Basis trade freakout (low key)

0:05Pushkin. There is approximately one way that finance blows up the world, and it is with borrowed money. Someone in the investing world decides, I've got a really good idea, but I want to do it not just one time, not just two times, but actually 50 times. And then something changes and the market moves against them. And then all that borrowed money has to be paid back. And oops, there's no money to pay it back. And then everything explodes. This has happened many times in finance. It will happen again. And on today's show, the hot new trade that's going to blow everything up, the basis trade. This is Unhedge, the markets and finance show from the Financial Times and Pushkin.

0:44I am reporter Ethan Wu, back from my one-show hiatus, joined today by my heroic substitute host, Katie Martin. Katie, are you sweating in your Birkenstocks about the basis trade? This is an extremely contrived combination of themes. No, I'm not. I'm keeping a level head, but I'm also keeping a very close eye on what should be a fairly sort of humdrum corner of the debt markets, but that is drawing the attention of lots and lots of regulators at the moment. Yeah, this is a complicated trade with a lot of mechanics that I think are relevant to a broader discussion. So I'm going to take a crack at it and you tell me if I've missed anything.

1:29So basis, right? In general, a basis is the difference between two very similar types of assets that are slightly different. In this particular case, we are talking about a treasury paper bond that everyone knows about, everyone loves. We talked about on the show a million times and treasury futures, which are a contract that are linked to treasury bonds for purchase or sale at some point in the future. The basis is the difference in price between what a treasury bond is worth and what a treasury future is worth. Now, pension funds, our dear friends, they like buying treasury futures. Treasury futures are more flexible.

2:09You can buy more of them with less money. They allow you to balance out a big portfolio. And just generally, they're attractive to pension fund investors. You can do all sorts with them. You can do some hedging with them to smooth out your risks. They have lots of uses. Absolutely. All kinds of stuff. So they're attractive for pension funds. And because they're attractive, there is structural demand for treasury futures. That creates a pricing difference between the paper treasury bond and the treasury future. That's the basis, right? That little pricing difference. And so if you're a very smart hedge fund, you look at the paper treasury bond market trading at$100, and you look at the treasury futures market trading at$100.05, and you say, there's an arbitrage.

2:51There's free money sitting right there for me to take it. However,$0.05 is not very much money, right? Especially if you're putting up$100 to do it. So instead of using your own$100, you use two of your own dollars and 98 of somebody else's dollars, and you have a profitable trade. There you go. Presto. The problem is those$98 of borrowed money. Did I get that all, Katie? Anything you would add? Yeah. So basically, this is the practice of taking two incredibly similar but slightly different numbers and playing them off against each other, but bolting a load of borrowed money or leverage in the kind of market parlance onto it.

3:26And it's that L word that really gets people worried because when you get situations where a trade moves against you and you've got products that are levered, very often hedge funds or whoever it is will have to not only get out of their bet, but will also potentially in this case have to sell treasuries very quickly to plug the gap and make sure that they can meet margin calls. This is the bit that's getting regulators hot under the collar or potentially even hot under their Birkenstocks, I wouldn't like to know. Because the scale of the basis trade has really rocked up recently. So the Fed put out a paper not so long ago talking about, you know, is the basis trade back?

4:08Because it had a moment where it got pretty big and it didn't end terribly well. So they're saying, has it come back? And the answer ominously is probably. And that is regulator speak. That is policymaker speak for this is something that we're watching really closely because we just keep getting these instances and they're generally not specifically connected to each other where little bits of leverage that have been shoved into pockets around the financial system just keep going pop. And one day this is going to cause what we call a financial stability risk, which, as you explained at the top of this recording, is everything goes wrong all at once.

4:45Yes. And it's not just, you know, fancy pants kind of hedge funds that need to worry about that. It's it potentially poses risk to entire financial systems. And so that's why policymakers are so keen to keep a lid on these things. Yeah, I think financial stability risk as a phrase is like a perfect example of the alphabet soup of global financial pinheads turning something scary and interesting and fun into something boring and tedious. However, that being said, this is not up, Oregon TDs, this is really important. And another one of that alphabet soup of global financial pinheads, the BIS, the Bank for International Settlements, they put the size of the spaces trade at something like$600 billion in a report that was out just a couple of days ago.

5:28That's a big trade. It's not - That's a big number. Yeah. Yeah. It's a pocket by the scale of the tens of hundreds of trillions of dollars in the global financial system, but it's not small by any means. It's not small. Also, it's built onto the world's most important market, which is Treasuries. If it was meme stocks or whatever, then, you know, okay, buyer beware. Don't mess with the Treasuries market. We don't want the Treasuries market to break because when that breaks, things go wrong very quickly. Previous examples of things going wrong very quickly include, but are not limited to, March 2020, not a great time in markets.

6:04And the point at which the March 2020 COVID crash in markets morphed from a bad thing into a terrible thing was when treasuries, which all things being equal, should jump in price because people are nervous, crashed. They went absolutely through the floor. There were lots and lots of reasons for this to happen, but one of them may have been that there were certain types of investors out there, including hedge funds, that were running these sorts of positions that unraveled very quickly and all of a sudden they found themselves having to sell treasuries even when what they probably really wanted to do was buy them because they were worried.

6:40And that's the point at which the Fed said, OK, enough of this. We're going to have to come in, rescue squad and make this go away. And over on your side of the pond, Katie, there was a more recent example just last year of something that, again, it's not exactly the same, but it has that general characteristic of little pocket of leverage and then something goes wrong and then pop. Exactly. So you have this sleepy little corner of the UK pensions market that is frankly quite boring. What is it called? The name is amazing. It'll just put you right to sleep. Gather round, children. While we explain liability-driven investment or LDI.

7:21Look, the mechanics of this thing don't matter. What does matter is there was a budget that came out from Prime Minister Liz Truss. Remember her? She was Prime Minister for like 40-something days. It doesn't matter anymore. I just remember the lettuce. That's it. Point is, she broke the gilts market, right? The UK government bonds market with this budget. Gilts fell in price really, really hard. And because of this pocket of leverage that you've got tucked away in this incredibly dull bits of the pensions market, all of a sudden hedging contracts relating to pension funds meant that people had to sell more and more and more gilts to meet margin calls.

7:55And that made the price of gilts fall further. And then they had to sell more gilts. And so you had this sudden cascade of nightmares that meant that the market got completely out of control. And again, the Bank of England had to step in. So that's how little pockets of leverage can go very wrong very quickly. Another recent example that has caught the attention of U.S. regulators is you'll remember when Silicon Valley Bank went down, right? Oh, do I? That was so much fun. Didn't we have fun? The point is, SVB dying was a bad thing. And yes, it makes perfect sense to buy treasuries when bad things happen.

8:32But after the weekend when SVB failed, the treasuries market on the Monday afterwards went absolutely postal. So people didn't just buy treasuries. There was an enormous amount of buying in treasuries to the point where the two-year yield fell by half a percentage point. That doesn't sound like very much to ordinary people. That's a lot. That's really a lot. Big move. Bad things happen when really core markets like treasuries move that quickly. You know, we don't mind if yields move half a percentage point over six months or something. We can't have it happen over a couple of hours. This is not healthy.

9:08I want to underline that point that in each of these three examples you gave, COVID, the UK 2022 gilts market crisis, Silicon Valley Bank, there's different causes. There's actually different types of leverage. There's different mechanics at play. The government bonds moved in different directions in some of these examples. They moved up in the SVB example and down in the COVID example. But it's actually not really about what the cause is or the direction things are traveling or whatever. It's about the size of the move and how quickly it happens, right? Financial markets are not always set up for giant moves overnight.

9:43That's the type of thing that causes the fund to blow up. That's the type of thing that causes people to get caught out. And that's where you have your financial stability risks. any given level of interest rates, any given market move done over a significant period of time can be metabolized. It's the suddenness that creates the problem. And I think it's a good example of when you have private actors acting in their own interests, but there's a broader socialized risk, privatized profits, socialized risks. So funds make money out of certain little market anomalies and that's fine. There's absolutely no rule against that.

10:18That's kind of what they're for. But what bothers the general public quite rightly is, okay, but if it goes wrong, why do I have to pay to stop this from going even wronger? So that's exactly what you've got people from the Fed, the BIS that you mentioned, the Bank for International Settlements, the Financial Stability Board, a bunch of different national central banks are all talking about financial stability vulnerabilities. And so they're all circling around this issue. But what I'm not seeing is any sort of answer because this is such a sprawling, unmanageable thing that I'm just not sure how they can really stop this from happening.

10:59Yeah. And it's evolved organically. I think that's important to say. There was no conspiracy to set up this basis trade in the last couple of years and to make the financial system brittle, right? There were the post 2008 regulations. There was the wave of US government borrowing we've seen in the last couple of years. Yeah. This and plenty of other things have just combined to create this setup. And unpicking that from a regulatory perspective is really hard, right? Because you don't know exactly what stops working when you try to change the setup of the financial system. It's just so much bigger and more complex than any individual actor, even highly sophisticated ones like the Fed or the FSB or whatever.

11:36Yeah, but I don't want people kind of, you know, buying tin food and guns and going to live in the hills out of panic over this. The good news is regulators are looking at this very closely and also that they've got actually quite good at hosing down incidents where this goes wrong. But, you know, do you want to live in a world where the world's most important market is vulnerable to this sort of stuff without anyone keeping any tabs on it? No. Yeah, I can think of just one type of person that would want something like this to blow up. And that's us, Katie. That's us. You're on this podcast. Crises do keep us in a job.

12:11So there is that to be said for it, I guess. But all things being equal, I'm anti. Anti in principle, forward in practice. No, we probably should not say that. Just kidding. We'll be back in a moment with Long Short. Welcome back. This is Long Short, that part of the show where we go long a thing we love and short a thing we hate. Katie, what do you got? I am long central bank decisions. There's like best part of like a dozen reasonably sizable central banks that have all got decisions over the next few days. And this is going to be a really big, really important way to tell what the health of the global economy is because it's not all about the states.

12:54We've got Norway, We've got Switzerland. We've got Bank of England. We've got Bank of Japan. I'm disappointed you did not mention the Central Bank of Brazil. Probably the most important Central Bank meeting this week. Well, look, there's so many. They're all at it. Well, they're going to be cutting, importantly. One of the first Central Banks to start cutting this cycle. South Africa, I think, is in. They're all in. Yeah, yeah, yeah. Well, Katie, I am short, and this really breaks my heart. I am short Hasan Minhaj, the comedian. The New Yorker had a rather heartbreaking piece on him last week about how he, People should read the piece, but essentially he invents facts and compresses timelines and just changes his stories to pursue a broader emotional truth as opposed to like the literal factual truth.

13:35And Hassan comes from Davis, 30 minutes from where I grew up in Sacramento. And I always used to use Hassan Minaj as like the guy I'd reference when people ask like, so who's from Sacramento? I'd be like, oh, well, you know, Joan Didion and Hassan Minaj. But now I feel like I can't do Hassan Minaj anymore. and then Joan Didion passed away last year. We're running out of like, you know, living landmarks of Sacramento. I don't know who to talk about anymore. I mean, clearly yourself is the answer there. Katie, I don't think the answer to, oh, who's from Sacramento? I don't think I can say me. Listen, Robin Wigglesworth does that about Norway all the time.

14:12You can definitely make this work. Most notable man from Norway, Robin Wigglesworth. All right, Katie, thanks for being here. It's good to be back with our normal Tuesday setup. and listeners will be back in your feed on Thursday with another episode of Unhedged. Catch you then.

14:30Hey, if you have not rated the show five stars on Apple Podcasts, Spotify, wherever you listen, we'd really appreciate you doing so. Katie, have you rated yet? I don't know if you have. No, I didn't know that was a thing. Come on, Katie. That's my fault. Don't be like Katie. Rate five stars. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free.

15:06A 90-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.