The scale of US Treasury basis trading has dropped to approximately $900 billions.

Wall Street strategists say that the size of a popular US Treasury trading strategy has fallen to its lowest level in more than two years, reflecting a reduction in mispricing opportunities in the bond market for hedge funds to exploit. This strategy, known as “basis trade,” helps provide demand and liquidity to the US Treasury market. The trade takes advantage of small price discrepancies between US Treasury futures and spot bonds, and amplifies the trade size by borrowing large amounts of capital. As these price gaps have continued to narrow, the strategy is cooling down and the market may lose an important source of funding as a result. However, strategists at banks such as Morgan Stanley and Citigroup say the trade is far from disappearing, and the weakening trade momentum simply reflects a decrease in relative value investment opportunities. Jason Williams, Citigroup’s Head of US Rates Strategy, said: “As market dislocations and volatility have dropped sharply over the past few years, basis trade positions are declining. Rather than signaling risk, this tightening of opportunity space suggests that underlying US Treasury demand may be stronger than we think.” According to statistics from Morgan Stanley, the notional size of US Treasury basis trades involving leveraged investors has dropped from $1.26 trillion at the start of this year to around $900 billion.