By Jen Saarbach & Kristen Kelly, Co-Founders of The Wall Street Skinny
There’s been considerable speculation that last week’s bond market chaos wasn’t caused by a loss of confidence in U.S. assets due to tariff policy announcements.
Rather, some argue, massively levered hedge funds unwinding something called “the basis trade” was perhaps to blame.
Bloomberg ran several articles on this subject, and Torsten Slok (Apollo’s chief economist) published this piece. On the “All In” podcast, we heard a theory that the move came from “Japanese hedge funds” blowing up. Seems unlikely, though perhaps this was a conflation of “hedge funds blowing up” whilst “Japan sells U.S. Treasuries.
Understanding the Mechanics Behind Interest Rate Trades
In order to understand these theories, we need to get a little technical.
First, you need to understand that there are two basic ways that investors can get long interest rates: buying cash bonds, or using derivatives.
Buying cash bonds means physically purchasing things like U.S. Treasuries, say $100mm 10 year notes. That purchase can be done one of two ways:
- Spending $100mm of your own money, or
- Financing a long position in the repo market by borrowing some portion of $100mm and pledging the Treasuries as collateral for that loan.
The latter is a leveraged position, where you might put up say $10mm of your own cash and borrow the remaining $90mm to buy $100mm worth of bonds. The interest rate you pay on the financing for that loan is typically the General Collateral rate, or “GC”.
You have many options on the derivatives side, but perhaps the most liquid is buying Treasury futures. It is a contract wherein the seller promises to deliver physical US Treasury bonds to the buyer at expiry. Futures give you exposure to the corresponding part of the Treasury curve — TY futures correspond to the 10 year sector — in a highly levered way.
Unlike the heavy balance sheet associated with a cash bond purchase, only a small cash outlay of margin is required upfront. No bonds change hands until physical delivery is taken. The contract will specify an eligible basket of bonds that can be delivered for contract settlement, one of which will be mathematically “cheapest to deliver”.
All else being equal, because futures are much less balance sheet intensive and offer levered exposure, they are more desirable than their cash counterparts for buyers like long only bond funds, big asset managers, pension funds, etc. This makes futures structurally “rich” relative to the very same cash bonds that can one day be delivered into that contract.
The Basis Trade Explained
Hedge funds look to arbitrage this price differential through something called the “basis trade”. They BUY the cheaper cash bonds, accessing leverage through the repo markets, and SELL the richer futures contracts, knowing that the two prices should converge as you approach contract expiry.
On paper, this looks like a low-risk carry trade, and only worth a handful of basis points at best. So in order to make the trade worthwhile, hedge funds lever up 20x, 50x, or perhaps even 100x through the repo markets to make the investment worthwhile.
Like all carry trades, it’s “up by the stairs, down by the elevator shaft.” If there is suddenly massive pressure on US Treasuries relative to futures — like we saw last week, due to decreased confidence in the credibility of the US government — the bonds these hedge funds own start collapsing in price. This triggers massive mark to market losses, especially for those operating with extreme leverage.
If hedge funds are forced to stop out — either by their risk controllers or investors — unwinds of this trade would sharply exacerbate a selloff in Treasuries.
And indeed, we’ve seen reports of hedge fund portfolio managers getting stopped out in the last week. However, the order of magnitude being reported here is nowhere near sufficient to explain the broader move we saw in Treasury markets. And without massive dislocations in the repo market, there’s nothing to suggest a funding crisis that might trigger Fed intervention (which is what we saw the last time the basis trade blew up, in 2020).
Instead, we think basis trade blowups may instead be a symptom, rather than the cause, of bond market chaos. The moves in the market last week seem much more indicative of a growing unease with the fundamentals of US debt and the shifting dynamics of investor attitudes towards US dollar denominated assets.
For our full detailed breakdown on the basis trade, swap spreads, and potential Fed action, click here!