U.S. rates market shifts into swap-spread bets as basis trade slows

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US rates shift to swap-spread bets

Highlights

Hedge funds are shifting capital from the plateauing Treasury cash-futures basis trade to swap-spread arbitrage as higher yields and financing costs reduce leveraged borrowing appeal.
Swap-spread positions, which reached $305 billion (13% of hedge funds' Treasury exposure) in September 2025, carry more dollar risk per unit than basis trades, raising market unwind risks.
Despite new interest in swap spreads and other relative-value trades, cash-futures basis positions still dominate with $830 billion (35% of total long Treasury exposure) held by hedge funds.

Shift in trading strategies and market signals

As reported by Reuters, the slowdown in the Treasury cash-futures basis trade is pushing some investors toward other relative-value positions, including swap-spread arbitrage tied to the gap between Treasury yields and SOFR-linked swap rates.

The basis trade, widely used by hedge funds, involves buying cash Treasuries with borrowed money in the repo market while selling futures against them. Analysts say the strategy has plateaued after several years of rapid growth because higher yields and financing costs have made leveraged borrowing less attractive.

Market participants say some of that capital is moving into trades that also use leverage but target different pricing gaps. Matthew Franklin-Lyons, global head of rates trading at JP Morgan, says speculative activity is extending into strategies that take on liquidity, volatility and credit risk, including sovereign asset swaps beyond the U.S.

Amrut Nashikkar, head of derivatives strategy at Barclays, says swap spreads are the kind of trade leveraged funds would be drawn to as basis-trade opportunities become scarcer. The Dallas Federal Reserve says in a recent research note that swap-spread positions carry substantially more dollar risk per unit of notional value than basis trades, meaning even modest outflows could trigger larger unwinds in Treasury futures and repo financing.

Risk exposure and implications for Treasury demand

Analysts say the basis trade and swap-spread arbitrage are both vulnerable to market shocks, but in different ways. Basis trades are more exposed to funding-market stress and rising trading costs, while swap-spread positions are more sensitive to changes in Treasury demand and moves in interest-rate swaps.

Gennadiy Goldberg, head of U.S. rates strategy at TD Securities, says that because swap spreads carry greater risk exposure, leveraged investors may not be shifting cash-futures positions into those trades on a one-for-one basis. Still, the Dallas Fed notes that swap spread wideners, especially at the front end of the yield curve, have become much more attractive in recent months, with expected returns relative to risk nearing levels seen in a traditional long basis trade.

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, estimates hedge funds held about $830 billion of cash-futures basis positions as of September 2025, equal to roughly 35% of their total long Treasury exposure, while swap spread positions reached $305 billion, or 13%, making them the second-largest Treasury-related position.

Other trades also appear to be drawing capital, including maturity-matched strategies involving on-the-run and off-the-run Treasuries, as well as arbitrage between Treasury Inflation Protected Securities and nominal Treasuries. Ali Meli, founder and chief investment officer of Monachil Capital Partners LP, says the retreat from basis trading may not last because growing government borrowing should keep demand high for Treasury buyers, even after regulatory changes expand banks' balance-sheet capacity.

Rising long-term U.S. Treasury yields and a deficit nearing $2 trillion are tightening financial conditions, pushing up mortgage rates and increasing federal interest costs, as we previously reported. Our earlier coverage also noted that heavy Treasury issuance and stronger competition for capital (including funding for AI-related investment) are reshaping investor behavior and pressuring borrowers in a tighter liquidity environment.

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