By Gertrude Chavez-Dreyfuss and Anirban Sen
NEW YORK, Oct 28 (Reuters) - The slowdown in one of the US Treasury market's most scrutinized trades has driven investors to other corners of the rates market.
The basis trade, a strategy in which hedge funds buy cash Treasuries using borrowed money from the repurchase or repo market while selling futures against them, has plateaued after several years of rapid growth, analysts said. The leveraged trade typically has become less attractive as rising Treasury
yields and financing costs have increased the risks of borrowing.
Regulatory changes have also allowed banks to hold more Treasuries on their balance sheets, reducing opportunities for hedge funds to profit from price discrepancies between cash Treasuries and futures.
But market participants said some money once deployed in basis trades has moved into other relative-value strategies, including swap-spread arbitrage, a wager on the gap between Treasury yields and swap rates linked to the Secured Overnight Financing Rate (SOFR). Investors often use swaps to hedge interest-rate risk or Treasury exposure.
"Speculative activity has extended into other strategies that load on liquidity, volatility and credit risk, particularly sovereign asset swaps, including outside the US," said Matthew Franklin-Lyons, global head of rates trading at JP Morgan.
"Recent market moves are exposing vulnerabilities in those positions."
EMBRACING RISKIER TRADING
With basis trade opportunities becoming scarcer, swap spreads are "the kind of trades that levered funds would be attracted to," said Amrut Nashikkar, head of derivatives strategy at Barclays.
Like the cash-futures basis trade, swap-spread strategies can employ leverage and require relatively little capital compared with the size of the positions.
The Dallas Federal Reserve said in a recent research note that swap-spread positions carry substantially more dollar risk per unit of notional value than basis trades. So even modest capital outflows could trigger disproportionately large unwinds of Treasury futures positions and repo financing.
Both the basis trade and swap spread arbitrage are vulnerable to market shocks, but their risks differ, analysts said. The basis trade is vulnerable to disruptions in funding markets and rising trading costs, while swap-spread arbitrage is more sensitive to shifts in Treasury demand and interest-rate swaps.
Given that greater risk exposure, "levered investors may not be rolling their cash-futures positions into swap spreads dollar for dollar," said Gennadiy Goldberg, head of US rates strategy at TD Securities.
APPEAL OF SWAP-SPREAD WIDENERS
Swap spread wideners, particularly at the front end of the yield curve, have become markedly more attractive in recent months, the Dallas Fed noted, with expected returns relative to risk approaching levels seen in a traditional long basis trade.
In a swap spread widener, an investor buys cash Treasuries, finances them in the repo market, and enters an interest rate swap in which it pays a fixed rate and receives a floating one. The trade benefits when swap rates rise relative to Treasury yields, which happens when banking regulations are eased, for instance, and balance-sheet constraints become less restrictive.
Even so, the cash-futures basis trade remains the dominant Treasury strategy among hedge funds. Phillip Monin, principal economist at the Board of Governors of the Federal Reserve System, estimated that hedge funds held roughly $830 billion of cash-futures basis positions as of September 2025, representing about 35% of their total long Treasury exposure.
"The much talked-about reduction in the size of the Treasury basis trade does not get felt in our volumes or open interest," said Agha Mirza, global head of rates and OTC products at CME Group. "If you look at Treasury futures, our overall futures volume is at a record level, up double digits."
Swap spread positions have expanded rapidly in recent years, reaching $305 billion by September 2025, or 13% of hedge funds' long Treasury exposure, according to Monin's research using the latest Fed data. That makes them the second-largest Treasury-related position for hedge funds.
Other relative value Treasury positions that may have taken more capital away from basis trades, analysts said, include so-called "maturity-matched trades" such as taking advantage of the difference in price between on-the-run and off-the-run or older securities as well as doing an arbitrage between yields on Treasury Inflation Protected Securities (TIPS) and those on nominal Treasuries.
RISING BORROWING DRIVES OPPORTUNITIES
Still, the move into other relative-value trades may not signal a lasting retreat from the basis trade.
Ali Meli, founder and chief investment officer of private credit manager Monachil Capital Partners LP, said he expects the strategy to regain momentum.
"The same types of pressures will come back," Meli said. Regulatory changes have given banks an estimated $3 trillion to $5 trillion of additional balance sheet capacity to absorb Treasuries, helping ease some of the pressures that had earlier encouraged hedge fund participation.
But with government borrowing continuing to grow, Treasury buyers will remain sought after, Meli said.
"Hedge funds are playing the game that suits them best at any point in time," said Padhraic Garvey, head of global rates and debt strategy at ING in New York.
(The first graphic was from Phillip Monin of the Board of Governors of the Federal Reserve System.)
(Reporting by Gertrude Chavez-Dreyfuss and Anirban Sen; Editing by Colin Barr and Andrea Ricci )
