It is well known that the most crowded hedge fund position – apart from being long risk – is the US basis trade and the US swap spread trade, where hedge funds buy US government bonds duration hedged either via futures or swaps.
Due to the regulatory framework established after the global financial crisis, banks needed to outsource these highly levered trades to the shadow banking industry, who are now arbitraging these nearly risk-free opportunities. The same is true for the cross-currency basis trade in the FX forward space but these trades require a higher haircut which makes leverage less appealing.
According to BIS data, the basis trade is roughly USD1 trillion in size and the Treasury asset swap roughly USD1.4 trillion in size. In Europe, hedge funds are nearly as active as in the US market, but it has not been that obvious until recently where hedge funds have had the most concentrated bets.
However, that has certainly changed over the last couple of months. As well as banks, hedge funds have also ramped up trades that are profiting from a rather unprofessional and well-announced exit by defined benefit schemes from the Dutch pension industry.
The decision has been made in order to switch the Dutch pension market to a defined contribution market where individuals will take care of portfolio risk and will be less focused on the rates sensitivity of their liabilities. Although this makes sense in theory, it has led to some procyclical behaviour that has not increased the returns of these funds.
This means that in January part of the Dutch pension industry will have to unwind the swaps they received to match the duration of the liabilities that had to pay out in the distant future (10yrs+). The market is estimating around EUR70 million DV01, which is an equivalent of some EUR70 billion notional of unwind in one month. That is a lot. The largest issuers like France, Germany and the EU will have net issuance needs of roughly twice that but over a year, and from time to time that has already lead to some indigestion.
EU governments will issue (assuming redemptions will be reinvested) some EUR650 billion on a net basis next year, similar to 2025 and 2024. That is a monthly run-rate of some EUR54 billion. Now imagine another EUR70 billion on top. Banks have made room to cover these trades when they are due and, from the BIS data, we assume that hedge funds are in this trade as well by up to EUR300 billion, either via steepener or outright shorts.
This would indicate that the market should prepare for a round trip in European core yields in January. Yields are currently rising fast but the unwinding of fast money could be significantly larger than that from pension funds!
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