Hedge funds shrink the Treasury basis trade 20% to $1.2 trillion as the bond selloff runs on

Hedge funds are pulling back from the Treasury basis trade, one of the largest leveraged positions in the bond market. Money tied up in the trade has fallen 20% this year to about $1.2 trillion, according to Morgan Stanley estimates cited in a Reuters analysis published Thursday. Reuters said hedge funds' net short positions in 2-year and 5-year Treasury futures, the other half of the trade, have dropped more than 40% from their March highs.

The basis trade works like this: a fund buys Treasury bonds, sells the matching futures contract, and pockets the small price gap between the two, borrowing heavily overnight to make that gap worth the effort. "The basis position in the market has been declining because the opportunity set is lower," Meghan Swiber of Bank of America told Reuters.

Why the gap has closed

Reuters pointed to three causes. Demand for both Treasuries and futures has softened. Changes to the supplementary leverage ratio, a capital rule for big banks, let dealers hold more Treasuries on their balance sheets, which improves trading conditions but shrinks the mispricings funds live on. And the Treasury's buyback program has pushed up prices of older bonds, the ones funds typically deliver into futures contracts, cutting the profit further. Morgan Stanley still says the trade "remains alive and well."

The thing to get right: how big is it?

Estimates of the trade's size vary a lot, and that matters for how worried to be. Federal Reserve staff, using the confidential Form PF filings hedge funds make to the SEC, put basis trade volumes at about $830 billion in September 2025 in a research note published in June. Morgan Stanley's figure implies the trade stood near $1.5 trillion at the start of this year before shrinking to $1.2 trillion. The two use different data and methods, so the right conclusion is not a single number but a direction: the trade is large and, for now, getting smaller.

The Fed note is useful for what else it measured. As of September 2025:

• Large hedge funds held about 8.5% of all privately held Treasuries, up from 4.5% at the start of 2023.
• Their gross Treasury exposure was $4.0 trillion, $2.4 trillion long and $1.6 trillion short, backed by $3.0 trillion of repo borrowing.
• The top 50 funds accounted for about 90% of those exposures.

The note concluded that "the combination of large scale, high concentration, and elevated leverage creates the potential for systemic stress if multiple strategies face simultaneous pressure."

Who it hits

There are two sides to this. The reassuring one: a smaller basis trade means less borrowed money that could be forced to sell all at once, which is the fear behind past sudden bond market breaks. An unwind is less likely to turn a steady selloff into a disorderly one.

The less comfortable side is demand. Basis traders buy the bonds Treasury sells. If they buy less, someone else has to take up the slack, and this week has shown buyers asking for more yield to do it. Wednesday's 5-year note auction cleared at 5.033% with the weakest demand since 2018, as we reported. The 10-year yield closed that day at 5.11% on Treasury's curve.

That flows straight through to borrowers. Many five-year commercial real estate loans and equipment loans are priced off the 5-year Treasury, and 30-year mortgage rates follow the 10-year. A thinner pool of buyers for government debt is one more reason those benchmarks may stay high even if the Fed stops hiking.

What traders watch next

Weekly CFTC positioning data on Treasury futures, the remaining auctions this month, and whether the Fed or Treasury comments on market functioning. Follow yields on our 10-year Treasury chart.

Sources: Reuters, Federal Reserve Board, U.S. Treasury. This is market information, not investment advice.