Stop What You're Doing And Watch Bonds Now

The Treasury market appears to be having a major malfunction, with yields skyrocketing in the last 48 hours - with the 10Y yield now over 4.3% as I write this, despite Treasuries supposedly being a “safe haven” in the midst of a broad market selloff that you’d think would have the bond market calling for lower rates.

To familiarize yourself with what could be going on, please read this article that I published last week, explaining how the “basis trade” works:

"The Bailout Of All Bailouts" Is Coming

The two second explanation, if I had to give it to you, is this.

Hedge funds are way overleveraged and exposed to moves in the Treasury market via this complex trade, foreign Treasury bond holders are selling, or both. As one of the sharpest friends I have said to me at about 5PM today: “something HUGE is breaking below the surface”.

The Fed will protect the bond market at all costs, which likely means we could see significantly more shock and downside to markets and the system before “the bailout of all bailouts” — if my friend is, in fact correct.

As usual, Zero Hedge was ahead of the story, noting back on March 28th that all of a sudden the Fed was being asked to explore a bailout for the Treasury basis trade:

According to the experts, a vicious unwinding of the roughly $1 trillion in hedge fund arbitrage bets would not only hamper the Treasuries market, but others as well, "requiring Fed intervention to assure financial stability."

When the US central bank did that in March 2020, during the initial Covid crisis, it engaged in massive outright purchases of Treasury securities, to the tune of about $1.6 trillion over several weeks.

…

What is far more scary is that the average regulatory leverage, or the ratio of regulatory assets (i.e., levered exposure) to assets under management (or actual, tangible capital), has increased to a record 7.8x from 6.3x a year ago!

…

Kashyap also echoed what we have been saying for years, that the basis trade "is a pretty concentrated trade,” involving perhaps 10 hedge funds or fewer.

If hedge funds need to unwind their basis pair trade positions quickly, similar to what they did in Sept 2019 and March 2020 when the move itself crippled the entire bond market, the danger is that bond dealers will not be able to handle the enormous sudden volume of transactions. And consider this: when the Fed had to intervene in 2020, the basis trade was roughly $500 billion in total — less half today’s figure.

“To relieve the stress on dealers, it would be sufficient for the Fed to take the other side of this unwind – purchasing Treasury securities, and fully hedging this purchase with an offsetting sale of futures,” the authors wrote.

And just minutes ago, one of my favorite investors that I love reading and following, Harris Kupperman, has offered up his thoughts on the entire mess.

Harris is the founder of Praetorian Capital and one of my favorite follows and I find his opinions - especially on macro and commodities - to be extremely resourceful. His thoughts are below.

Please be sure to read both my and Harris’ disclaimers, located at the bottom of this post.

“I’m terrified that bonds are acting like the next leg down is starting soon…”

Emerging Market governments are highly attuned to changes in their bond markets. This is because they risk getting cut off from funding at any sign of stress. Often-times, Emerging Market leaders will do crazy things that appear inexplicable to outside observers. At such a moment, the bond market comes to the forefront, because if bonds rebel, it becomes incredibly difficult to reassert control of the situation later-on, especially as funding costs explode, driving deficits higher in a feedback doom loop.

In many ways, this is the curse of an Emerging Market that doesn’t act with fiscal prudence. We’ve seen this most recently in Brazil, where the Central Bank has been forced to raise rates each time Lula got out of line. The risk of a bond rout was too great if they didn’t. The thinking was that it was necessary to stop the long end of the curve from blowing out, even if short term economic pain had to be doled out through higher short-term funding costs.

I bring this up, because Scott Bessent has been on a never-ending roadshow for his bonds. I like to joke that he’s gone on podcasts that I wouldn’t even consider appearing on. He’s been pumping his bonds to anyone and everyone; yet has very little to show for it. I’m going to use TLT, just because it’s a liquid mark on the curve that we all grudgingly track.