Lots More with Matt Levine and Mike Mackenzie

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1:01Acrobat Studio. Learn more at adobe.com slash do that with Acrobat. I want to talk about the basis trade. I have a song. A natural conversation. Basis, basis trade, basis trade. I want to talk about the basis trade. Let's do that. Matt, you've been writing about this. I have. You have. I feel like you've been writing about it for years. Well, so can I just say I commissioned the first story about the basis trade when it blew up in March 2020. And Stephen Spratt actually wrote it, but I helped him with it and gave him a bunch of stuff from Josh Younger at J.P. Morgan at the time, actually. I kind of regret not putting my name on that story because, of course, it became this huge thing that everyone's talking about.

1:44Yeah, everything I know about the basis trade I got from Josh Younger. That's not really true. No, I believe that. As a sort of philosopher of treasury markets, I feel like his philosophy of treasury markets has really influenced how I think about the basis trade. So everyone seems up in arms about it and there's all this media attention, but I feel like there's also a lot of pushback at the same time because things are different to the way they were in March 2020 when no one was expecting the kind of interest rate volatility that we saw. yeah you know i think that everything always the sort of great meta story of financial media is everyone like over learns the lessons of the last crisis and is like oh this blew up once it'll blow up again but actually a different thing always blows up again i did a deadlift one two three okay good What to?

2:37Congemini. Barges. This is an after school special, except. I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid ink pasta? These are the important questions. Is it robots taking over the world? No, I think that like in a couple of years, the AI will do a really good job of making the Outlaws podcast. And people will say, I don't really need to listen to Joe and Tracy anymore. We do have the perfect guest. Well, in the meantime, this is lots more. A weekly chat about whatever is on our minds. Matt Levine, Bloomberg Opinion columnist, is here with us.

3:17We also have Mike McKenzie, who I have worked with for a very long time at the Financial Times and who is now at Bloomberg. Mike, it's so nice to have you here. Thanks for having me. Are you enjoying Bloomberg versus the FT? Yes, I am. short and sweet i say that without her with a straight face i'm gonna make a bunch of edited out comments about bed bugs now oh oh the bed bugs oh dear okay apart from the bed bugs well i was also thinking joe's not here today so we can really geek out on the bond market but we can also just gossip about joe the email that i got about this was like we're gonna talk about joe taking a self-driving car but then of course we're not here so now you can just tell me about joe's experience taking a self-driving car oh yeah Yeah, I should say Joe's not here today.

4:02He's really, really sick, which is why I have two guests with me, Matt and Mike. Joe and I were in Austin recently, and that was really fun. We ate a lot of barbecue, a lot of Tex-Mex. And yes, Joe went in a self-driving car for the first time. We were all a little bit scared because he left late at night from this line dancing club that we were in. And we didn't hear from him until about 12 hours later. But apparently he got home safely if somewhat circuitously. Apparently the car took a really long route and he was asking people why that was. And they said it's because the car tends to take the roads that it's most familiar with or the ones that are like less risk.

4:44And it ends up taking a while. But seems to have been a good experience. It's like really capturing the human experience of being a student driver, right? It's like I'm not going to go on the highway. way i'm just gonna take the back roads how's joe's line dancing i feel like he might be an expert line dancer um i did not see him line dance that night i'll just put it that way yeah fair enough mike have you been in a self-driving car no not yet do you want to well as someone who takes four hours to drive to the mon on a friday night to go skiing on weekends in winter being able to sit in a self-driving car for four hours and get a nap will do something else would be great matt do you want to oh yeah i'm like a like a sort of disgruntled recent transplant suburbanite and like really you're like really don't like driving all the time like it's really like really diminishes my quality of life to like have to drive everywhere and if like a robot was driving me it would make it slightly better do you drive into the office every day oh no no okay but i but i drive to the train station right okay actually this reminds me I wanted to ask like what is your work day like nowadays because everyone knows you write the newsletter how early do you get up to do that uh depends like I you know I I used to say 4 30 but then I got kind of lazy so now it's like now it's like I I'm doing more of the newsletter during like regular working hours and as a result it comes out at like 2 30 instead of like noon yeah which is embarrassing but here we are i think that's okay i think i think people can wait two hours for the newsletter yeah there's something to be said for like hitting people during their lunch break but it is driven by my ability rather than anything rather than any conscious plans so it comes out when it comes out okay and how do you decide what to write about so we were talking earlier that you were talking about the the basis trade but you write about all sorts of things Yeah, I try to write about things that I find interesting and that I feel like I can say something funny about or fun.

6:50Like, you know, I try to have some sort of balance of topics. I try not to write about crypto too much. But mostly I just, you know, like I try to say, write about things where I can say something and I try to avoid like big issues where I'm just like, you know, just would say what everyone else says. Mike, how do you decide what to write about? I know you have a beat, but there's a lot going on on the Bond beat at the moment. Exactly. And actually, ever since I came to Bloomberg in late 21, the bond market's been really big story. So you come in every day and something's happening. And I mean, this week, for example, was great.

7:23Everyone was coming in thinking, OK, the bond market is going to settle down. We've got quarter end month end coming up. So we should see buyers and right out the gate on Monday morning, big block trades and futures. People are hedging for higher rates and it just hasn't stopped. So it gives you plenty to write about. And we've seen some really big, interesting moves this week. and things like geeky things like term premium, for example, it's had the biggest rise. It's actually outpaced the rise we saw in May of 2013 when the taper tantrum kicked off. That's just how big a week it's been. That's crazy.

8:00You used to be a broker as well, right? Swaps broker back in the 90s. I remember doing swaps in Tokyo in 98 when LTCM blew up and Salomon Smith Barney had to come in and unwind its yen carry trade. And it just, it was ridiculous. They basically filled every other bank on the street in a matter of hours with trades. Wow. And they kept going and going. So it just told you how big it was. And I think the yen, we had a ticker above us showing the spot yen versus the dollar and it went from, I think, 135 down to 110. It was just incredible to see that. And that was really the first time in my experience that financial markets were just so huge.

8:44I feel like that must have been a really interesting time being like a broker in the 1990s in Tokyo. It definitely was. I also worked the night shift, so I'd come in at 2 o 'clock in the afternoon and work through to midnight. Wow. And then go to Roppongi after. Yes, because I'd meet up with all the other expat brokers who were working for rivals and people go and have a beer at Magumbo's and talk about who was doing what. Oh, my gosh. I remember that place. Yeah. I wonder if it's still going.

9:18So, Mike, have you been writing about the basis trade as well? Actually, that's been something that's been covered by my colleagues. So I've sort of been an observer. I actually don't think it's that big a deal this time around. I always find it interesting when regulators start piling on and we've got Gary Gensler lining up hedge funds. the bad guys yet again. It kind of reminds me when I met with Tim Guythor at the New York Fed in 2007 and he was obsessed with hedge funds being the next, who was going to be the next LTCM and didn't really think repo was a problem. Oh, wow. And I just came away thinking they always fight the last war and I just wonder whether they're doing the same again.

9:56And also I think the basis trade this time is somewhat different. I mean, I think Goldman and other banks have pointed out that the amount of leverage is less than what we saw. and don't forget this year in the bond market you've had a lot of institutional long only bond managers piling into futures they've had a huge position long position so it's natural that the basis trade is going to be big because the taking the other side of hedge funds and given this sort of post financial crisis regulation primary dealers don't play that role they used to. So again, it's the algos, it's the likes of Virtu, Citadel, who are the new market makers, plus these hedge funds who are stepping in.

10:38And again, they're picking up steamrolls, pennies in front of a steamroller. It could go wrong, but I think the real story in the bond market now is a lot of investors are long bonds and they're underwater. And that I think is, and we already saw a first glimpse of it was back in March when the regional banks went under. And right now, if you own 10-year-plus treasuries, you're looking at a loss of nearly 9 % year-to-date. That's after 29 % dropped last year. So we're looking at three straight years of losses in bonds, which are supposed to be risky low-vol instruments.

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12:50I'm always interested in like what the basis trade is, right? Like, I mean, like I think of the Citadels and hedge funds of the world as being in this respect in the business of manufacturing a product for long-only managers, where the product is like people want to buy treasury futures and like what there is to manufacture those futures out of is bonds and so somebody does the kind of like low margin grunt work of turning bonds into futures right and that work you know is sort of necessarily levered because like you know why wouldn't it be wait i should step back and just give like a very quick summary of this trade for people who haven't been for people who have a life and haven't been following it as intensely as we have but like the trade is basically you buy treasuries and sell the associated futures contract and you get to pocket the difference or the spread between them, which is usually minuscule.

13:40And so what tends to happen is the people doing this, typically hedge funds or high frequency traders, those types, they lever up, they borrow a lot of money to amplify that spread. And in March 2020, when the treasury market started blowing up, that spread became problematic. A lot of people had to unwind the trades and then you had this sort of self-reinforcing loop where people were dumping treasuries and that was sort of fueling volatility in the wider market and it just didn't stop until the Fed kind of stepped in. So that was the major concern that this could somehow happen again. But Matt, as you point out, there's a reason this trade exists.

14:22Yeah, that story is like, okay, why does someone get long$900 billion of treasuries and short$900 billion of treasuries? What is that thing? What are the users on either side? And I think the answer is, as Mike said, long-only bond managers are getting long a lot of duration by futures, which I think is a little, I don't know, it's a little curious to me just why that sociologically exists. But I guess it's like, you know, basically it's a sort of like efficient way to get a lot of treasury. And so, you know, to get that efficiency, if you're a pension manager or whatever, like someone's right, like you're synthetically borrowing money to buy treasuries.

15:02And like to get that, someone is actually borrowing money to buy treasuries. And that someone is a hedge fund. Yeah. And I mean, we mentioned earlier, but like Josh Younger has made this point many times that treasuries exist in the financial system, but they exist in many different forms. And someone has to kind of take on that business of transformation. In this case, you offer up duration through futures contracts and it's the hedge funds doing it. But if it wasn't the hedge funds, then the, you know, the big asset managers would have a harder time doing it or potentially someone else could step in and try to provide that service and arbitrage the difference.

15:36Yeah, I mean, another thing that Josh Unger and Lev Manon point out in their paper, something that Mike said, which is that this used to be the business of intermediating treasuries used to be the business of primary dealers. And post-2007, capital and other regulations have made the primary dealers step back. And now it is the hedge funds and algorithmic traders of the world who do this. And it's like, you know, if you're worried about the basis trade right now, like you're partly worried about like unintended consequences of like tightening regulation treasury market so that the treasury market migrates to like less regulated pockets of the world.

16:13Right. Well, and the other thing I think Goldman pointed this out, was it Goldman or JP Morgan? I can't remember. But like to Mike's point earlier, when when the basis trade blew up in 2020, it was after a period of relative stability in the bond market. so no one was expecting that suddenly you would have all these initial margin, extra margin requests. But now we've had two years of intense bond market volatility. So it seems really unlikely that people are going to be completely surprised if there was a big move in the market. I could be wrong, but that does seem like it's a little bit of a cushion.

16:51I think that's a good point. Yeah, I agree with that. But I also think that the notion that this is a market that is ultimately backstots by someone and that someone is basically the Fed, I think there's truth to that. I think if you trace down what happens if people are taken by surprise and initial margin requirements do get a lot heavier, yeah, the ultimate supporter of the Treasury market is the Fed. And that's a legitimate thing to worry about. But it's also sort of like the like like like i think of like the treasury market as being a sort of like parallel to the banking system where like it is again like a sort of way of you know just as the banking system is like a way to turn like people's short-term cash like deposits into like long-term mortgages and loans the treasury system is kind of a way to turn short-term cash deposits in the form of repo into like long-term loans to the government right right and like that is just like inherently a fragile situation right it's inherently fragile for people in the repo market to expect to be able to get their money back overnight and like that money is being used to loan money to the government for 30 years and like that inherent fragility you deal with it in the same way you do in the banking system with like equity requirements with like repo you know haircuts and and and like you know futures margin but like that is 99 point whatever percent reliable and you understand that there is a fail state and the fail state is like there's some lender last resort that steps into the market if the market collapses.

18:19And I just think that people don't like to hear that. People don't like to think about the idea that there's not 100 % reliability but 99 % reliability. That's how you get this sort of financial intermediation is you take a certain amount of that kind of run risk. Yeah, and I think another really interesting aspect to this market since the Fed began tightening policies that we did see a surge of volatility, a lot of stress in liquidity measures last year. But if you talk to investors, they told you, I can still buy and sell treasuries. And I think given the fact the Fed did a number of jumbo rate hikes last year for the first time since 94 when they only did one 75 basis point hike back then, and that was always seen as the worst ever bond bear market.

19:03Well, obviously last year was the worst ever bond market for investors. but it's remarkable to me that the basis trade hasn't blown up. It's actually kept functioning and I think when you step back and look, if you said to someone, hey, the Fed's going to jack rates over 500 basis points, they're going to throw in 75 basis point rate hike shots and things are going to be fairly orderly. In fact, when I was talking to investors last year and said, how bad is it? More than quite a few of them said, well, actually, it's actually fun because it was so boring for the last 10 years when rates were slumbering around zero.

19:38He said, you're coming in every day and you're talking about where rates are going to go. We used to write stories about how boring bonds were and all the traders were complaining about it. There wasn't enough volatility. It's not boring anymore. But I think it's amazing to me looking at this, how the market has really held in. Now, I look at the credit markets and think they might be whistling past the graveyard here because spreads are still stayed in pretty tight. This has been predominantly a rate shock. Yeah. But it's also occurring when the Treasury is going to be selling a lot more Treasuries.

20:09And that, if you want to know what was the trigger for the recent rise in yields, it really began in late July when the refunding was coming. And that was a definite shock. And really, the market just hasn't stopped selling off since then. Yeah, I think this is important because a lot of this is being interpreted as a rate shock post the FOMC, the recent FOMC meeting, the sort of higher for longer narrative. But it seems like it's more of a supply demand issue. It's really interesting because normally when you ask people that question, how important is supply, they just shrug their shoulders and go, oh, it's only something at the margin.

20:43But this is what it kicked this off. And now last week's Fed meeting, I think, really did nail this because once the Fed said higher for longer, it does seem to be finally registering with bond markets that the Fed is definitely serious about this. And this week's pickup in oil prices has only added to that sort of anxiety that, well, if inflation isn't really going to come back to 2%, just how much can the Fed conceivably cut rates from here? So I think there's a lot of anxiety now. And the realization is that when you combine supply with a Fed that is on perma hold at higher levels, the Treasury curve is still below the funds rate.

21:29That's not a good look. If you think back to 2007, eventually that 10-year did get to 525, bang in line with the then Fed funds rate of 5.25.

21:46I think it's really interesting what you said about you can still buy and sell treasuries, because I think that there was, in addition to the narrative of it being boring, I think there was a real narrative in rates, but also in credit and kind of everywhere, that as banks retreated from providing balance sheet and intermediation was being done by high-frequency traders who have no balance sheet, that the market wouldn't work anymore, and that it It's fine now that the market is boring and rates never move, but if rates go up, these high-frequency traders won't be there to provide liquidity and everything will break down.

22:18And you're right, that just didn't happen at all. And it turns out that the modern system of treasury intermediation can work even in a volatile rates environment. People are worried about bond market liquidity. They really were. I have a confession, Matt. I used to write about this a lot, and your section, your title annoyed me. Well, it was meant to. legitimate concerns at the time it was although i will say i think a lot of people i think a lot of people used liquidity as a synonym for price so i completely agree with that i'm angry about the price i have to trade these at not really that i can't trade them at all right like there's like a thing where it's like liquidity like bad liquidity means like that like wide bid-ask spreads but there's another thing where bad liquidity means like the price has gone down right like you know and i don't like that's like your thing you say right that's not that's not a real liquidity thing but um but yeah no i i was uh people were very worried about bond market liquidity and i enjoyed making fun of them and i feel like you know there's like there's like ups and downs but more or less i feel vindicated by making fun of them for like 10 years or whatever it was well now wait a second wait i mean it's not like this was a complete non-issue yeah thank you thank you matt for rescuing that it's not like this was a complete non-issue though because in march 2020 again we saw treasury seize up in one way or another we saw the fed announce a corporate bond buying program that it's never done before in the end it didn't actually have to buy that many bonds the announcement was enough to kind of you know calm the market but that was i mean that was the worst case scenario you know in 2015 when we were talking about a credit market blow up the end game was always oh well maybe one day the fed will have to buy corporate bonds okay that's fair that's fair right it was an armageddon trade though everyone was yeah that's true to get cash it was it became a cash well you needed to have cash so when they start selling treasuries for that reason i don't getting back to matt's earlier point that's when the fed does step in yeah like that's true that didn't feel like you know the market functioning that people had set up just didn't work you know it felt more like you know there was an armageddon trade but yeah i hear you okay fair enough we need another credit blow up to test this thesis and we might get one.

24:38Well, okay, wait. Yeah, that's true. I mean, that's a real point, right? I mean, like, you know, as Mike said, like rates have gapped out and credit really hasn't. And like when there's a wave of bankruptcies or whatever, like, you know, how will that market function?

24:56So, Mike, you brought up SVP earlier. And I've seen at least two research notes this week, one from TD and I think one from Victor Schwetz over at Macquarie talking about the notion that maybe this is the point at which we start to see another thing break. Yeah, I'm beginning to hear a bit more talk in that direction from a few people I speak with regularly. I mean, I think the Fed did surprise the bond market by ring fencing the sovereign bank. It's not the original bank problems. So I think that's one potential wildcard as we get into the fourth quarter. And it's at a time when markets are already down for the year, which is the case for treasuries.

25:34You're going to have some investors going for a Hail Mary and probably trying to short and get on the momentum. Others are going to have to start keep cutting back. So I think Q4 could be a really interesting time for all kinds of reasons, but particularly given the way it's setting up. So you've got to keep an eye on the regional bank problems. As for credit, I actually think credit markets are completely different to what we've seen before. I think the rise of private equity and their own internal private credit funds has changed the game here. I'm not so sure that you get the kind of credit blow up.

26:07Everyone's looking for it. I mean, Howard Marks, they're all looking for this because they all want to come in and buy really, you know, bonds at big discounts like we saw, particularly in the jump bond market at the end of 2008. 2008 and in fact the money that was made by hedge funds who jumped on that trade like blue mountain for example in early 09 was just enormous so i think private equities they've got a stockpile of dry powder they're now in the credit game i think the baton was passed when um blackstone's credit fund took apart goldman sachs on a on a credit derivatives trade circa 2016 2017 i think and that they're the guys who have all the information now.

26:48They have the kind of the edge. They know these companies. They know what's going on. So I'm just not sure you're going to get the kind of credit blow up people are anticipating. And I think it's a function that, you know, private equity is now the big player in credit. Yeah. And they don't have to mark to mark it as much. Well, that's the illusion of liquidity. Yeah. All right, guys, we're going to wrap up. Last chance to gossip about Joe. any complaints you want to offload no he's sick i feel bad i didn't yeah you like i thought he had a call but you're like he's severely ill i don't want to send him yeah he is sick we should be nice to him carmen just put in like five different complaints about joe in the ib chat didn't he like did the checkout from unico or something yeah that was his other big yeah but that's been there for years along with the driverless cars yeah the things that are he's very impressed by technology nowadays

27:44Lots More is produced by Carmen Rodriguez and Dashiell Bennett with help from Moses Andam. Our sound engineer is Blake Maples. Sage Bauman is our head of podcasts. Catch you next time for Lots More. Thanks for listening.

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