If it’s possible to write a scary-sounding or otherwise foreboding basis trade story, somebody will do it.
Disaster postmortems sell. So do tales of ostensibly esoteric trades. Happily for an ambulance-chasing financial media that excels at telling you what happened after the fact, but generally fails to warn you ahead of time, a blown-up basis, a busted convergence or RV-gone-wrong check both boxes: They’re ostensibly esoteric and they’ve been behind more than a few notable market events and dislocations.
Over the past several months, the Treasury basis elbowed its way back above the proverbial fold or at least managed to garner some attention from mainstream outlets including, earlier this month, The Wall Street Journal, where Eric Wallerstein flagged the large spec short in Treasury futures while noting that “higher yields and worries about a recession have asset managers scooping up long-term bond futures [while] the continuing influx of debt issuance has weighed on short-term Treasury prices.” The resultant gap is a small opportunity, and with a “little” leverage, it can be a much larger opportunity.
Of course, things can go wrong with convergence trades. And things have gone wrong. LTCM is the poster child. If you’re too young to remember LTCM, that’s ok because March of 2020 offered another lesson in what happens when basis trades go wrong and need to be unwound rapidly.
In their latest quarterly review, the BIS cautioned that “speculative positions by leveraged investors in US Treasurys are back.” Fernando Avalos and Vladyslav Sushko offered the following simple explainer:
Back in September 2019 and March 2020, price discrepancies between futures and the underlying cash bonds encouraged highly leveraged funds to engage in relative value trades. Recent evidence suggests that the same type of trade may be driving the current build up. When Treasury futures are priced at a premium relative to cash bonds, a common relative value trading strategy consists of selling futures forward, matched by purchases of bonds. Such a trade generates profits because the futures and cash prices eventually converge on the futures contract’s expiration date. Since the basis is typically narrow, investors need to boost profits through very high leverage, i.e., they commit little of their own capital and borrow the rest. A key way of levering up involves the long positions: Investors borrow cash in the repo market (usually having to roll over daily) by posting their US Treasury holdings as collateral.
As that short passage makes clear, this really isn’t complicated (conceptually, I mean) and it’s not esoteric either. I don’t know if everyone who engages in the cash-futures basis considers themselves an RV trader, but this is just RV at the end of the day.
Avalos and Sushko went on to detail the role of initial margin. That isn’t complicated either. When margin requirements are low, market participants tend to lever up, when margin requirements become more onerous, they deleverage (the more collateral you post, the less leveraged you are). In the event margin requirements are hiked in a hurry, or by a lot or by a lot in a hurry, chaos can ensue as positions are unwound.
Some worry the current situation, to the extent it recalls the conditions that persisted in the lead up to previous episodes, could presage a “destabilizing margin spiral,” as the BIS put it. So, does it? I don’t know. Like most latent market events, it needs a spark to get volatility moving such that leveraged positions get squeezed.
For those interested, Goldman’s Praveen Korapaty weighed in on the setup and also on the above-mentioned BIS piece. The Bloomberg trawlers among you might’ve seen Korapaty quoted on Monday. The excerpts below are from the same note:
There have been renewed concerns about the size and risks of the “basis trade” in Treasury markets, which involves selling Treasury futures and buying USTs financed in repo markets to hedge this short position. Although the trade is popular amongst levered funds, the conditions that facilitate this position are more structural. For a variety of reasons, such as leverage and the ability to earn spread, many asset managers prefer to source duration synthetically in the futures market over purchasing USTs. At the same time, large increases in Treasury supply at a time when many cash buyers have stepped back means that futures trade rich relative to many deliverable bonds. These twin elements lead to futures trading rich to USTs. Because the underlying bond and futures prices converge as the futures contract nears expiry, investors can in theory profit from selling the rich futures contracts and buying underlying bonds. However, because the Treasury-futures basis is typically narrow, positions tend to be large. A few months ago, we highlighted the uptick in levered investors’ Treasury exposures, noting that basis positions appeared set to eclipse the highs from 2019 (in dollar amounts). Since then, CFTC levered investor shorts continue to build — from the second half of last year, the increase is over $700 billion.
A recent BIS report discusses how sudden fluctuations in margin leverage could result in “destabilizing margin spirals,” specifically focusing on implicit leverage in the futures market, which is roughly the futures contract value relative to the Initial Margin (IM). It documents instances in both August/September 2019 and March 2020, when a large increase in IM appears to have precipitated a partial unwind of the trade, which led to richening of futures and widening of bases, in turn triggering further unwinds. Despite this, we do not think the trade poses a major risk to Treasury markets in the near-term. As Exhibit 3 shows, leverage in the system is materially lower than it was in 2019/20 as a result of a series of IM increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near-term, we expect to migrate to a less volatile rate regime. To be sure, margin increases could be mandated on the cash leg as part of a regulatory push, but the lower leverage levels will mean the magnitude of unwinds that are triggered will likely be smaller. From a financing perspective, the presence of sizable RRP balances will likely prevent significant increases in repo financing spreads for a while. Therefore, although the buildup in basis positions bears watching, it does not appear particularly concerning to us at the moment. More fundamentally, the position is the result of structural mismatches between the form in which duration is supplied versus the format in which it is desired, and is unlikely to be eliminated, in our view — mandating lower leverage will simply mean a wider basis.
In the end, it probably doesn’t matter. Some (many) readers already know the punchline. Jerome Powell famously bailed these trades out in 2020 (he wouldn’t call it a bailout, but he wouldn’t call QE a Ponzi scheme either).
It wasn’t the first time the Fed bailed out a convergence trade gone awry. And it surely won’t be the last.
