(Bloomberg) -- The basis trade, a strategy hedge funds use to profit from small price discrepancies between Treasury bonds and their futures contracts, is back. And its popularity may grow unless a liquidity squeeze disrupts those markets.

The approach typically calls for purchasing the security that appears undervalued, while selling short the other asset in anticipation the two prices will converge. It relies on significant leverage from borrowing securities in the market for overnight repurchase agreements, which are loans collateralized by Treasuries. 

Almost 0.8% of all US Treasuries outstanding are on loan, or being shorted, according to a BNY Mellon note to clients that cites the bank’s securities lending program. That suggests leveraged money is borrowing bonds to short at the fastest rate since 2018, according to the bank.

And short positions in two- and five-year Treasuries for leveraged funds have grown, according to Commodity Futures Trading Commission data. Meanwhile, BNY Mellon’s proprietary iFlow data show that since the middle of 2023, flows into the US Treasury market have been consistently positive, John Velis, a foreign-exchange and macro strategist at the bank, wrote in the note.  

While funding markets are stable for now as the Federal Reserve slowly removes liquidity from the financial system, the concern is that the ongoing appetite for basis trades makes both the repo and cash markets vulnerable to pressure on liquidity, or the ability to find ready buyers. Bouts of volatility can increase the cost of the trade, killing any profits generated by the current strategy of buying bonds and shorting futures.

When that happens, hedge funds have to rapidly unwind their positions to repay their loans. The resulting price fluctuations can lead to further dwindling of liquidity, prompting disruptions in the Treasury market.  

“Should repo markets begin to get stressed, an ugly unwind and hasty and significant short covering could pose a vulnerability for the bond market,” Velis said in the note.

Still, he is “relatively sanguine that funding markets can remain relatively stress free — through the end of the year, at least. We think this should enable the basis trade to endure over that time horizon.” 

Massive market volatility prompted margin calls in Treasury futures and intensified stress in funding markets in the recent past, during the onset of the coronavirus pandemic in 2020.

While it’s unclear to what extent the basis trade contributed to the turmoil, there was wide agreement in the markets that the rapid unwinding of positions amplified the volatility. 

The basis trade recaptured market prominence last year, as evidenced both by growing short positions in the futures market and a surge in borrowing in the repo market. 

But demand for leverage in short-term funding markets faded at the beginning of 2024. Stronger-than-expected economic data made Fed officials more hawkish, and speculation that the central bank would cut rates waned.

But when hopes for rate cuts and increased liquidity revived, repo desks — as recently as last month — started to notice a large increase in Treasury basis flows, adding to their inventory. 

The basis trade had returned.

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