Hedge funds and asset managers are in opposite camps, with leverage, posing risk of an accident.
Hedge Fund Basis Trade ‘Probably’ Back and Posing Risk
Bloomberg reports Hedge Fund Basis Trade ‘Probably’ Back and Posing Risk, Fed Says
Hedge funds have “probably” increased their positions in highly leveraged Treasury basis trades, posing a risk to financial stability, according to a research paper published by the Federal Reserve.
Even the US central bank can only guess at the magnitude of basis trades — which exploit price differences between Treasury futures contracts and the notes and bonds eligible for delivery.
The need to unwind basis trades during the global flight to safety at the onset of the pandemic contributed to instability in the Treasury market, regulators have concluded. At the time, massive volatility in bond futures sparked margin calls and contributed to the Fed’s decision to pledge trillions in stimulus.
“The Treasury basis trade is large enough for the Fed to be aware that if it does overtighten by withdrawing too much liquidity, it could cause an accident in the system,” Emons wrote in a Thursday note to clients.
Hedge Funds and Asset Managers in Opposite Camps
Recent Developments in Hedge Funds’ Treasury Futures and Repo Positions: Is the Basis Trade “Back”?
The Federal Reserve Board of Governors comments on Recent Developments in Hedge Funds’ Treasury Futures, asking Is the Cash Futures Basis Trade “Back”?
In short, the answer is “probably”, at least to some degree. The cash-futures basis trade is an arbitrage trade that involves a short Treasury futures position, a long Treasury cash position, and borrowing in the repo market to finance the trade and provide leverage.2 This trade presents a financial stability vulnerability because the trade is generally highly leveraged and is exposed to both changes in futures margins and changes in repo spreads
One hallmark of hedge funds’ basis trade positions in 2018 and 2019 involved substantial short positions in Treasury futures contracts.
Figure 3 [lead image] shows that hedge funds’ short futures positions in the 2-year, 5-year, and 10-year contracts have increased by $411 billion between October 4th, 2022 and May 9th, 2023, reaching a total of nearly $715 billion, only $35 billion shy of the previous high of $750 billion in July 2019.
One notable difference between the current rise in short futures and the 2018–2019 period is the much larger growth in the 10-year contract, and comparatively lower growth in the 2-year contract (although as discussed in the conclusion, the most recent data suggests 2-year short futures have also risen dramatically). Figure 4 [below] shows the rise in hedge fund short futures positions separately for the 2-year, 5-year, and 10-year contracts, alongside the growth in long futures positions held by asset managers.
Should these positions represent basis trades, sustained large exposures by hedge funds present a financial stability vulnerability. While the contribution of sales from the basis trade to March 2020 Treasury market liquidity remains debated, several papers suggest that absent prompt intervention by the Federal Reserve, the situation may have been far worse.
Without prompt intervention by the Fed in March of 2020 “the situation may have been far worse.”
The Fed intervened to help the market. Gee who coudda thunk?
Meanwhile, Consumers Go on a Spending Spree in July, but Income Doesn’t Match
Increased leverage is everywhere.
my source is institutional investor. maybe this will help mish and all his great readers understand what is really going on. “The big reveal for year-end 2018: Citibank, the No. 1 institution on the roster, held 87.9 million New York Federal Reserve Bank shares – or 42.8 percent of the total. The No. 2 holder stockholder was JPMorgan Chase Bank, with 60.6 million shares, equal to 29.5 percent of the total.Feb 24, 2020”
“if it does overtighten by withdrawing too much liquidity, it could cause an accident in the system”
And, as all card carrying members of the the stupid and well indoctrinated peanut gallery have been told to mindlessly regurgitate: “an accident in the system” is, you know, like, the Man on Teveeee said, like, baaaad and, like, stuff!! Yeah! And, like scary! Gommiment must, like, rob someone and, like, save the system. And, like, stuff!
“Fed Warns of “Financial Stability Vulnerability Due to Leveraged Treasury Short Positions”
If I may fix the headline….
Fed warns taxpayers will bail out banks again, be ready to be fleeced again you suckers
The only question to ask here is how do I profit from what the Fed’s warning about…I need to tag along for the ride on this money train…Choo! Choo!
As I recall covid hysteria began March, 2020. Was right at March that paper products began vanishing from grocery shelves.
5) 60% of $19T GDI ==> up from $9T to $11.4T Fed assets. Phase #3…
1) The Fed knew it was coming. Bernanke Financial Services Regulatory Act of 2006
was the greatest bank robbery in history. It was applied in 2008 to save the banks.
No printing. It was your money that saved the banks in 2008 and the comatose economy in 2020.
2) The Real GDI dented in 2012 and in 2016, but the raids saved the economy.
3) Total Fed assets are below $9T. The QT lifts the 6M, but gravity with Germany
drags the long duration down. The Fed trimmed assets in preparation for the next
recession. They know it’s coming.
4) Fed assets : 2008 was the preparation phase. The $9T was phase #1.
In Phase #2 Fed assets might reach 60% of the GDI. The Fed might support other
central banks.
@Michael Engel,
I have always suspected the Re-Build of Ukraine will be from the Fed balance sheet! They’re keeping it quiet for now, but believe me, the privileged warmongers know….cake is waiting.
Are these what were formerly known as synthetics??????????????????????????????????????????????????????????????????
You are missing one question mark, so how can anybody answer your question?
“…absent prompt intervention by the Federal Reserve, the situation may have been far worse. ”
How unlike Fed economists to pat The Fed on the back for everything they’ve done to save the world. I’m not sure one Nobel Prize is enough for the talent that fills the halls of the central banks.
They’ve known about these issues since 1982 and have turned a blind eye to the entire ballgame. I’ll leave the speculation on why they made that choice to you.
The monetary system blew up in their faces with Bear Stearns, which they hiked into because strong jobs numbers. Nothing they did to fix the problem, to add liquidity prevented B of A, or Lehman, or AIG.
Because they’ve long turned a blind eye, they can’t see what’s going on, as they admit above. They have to guess, and because this is a metastasizing problem, it rarely pops up where it just was. Issues with the spreads between German and Italian bonds caused the Gilt market to blow up. On the watch of the central banks. They had to create a facility, BTFP to help out the regionals, which were also failing on their watch. The facility just got hammered yesterday. Japanese 3mo prices jumped two days ago and stayed up today. ECB is probably fighting a losing fight in the Bund market. Volatility in the bond market… Yeah no kidding. The very entity The Fed is fighting. That’s the issue more than the actual swaps. That and how much of that collateral has been rehypothecated.
The system is creaking with tightness.If you’re a bank in this environment, ie since 2007, do you trust the CBs to be capable of saving your ass? Or that they will save your ass? Lender of last resort. More like lender too late to the party.
I don’t know.
Maybe Luongo’s right and Powell knows what he’s doing and he’s out to break the globalists in Europe through their banking system and prevent the centralization of central banking by forces not acting in the interests of Americans.
Could be, and that’s at least an optimistic take. But I see a Fed that refuses to ask the NYSE and the IFRS to force more reporting on off shore off balance sheet activities. Of derivative positions. On collateral chains. There’s on-shore things they can do. Like get off balance sheet on balance sheet. That is, after all, what money is.
Why aren’t they blockchaining treasuries so ownership and hypothecation are public? Why do these credit events keep happening?
On one hand, I’m happy, perhaps comforted is a better word, that a system of private credit and banking evolved outside of The Fed’s control. It seems to be an automatic consequence of attempts at central banking. That pleases the libertarian in me. On the other hand, this system is now holding the world back, putting everyone’s wealth in danger, a part of which is because of the fiscal and monetary policies they’ve been forced to manage over the years. The system has never recovered from the GFC, teetering on from credit crisis to liquidity facility ever since.
In a world where every crisis is leveraged to gain power, I’d prefer for the common folk to get ahead of the elites for once and figure out the best way to proceed forward, the way that benefits the most, ie the most *economic* choice and then demand those changes be implemented.
“I’d prefer for the common folk to get ahead of the elites for once and figure out the best way to proceed forward, the way that benefits the most.”
This hard working common man, like many, not only can’t figure it out the best solution, he is not optimistic of the future. Worked a lifetime for central bankers and corrupt system to blow it all up.
“The Fed intervened to help the market. Gee who coudda thunk?”
Yeah, who could’ve known that printing trillions to purchase financial assets would benefit those with the most financial assets. Amazing how that worked out.
The Fed will eventually halt QT. It doesn’t matter much whether the excuse given is providing banks with ample reserves or maintaining stability because of the Treasury basis trade or stepping in to curb a sell-off.
The important point is the Fed will likely keep an enormous balance sheet and remain committed to supporting the markets.
Although, after making housing unaffordable for the next generation and dumping inflation on the less affluent, maybe their role in the financial system should be reevaluated.
Their role is to protect the bankers at all cost . No matter the consequences to the tax payers. Their inception was to exclude anyone from not having to contribute to their institutions.l failure.
Win, win no matter the outcome.
We witnessed their collapse in 2007 to 2009, no one was jailed or attacked by the mob. There were some skirtishes and protests.
The coming failure should top the previous.
There talk of bank holiday, Money conversion to digital and personal ID scores for travel, purchases and spending.
Not a world I want to live in.
You are exactly right while we may complain about what the FED does their share holders are reaping huge benefits so the FED is doing exactly what is was set up to do. This talk about 2% inflation and full employment is pretty much hogwash as it relates to the average tax payer.
Yup. They are trying to justify the impending rate cuts. I can already hear Powell, “Our studies show……blah, blah, blah….it is more prudent to cut rates than to hold them at high levels indefinitely”.
Same thing they do every time they cause a recession.
I sense some anti-elitist, anti-bankster vibe in this comment section. So much so that I don’t feel a need to add my own vitriol.
THe beauty of the basis trade……the people doing it are on various consultative boards of….The Fed itself! Only in Murica!
The inverted yield curve makes shorting long term Treasuries very profitable.
Is is very simple and I am not sure why the explanation was not provided.
1) If we are in a recession the Dow will have to show it first.
2) The Dow 3M : The current bar (July, Aug and Sept) closed today (Aug 31) at 34,721.92 slightly above Oct 2022 ( Oct, Nov, Dec) high at 34,712.28, for the first time. That’s a good sign.
3) Sept 1929 to Jan 2000 highs resistance line is slightly above. In Jan 2021 the Dow breached above it, after 21 years, but lost its grip. If the Dow will lose its grip for the second time bad things can happen.
4) The 6M at 5.541%. The 10Y (4.114%) is dragged down by gravity with Germany and Japan.
They never intervened like that in 2008. The 2020 policies were designed to pump inflation. And certain people made out, and inside traded. Now lets talk about why unions are not the issue.
Can we talk about the, “Certain People.” Where the same people who retired from the Federal Reserve or the politicians?
The SEC is negligent since it even allows leverage on government bonds. Shorts exert selling pressure, which raises rates. This harms consumers with higher interest rates. Or consumers buy less, which reduces taxes the government collects. As Mish points out, deleveraging when bets go the wrong way threaten to collapse the financial system. None of this is good at the macro level. Futures and shorting on government debt should be outlawed. I would even extend that to bank stocks and bonds because of the systemic problems futures and shorting create.
Isn’t the basis trade what you’d expect in an efficient market? If profit was to be had by buying Treasuries, then hedging them by shorting futures, you’d expect someone to do it.
The question is, why is the arbitrage consistently possible in such large amounts? There must be lots of Treasury buyers choosing futures instead of the cash equivalents, even if the cash equivalents were cheaper?
Are these what were formerly known as synthetics?????????????????????????????????????????????????????????
Any and all kinds of nonsense dreamed up by morons, are given otherwise impossible leases on life, when the morons have all received de facto guarantees they will be protected from any possible loss. With money stolen from those less moronic, as always.