The Federal Reserve has issued a warning to stop the deal that led to the bond market crash in 2020

Federal Reserve researchers have warned in recent weeks that...The Treasury market could be disrupted by the return of a popular hedge fund trading strategy that contributed to the collapse of the world's largest bond market in 2020。

According to analysts,Hedge funds' short positions in some U.S. Treasury futures recently hit record highs as part of so-called basis tradingBasis trading takes advantage of the premium the futures contract pays over the price of the underlying bond

These transactions include selling futures contracts and buying deliverable Treasuries with repurchase agreement funds, which are delivered when the contracts expire.

In two reports in recent weeks,Federal Reserve economists have highlighted the potential risk of financial fragility associated with these transactions.The transactions come as the U.S. government bond market is volatile due to rising interest rates and uncertainty over future monetary policy actions.

Industrial foreign exchange"During a broader market correction, the basis between spot and futures could come under renewed pressure," economists said in a report on Aug. 30.This transaction requires continuous and careful monitoring。”

Separately, in a September 8 report examining hedge fund exposures to Treasuries, Fed economists said,In the case of rising repurchase financing costs, there is a risk of rapid positioning squaring of basis trading positions.

They warned that...That would add to market pressures, "potentially leading to increased volatility in the Treasury market and amplifying disruption in Treasury, futures and repo markets."

Data from the US Commodity Futures Trading Commission (CFTC) show that net short positions by leveraged funds on some US Treasury futures have been near record highs in recent weeks, matched by long positions by large asset managers, indicating a basis trade.

Steven Zeng, US rates strategist at Deutsche Bank, said, "The Federal Reserve is unlikely to let these accumulated basis positions go and may eventually want to suppress themHowever, their approach may not be straightforward because the Fed does not have direct oversight of hedge funds, "he said.

The Fed declined to comment on possible policy action.

Worried about a repeat of the 2020 crash? The Federal Reserve is eager to stop it

Basis trading position squaring led to illiquid Treasuries in March 2020At the time, markets stalled amid heightened concerns about the COVID-19 pandemic, prompting the Federal Reserve to buy $1.60 trillion in government bonds.

Some market participants are concerned.A similar situation could still be repeatedBarclays said in a report on Tuesday, "Basis trading is vulnerable to two risks: higher margins for futures bears and higher financing costs for spot bulls。”

If funding costs rise in the repo market, where hedge funds take short-term loans for Treasuries and other securities, the spread - or premium - of futures contracts over spot Treasuries would also need to increase to maintain a profitable basis position.

On the contrary, a sudden economic deterioration and a rapid drop in interest rates could push up futures prices, trigger stop-loss orders, and force hedge funds to exit basis trading.

"This could lead to a repeat of the market turmoil of March 2020," said Deutsche Bank's Zeng.This is something the Federal Reserve is eager to prevent。”