The U.S. Bond Market Turmoil: A Deep Dive into the Basis Trade
Recent events have highlighted volatility in the U.S. bond market, raising concerns about potential systemic risks. This article explores the factors contributing to this instability, focusing on the role of basis trades and the Federal Reserve's response.
Treasury Secretary's Perspective on Market Deleveraging
The article opens with a discussion about the increase in the 10-year Treasury yield. The speaker spoke with Treasury Secretary Scott Besant, who attributed the market movements to a deleveraging event. According to Besant, large, leveraged players experiencing losses are being forced to deleverage, but he believes this is a normal, albeit uncomfortable, occurrence in the bond market and not indicative of a systemic issue.
Trump's Tariffs and the Bond Market Reaction
Trump's tariffs have negatively impacted the U.S. bond market, with long-term bond interest rates experiencing a significant surge. This is unusual, as investors typically flock to the perceived safety of U.S. bonds during stock market declines. The simultaneous selling of stocks and bonds has led to speculation that China may be retaliating by selling off its U.S. bond holdings. Jamie Dimon, CEO of JPMorgan Chase, also seems to agree with this idea.
The Basis Trade and its Near-Bankruptcy
The article contends that the fluctuation in U.S. bonds caused by Trump's tariffs triggered a near-bankruptcy situation due to a basis trade incident. While the Treasury Secretary didn't admit to this directly, the article suggests that the potential bond market crisis played a role in the decision to suspend tariffs. The piece also claims the Fed has been aware of this risk for at least two weeks prior.
Understanding the Basis Trade
The basis trade involves hedge funds simultaneously buying bonds and selling corresponding bond futures contracts, profiting from the small price difference between the two. This strategy relies on the stability of this price difference. To amplify profits, funds employ significant leverage, sometimes reaching levels as high as 50 to 100 times their initial investment.
The Unraveling of the Basis Trade
When market fluctuations, such as those caused by tariffs, occur, the prices of bonds can begin to fall. If bond futures prices don't fall in proportion, the basis trade starts to unravel. Hedge funds then attempt to reduce leverage by selling bonds, which leads to a further decline in bond prices. Margin calls are triggered, leading to further sell-offs, creating a vicious cycle where funds are forced to sell even good assets. Without intervention, this can escalate into a full-blown crisis.
Historical Context: The 2020 Crisis
A similar incident occurred in 2020, when a rapid flattening of basis trades by hedge funds contributed to pressure on the U.S. bond market during the stock market crash. This forced the Fed to launch rescue mechanisms, buying over $1 trillion in national debt in the first quarter of 2020. The current amount of basis trade activity is estimated to be double what it was in 2020.
The Fed's Dilemma
The article questions why the Fed hasn't taken action to limit the use of leverage in basis trades. The argument is that hedge funds serve as buyers of national debt, and banning the basis trade could reduce liquidity in the bond market. Furthermore, U.S. debt has lost its position as a safe asset and has become a risk asset like the stock market, as evidenced by negative returns in long-term national debt.
Investor Outlook and Uncertainty
The article suggests the stock market is likely to remain volatile. It references investor Howard Marks' memo, emphasizing the uncertainty of the current situation and cautioning against attempting to predict the end of the world. The article concludes that assuming the current downturn can be stopped is the most reasonable approach, suggesting investors should be prepared to invest in financial assets when opportunities arise.