called “the dash for cash” in preparation for pandemic shutdowns.

As traders and investors tried to sell U.S. Treasury securities en masse, the 10-year U.S. Treasury yield shot higher, more than doubling to 1.27% on March 18, 2020, from its yield nine days earlier.

A similar spike had occurred a few months earlier when the 10-year yield surged to 1.90% from 1.46% in a nine-day span. Both times, significant increases in initial margin requirements presaged the yield spike, with the pandemic’s abrupt arrival making the latter event worse.

Joseph Wong, chief investment officer at Monetary Macro and a longtime Treasury trader, said it’s possible the heavy net short positions now inherent in the U.S. market could spark a similar scenario—especially if traders have to come up with more margin.

“If you’re already in the trade, and margin goes up, then you get out,” Wong said.

In this case, a widespread push to “get out” could dislocate markets and push Treasury yields sharply higher. However, he added that in the absence of rising margin requirements or an unexpected event, current conditions could persist for a while.