The Federal Reserve has started its rate-cutting cycle, and Wall Street’s consensus is that quantitative tightening will end in March 2025. The Fed will then have to make the critical, if seemingly sleepy, decision on the maturity structure of its portfolio.
Before the 2008 financial crisis, bills accounted for over half the Treasury portfolio, while almost three-quarters of it matured within three years. Chris Waller – member of the Fed board of governors and a shortlist candidate to be the next Fed chair – recently gave a nostalgic speech on this front, saying: ‘I would like to see a shift in Treasury holdings toward a larger share of shorter-dated Treasury securities.’
Indeed, when the Fed in 2019 began to expand its balance sheet – not for quantitative easing reasons, but rather to simply accommodate a growing economy – its balance sheet growth came only from purchasing T-bills.
While this may seem trivial, this choice is more than just an exercise in defining the ‘neutral’ central bank portfolio. The minutes from the Fed’s November Federal Open Market Committee meeting revealed: ‘Several participants noted that leverage in the market for Treasury securities remained a risk and commented that it would be important to monitor developments regarding the market’s resilience.’
But the Fed has more responsibility than monitoring this risk. Any shift towards a bills-only portfolio would mean starving institutional cash investors of these bills and forcing them to instead provide short-term financing of the long-term Treasury securities to leveraged investors.
From the Fed balance sheet to hedge funds
The FOMC minutes also said: ‘Leverage at hedge funds remained high, partly on account of the prevalence of the Treasury cash–futures basis trade.’
The basis trade exploits the arbitrage spread between Treasury futures and cash Treasuries that are ‘deliverable’ into those futures contracts. A hedge fund goes long on the Treasury bond and short on the corresponding futures contract that is trading relatively richly – with asset managers on the other side of the futures – and collects the ‘basis’, or spread. Conservatively estimated, the basis captures 45 basis points annualised, which hedge funds leverage at least 20x in repurchase agreements or prime brokerage for upwards of 9% annualised return.
The Treasury Borrowing Advisory Committee – a group of market participants that advises the Treasury – said that 20x is ‘anecdotally’ a good approximation basis trade leverage. An article from Fed researchers Ayelen Banegas and Phillip Monin reported that hedge funds were averaging 56x leverage on Treasury repo borrowing.
The trade is not actually risk-free; it is particularly risky when there is a ‘dash for cash’ and the basis diverges. Most infamously, when the pandemic struck the economy, rates were headed lower for longer, so futures prices rose, but cash Treasuries nonetheless sold off as investors sought cash.
The true size of the trade is also unknown, but current indicators suggest it’s bigger than its pre-pandemic peak. Earlier this month, the Financial Stability Oversight Council reported: ‘As of September 2024, leveraged funds’ net short Treasury futures contracts had a notional value of $1.1 trillion, nearly double the peak observed in the leadup to the COVID-19 pandemic.’
What does the basis trade have to do with the Fed’s portfolio choices? Well, in the limited history of QT we have, it seems the basis trade machine goes into overdrive when the Fed puts duration back on the market.
QT and the hedge fund basis trade: a symbiotic relationship
The Treasury greatly expanded its issuance duration in both QE eras. It increased the weighted-average maturity of outstanding Treasury debt to 70 months during the post-2008 financial crisis QE, from 55 months previously; WAM rose to 75 months amid pandemic-era QE (Figure 1).
Figure 1. Weighted average maturity of marketable debt outstanding
Source: US Treasury
These increases petered out or fell once the Fed stopped bond purchases and began QT. During these QT episodes, when the Fed was pushing the Treasury’s new duration onto private markets, the hedge fund basis trade appears to have done a lot of the heavy lifting. After the 2008 financial crisis, the Fed started shedding bonds in October 2017; after the pandemic, QT began in June 2022. Both of those dates look like inflection points on the various size proxies of the hedge fund basis trades (Figures 2 and 3).
Figure 2. Hedge fund net short positioning in Treasury futures has increased further as asset manager net long positions have continued to grow
Aggregate net positioning across US Treasury futures, $bn
Source: Financial Stability Oversight Council
Figure 3. Hedge fund net repo positioning
Source: Jonathan Glicoes, Benjamin Iorio, Phillip Monin, and Lubomir Petrasek (Federal Reserve Board)
Note: Net repo is defined as the total repo positions minus reverse repo positions held by qualifying hedge funds that report on SEC Form PF.
Hedge funds’ manufacturing floors
Of course, there’s nothing inherently bad about hedge funds taking maturity transformation risk and getting paid for bearing it. But it’s worth zooming out to inspect what kind of maturity transformation we’re asking of them here – and if it’s worth running blowup risk of the basis trade, or if there’s a better way.
In the basis trade, hedge funds are taking long-term Treasuries and using them to manufacture different Treasury instruments: short-term, Treasury-backed repos that can then be held by the ultimate source of funds – institutional cash piles. From an institutional cash management perspective, a Treasury-bond backed repo is wholly dominated by a Treasury bill. There is no counterparty risk, no duration risk in the collateral, no risk of needing to take possession of an asset the liquidity pool is not allowed to own.
The Treasury is thus missing an opportunity to issue substantially more bills, the size of which can at least be proxied by the basis trade. Indeed, such issuance would crowd out the trade. Yet, Treasury secretary-nominee Scott Bessent wrote in the Wall Street Journal that the Treasury’s recent inching toward shorter-term issuance ‘has distorted Treasury markets’, suggesting he’ll seek to term out Treasury issuance.
As such, it is particularly incumbent on the Fed to avoid further exacerbating the problem by reallocating to bills or focusing exclusively on bills when organic balance sheet growth resumes. That’s not to suggest it would be appropriate for the Fed to exclusively buy duration, as that would look and feel like monetary financing.
The Fed’s portfolio should, however, use a strategy it has used in small doses in the past: it should aim to match its portfolio maturity to that of oustanding Treasury debt. This avoids incentivising the issuance of any particular duration, and it avoids the net negative outcome for financial stability of exacerbating the bill shortage.
Steven Kelly is the Associate Director of Research at the Yale Program on Financial Stability and author of the popular Substack, Without Warning.
