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Yesterday, our Mainft colleagues published an important story about some of the strange behaviours of the US government bond market these days. Unfortunately, it was quickly buried in an endless avalanche of other news.
The US government debt was sold heavily on Monday as hedge funds reduced the risk of their strategy and investors continued to move to cash on the third day of the Wall Street acute turmoil.
The benchmark’s 10-year Treasury yield increased from 0.19 percentage points to 4.18 percent on Monday, the largest daily gain since September 2022, according to Bloomberg data. The 30-year yield jumped to 0.21% points, the biggest move since March 2020.
. . . Investors and analysts pointed to hedge funds in particular that took advantage of the slight differences in the Treasury price, known as “basic transactions,” and related futures contracts. As large players in the fixed income market, these funds unlock their positions as they reduce risk and encourage sales at the Ministry of Finance.
“Hedge funds have been fiercely liquidating US Treasury standard transactions,” the hedge fund manager said.
As many Alpha Bill readers know, we are above average interested in Treasury standards trade, and have been ongoing ever since scaring Bezès in March 2020.
Treasury futures contacts are usually traded at a premium on government bonds that can be provided to meet derivative contracts. That’s mainly because it’s a convenient way for investors to gain leveraged exposure to the Treasury (it should just put the first margin for the nominal exposure you’re buying). As a result, asset managers are primarily Net Treasury futures.
However, this premium opens up opportunities for hedge funds to take the other side. They sell Treasury futures, hedge themselves by buying Treasury bonds, capturing the near-risk spread of some basis points. Normally, hedge fund managers don’t get out of bed due to some small BPS, but the Treasury is so solid that they can often take advantage of the transaction multiple times.
Let’s say you beat $10 million for the Treasury and sell the equal value of your futures. The Treasury can then be used, for example, as collateral for a $9.9 million short-term loan in the repository market. Then they buy another $9.9 million Treasury Department, sell comparable amounts of financial futures, and repeat the process over and over again.
It’s hard to think carefully about what leverage the typical leverage hedge funds use in financial-based transactions, but Alpha Bill is gathering that 50 normal times can occur and up to 100 times. In other words, just $10 million in capital can support as much as $1 billion in financial purchases.
And how important is total transactions? Well, that’s an incomplete measure for many reasons, but the best proxy for its overall size is the net Treasury futures positioning of hedge funds, currently over $800 million.
The problem is that if there is an extraordinary amount of volatility in the Ministry of Finance market, both the Ministry of Finance futures and the repository market will demand more collateral. And if the hedge fund cannot pony up the ponies, the lender can seize the collateral (Treasury debt) and sell them to the market.
As a result, as Apollo’s Torsten Sløk pointed out today, it is a major danger lurking in a market that should be equivalent to a bomb shelter in the financial system.
Why is this the problem? This is because cash focalter-based trading is a potential source of instability. In the case of exogenous shocks, the long, highly leveraged positions of cash treasury securities by hedge funds risk rapid rewinding. Such unwinding must be absorbed in the short term by broker-dealers, which themselves are capital-constrained. This could significantly disrupt the market functioning of broker-dealer companies. For example, it can provide liquidity to the Ministry of Finance’s secondary market and broker the market for borrowing and lending repos.
This potential vulnerability has seen exactly how a “dash for cash” by bond funds, overwhelmed by foreign central banks in March 2020 by foreign central banks and a “dash for cash” by bond funds, was forced to throw away the most sold assets they had. It stumbled upon the Treasury’s standard transactions and thwarted hedge funds that threatened to turn the troops’ liquidation troops into a fierce financial crisis.
Hercules’ efforts only by the Federal Reserve – its balance sheet expanded by $1.6tn in just one month – prevented it.
What happened on the second half of Friday and Monday is not something we saw in March 2020. In March 2020, the US Treasury Department (the bedrock of the global financial system) was not nearing a breach for more than a week. However, as our colleagues pointed out, the volatility was high, and their hard selling yesterday strongly suggests that at least some lever Treasury transactions will be forced to be liquidated.
Many regulators and policymakers are concerned about the Treasury standard trade, particularly as the Fed’s actions constituted a de facto relief for the strategy. Trade has been able to further increase these concerns since it swelled to a much larger extent than before March 2020.
Unfortunately, it is difficult to force something to do exactly that, as basic trade became a major pillar of financial market support at a time when US government borrowing costs were already rising.
As Citadel’s Ken Griffin pointed out in 2023 – when SEC’s then-head Gary Gensler had a strategy on his cross, killing Treasury trade “increases the cost of issuing new debts that US taxpayers would bear on billions or billions of dollars a year.”
So far, trade liquidation does not appear to have had a major disruptive effect on the financial market. What was scary in 2020 was how yields rose when they should fall, and how they trading perfectly in asset classes that today often see around $100 million a day trading.
If the Treasury moves higher on a risk-off day, that doesn’t seem to happen so far. However, this is something to note, as Bloomberg’s financial market liquidity (warning!) index has been a bit of a loopy rating recently.
Read more:
– Regulators scared to burn debt to the US Treasury Department (FT)
– Hedge fund trader who controls large bets on bonds (Bloomberg)
