Basis Trades Bite

The Credit Strategist Blog

Markets are reeling as they seek steady ground as the aftershocks from President Trump’s tariff earthquake continue. While the media focuses primarily on stocks, the government bond market (at least for now) is starting to suffer sharp losses after initially rallying in the wake of Liberation Day. Ten-year Treasury yields are back to 4.37% as this is written, up from under 4% a few days ago. Higher interest rates are the last thing the markets need right now. But interest rates aren’t rising for fundamental reasons in government bonds (they are rising for fundamental reasons in corporate bonds as they should - yields were far too low in that market). They are rising because large hedge funds were using enormous amounts of leverage to try to squeeze a few basis points of profit out of ostensibly hedged heavily leveraged US Treasury “basis trades” while believing (praying?) they won’t blow up (and if they did that the Fed would come and bail them out again like it did in 2020). Let’s hope these trades don’t blow up but that if they do that the hedge funds are left to take their medicine.

Basis trades involve hedge funds taking advantage of small differences in the prices of Treasuries and associated futures contracts to generate profits. They involve the use of enormous amounts of leverage (as much as 50 to 100 times) which means they can trigger large losses when go wrong (for example, when markets suffer unexpected volatility as they are doing now). When volatility rises, prime brokers require the hedge funds to put up more collateral which reduces the potential profitability of these trades and generally leads to the trades being unwound. This becomes a source of selling and instability in the market because it places pressure on all of the participants in the Treasury market. Funds are like wolves and tend to trade in packs in today’s momentum-driven markets. And that’s what we seem to be seeing now in Treasuries.

Any trade that uses this much leverage can be compared to trying to pick up pennies in front of a steamroller. After all, one has to ask whether any trade that requires ridiculous amounts of leverage to generate a profit is particularly attractive in the first place (my answer is a resounding “No!”). These trades are hedged but hedges have costs and there are no perfect hedges especially in a highly volatile market. In March 2020, the US Treasury market nearly blew up due to hedge funds (reportedly led by Citadel and Millenium but there were others) carrying huge volumes of leveraged basis trades. The Federal Reserve had to inflate its balance sheet by $1.6 trillion in a single month to prevent these funds from blowing up and creating a financial crisis (shades of heavily leveraged Long Term Capital Management in 1998). The bailout of these huge hedge funds was largely kept under wraps but points again to the fact that America has a system of socialism for the rich and capitalism for the poor. Proponents of the basis trade - including Citadel’s Ken Griffin - correctly argue that it helps lower overall debt issuance costs for the US government. But whether Mr. Griffin and others should be rewarded with billions of dollars of bailouts for providing this public service at the risk of creating a financial crisis is a question worth asking.

In any event, basis trades are only some of the positions being unwound in the wake of President Trump’s tariffs. Just like we were in an “everything bubble,” now we are in an “everything sale.” But basis trades have significant systemic consequences because they contribute to higher interest rates. One would normally expect a flight to quality trade that pushes down Treasury yields as investors flock to the safe haven of government securities, but instead many of these securities are being dumped to reduce dangerously high amounts of leverage that pose existential threats to the hedge funds that hold them. This is the type of trade that could only exist in a system drowning in debt. I’m sure the Fed is watching this closely to see if it needs to intervene again like it did in 2020. Keep an eye on their balance sheet during this period to see if they had to bail anybody out again.