To find clues about the next sharp rise in US Treasury yields, it may help to look at the fine print of US Treasury futures contracts. As the 30-year US Treasury yield gets closer to 6%, this move could trigger adjustments in the futures market.
Treasury futures are widely used by investors to hedge Treasury positions, and leveraged funds also use them for popular strategies such as the "basis trade." This is tied to how Treasury futures work. US Treasury futures are exchange-traded contracts that agree to buy or sell Treasuries at a specific price and date. The contract terms specify which underlying Treasuries a short seller can deliver to a long buyer, and usually multiple securities are eligible. Traders then identify the one with the lowest delivery cost, known as the "cheapest-to-deliver" (CTD), and the futures contract price tracks that bond.
When yields rise as quickly as they are now, the pricing relationships within the deliverable basket change, and the CTD begins to shift toward longer-dated Treasuries. Strategists at BNP Paribas, including Guneet Dhingra, Sebastian Mauleon and Vincent Zhou, said in a recent report that this will force asset managers to sell US Treasury futures because of the so-called duration change, or "CTD switch," a move that "could intensify the rise in long-end yields in the Treasury cash market."
As the CTD shifts toward longer-duration bonds, asset managers need to sell futures long positions and buy back short positions in order to keep portfolio duration stable. These dynamics may further affect the corresponding cash Treasuries. The market is paying especially close attention to long-dated contracts, particularly the long bond futures contract, whose current CTD is the Treasury maturing in February 2045 with a 2.5% coupon. Bloomberg analysis shows that if the 30-year yield rises to near 6%, the CTD may switch to a bond maturing in 2050.
On Monday, the 30-year US Treasury yield rose to 5.68%, close to recent highs. Recent positioning data show that investors have already begun making related adjustments. Over the past few weeks, as the 30-year yield climbed well above 5.6%, asset managers have been cutting net long positions in long bond and ultra-long bond futures.
Strategists at Goldman Sachs, including George Cole and William Marshall, said in a recent report that a decline in long bond futures longs likely means investors are "actively managing the duration extension risk brought by a potential CTD switch in US Treasury futures." The latest data from the US Commodity Futures Trading Commission show that ultra-long bond futures saw heavy selling. In the week ended September 29, as the 30-year Treasury yield rose from 5.28% to as high as 5.62%, asset managers cut net longs in ultra-long bond futures by nearly 100,000 contracts.
Position adjustments in long bond futures were smaller, indicating that CTD switch risk in that tenor, and the forced selling risk it creates, still remains. Monty Gandhi, a rates strategist at Sumitomo Mitsui Banking Corporation, said: "Ultra-long bond futures have already switched to a higher-duration CTD, but long bond futures still face the risk of further duration extension."