I want to talk about the Basis Trade. I have a song from 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 to. I feel like you've been writing that for years.
Well, so can I just say I commissioned the first story about the Basis trade when it blew up in March twenty twenty, and Steven Spratt actually wrote it, but I like helped him with it and gave him a bunch of stuff from Josh Younger at JP 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.
Yeah, everything I know about the Basis trade I got from Josh Younger.
Yeahes not really trade it like, no.
It's a sort of like philosopher of treasury markets. I feel like he he 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 twenty twenty, when no one was expecting that the kind of interest rate volatility that we saw.
Yeah, you know, I think that everything always that sort of great metastory of financial media is everyone like over learns the lessons of the last crisis, and it's like, oh, this blew up once, it'll love again. But actually a different thing always blows up again. I did a deadlift one, two, three, Jimmy, Okay, so many up marches.
This isn't 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 US.
Where's the best imposta?
These are the important question? Is that 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 odd launch podcast And people say, I don't really need.
To listen to Joe and Tracy anymore.
We do have the.
Well in the meantime, this is lots more.
A weekly chat about whatever's on our minds.
Matt Levine, Bloomberg opinion columnist, is here with us. We 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 shortened with a straight face.
I'm going to make a bunch of edited ed Commons bed bugs.
Then, oh oh, the bed bugs.
Okay, okay, from the 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 going to tell you 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, I should say, Joe's not here today. He'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 like line dancing club that we were in, and we didn't hear from him until about twelve 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 are the ones that are like less risk, and 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, I'm not going to go on the highway. I'm just going to take the back roads.
How was Joe's line dancing? I feel like.
I did not see him line dance that night. I'll just pay that.
Is this?
Yeah?
Fair enough? Mike. Have you been in a self driving car?
No, not yet.
No? Do you want to, Well, there's somebody who takes four hours to drive to the morning on a Friday night to go skiing on the weekends and winter. Being able to sit in a self driving car for four hours and get an apple'll do something else will be great.
Matt. Do you want to?
Oh? Yeah, I'm like like a sort of disgruntle of the recent transplant suburban night and like really really don't like driving all the time. Like it's really like really diminishes my quality of life to like you have to drive everywhere, and if like a robot was driving me, it would make it slightly.
Better drive into the office every day.
Oh no, no, no, okay, but I bet I drive to the transition right.
Okay, Actually this reminds me. I wanted to ask, like, what is your workday like nowadays? Because everyone knows you write the newsletter, how early do you get up to do that?
It depends, like you know, I used to say four thirty, but then I got kind of laziest. It's like now it's like I am doing more of the newsletter during like regular working hours, and as a result, it comes out at like two thirty 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 basis trade, but you write about all sorts of things.
Yeah. I try to write it out things that I find interesting and that I feel like I can say something funny about or fun like, you know, I try to have some sort of balance of topics. I try 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, eh, you know, I 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 twenty one, and the bomb market's been really the big stories. So you come in every day and something's happening. And I mean, this week, for example, was great. Everyone was coming in and thinking, Okay, the bomb market's going to settle down. We've got quarter in a month and coming up, so we should see buyers. And right out the gate on Monday morning, big block drays in 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 examples. The biggest rise it's actually outpaced the rise we saw in May of twenty thirteen when the tape a turntrum kicked off. That's just how big a week it's been.
That's crazy. Used to be a broker as well, swapsbroker back in the nineties.
I was around. I remember doing swaps Tokyo in ninety eight when LTCM blew up and Salomon Smith Barney had to come in and unwined it's 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 what
one thirty five down one ten. It was just incredible to see that, and that was really the first time in my experience at financial markets, we're just so huge.
I feel like that must have been a really interesting time being like a broker in the nineteen nineties in Tokyo.
It definitely was. I also worked the night shift, so I'd come in at two o'clock in the afternoon and work through to midnight.
Wow. And they go to a punky after.
Yes, because I'd meet up with all the other expat brokers who are working for rivals and go and have a beer at my Gumbo's and talk about who was doing what.
Oh my gosh, I remember that place.
Yeah, I wonder if it's still going.
So, Mike, have you been writing about the basis trade as well?
Actually does mean something to be 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 regular to start piling on and we've got Gary Gensler lining up hedge funds as
the bad guys. Yet again. It kind of reminds me when I met with Tim Guy through New York FED in two thousand and seven, 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. And 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 bomb 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 we used to. So again it's the algos, It's likes of Virtue Citadel who are the new market makers, plus these hedge funds who are stepping in and again they're picking up steam rolls, pennies in front of a steamroller.
It could go wrong, But I think the real story in the barb market now is a lot of investors are long bonds and they're underwater, and that I think is, and we already saw our first glimpse of it was back in March when the regional banks went under. And right now, if you own ten year plus treasuries, you're looking at a loss of nearly nine percent years to date,
up to twenty nine percent drop last year. So we're looking at three straight years of losses and bonds, which is supposed to be risky, low vol instruments.
I'm always interested, like what the basis trade is, right, Like I mean, like I think of the Citadels and hedgehones 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 features, 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. And 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 twenty twenty, when the treasury market started
blowing up, that you know, 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 that was the major concern that this could somehow happen again. But Matt, as you point out, yeah, I mean there's a reason that exists.
Yeah, that's like okay, like why is there like why like why does someone get long you know, nine hundred billion dollars of treasures and short nine hundred million dollar to like what is that thing? Like what are the users on either side? And I think the answer is, you know, as Mike said, like long only bond managers are getting along a lot of duration by futures, which I think is a little I don't know, it's like a little curious to me, which is why that like
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, and like to get that someone is actually borrowing money to buy treasuries, and that's someone is a hedge fund.
Yeah, 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.
Yeah. I mean another thing that Josh Hunger and left Manon point out on their paper that something that Mike said, which is that this used to be you know, the business of like intermeding treasuries. Intermediating treasuries used to be the business of primary dealers, and like post two thousand and seven, capital and other regulations have made the primary dealers step back, and now it is the headgehuns 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 the like less regulated pockets of the world right well.
And the other thing I think Goldman pointed the stat 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 twenty twenty, it was after a period of relative stability in the bond market. 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 spawn market volatility, so it seems really unlikely that people are going to be completely surprised if something, you know, 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.
I think it's a good point.
Yeah, I agree with that, But I also think that like the notion that like this is a market that is ultimately backstops by someone, and that someone is basically the fad. Like, I think there's like truth to that.
I think if you sort of like trace down like what happens if like people are taken by surprise and like you know, initial margin requirements do get a lot heavier, like like yeah, like the ultimate you know, sort of supporter of the treasury market is the FED, and like 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 prepo 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 repoul 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 thirty 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 repubm, you know, haircuts and and like you know future's margin.
But like that is ninety nine 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 in to the market if the market collapses. And I just think that, like people don't like to hear that, you know, PEO. People don't like to think about the idea that there's like not one hundred percent
reliability but ninety nine point whatever percent reliability. That's just like sort of that's like, 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 titling policies, that we did see a search volatility, a lot of stress and liquidity measures last year. But if you talk to investors, they've told you I can still buy and sell treasures. And I think given the fact the FED did a number of jumbo rate hikes last year for the first time since ninety four, when they only did one seventy five basis point hike back then, and that was always seen
as the worst ever bond bear market. Well, 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 he said to someone, hey, the Fed's going to jack rates over five hundred basis points, They're going to throw in seventy five basis point rate hike shots, and things are going to be fairly orderly.
In fact, when I was talking to investors last year, 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 ten years when rates was slumbering around zero. He said, you're coming in every day and you're talking about where rates are going to go.
I used to write stories about how boring bonds were, and all the traders were complaining about it.
There wasn't enough vault.
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
sayed in pretty tight. This has been predominantly a rate shock, but it's also occurring when the Treasury is going to be selling a lot more treasuries and that if you want to know what was the trigger for the recent rise in the lee 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 the shoulders and go, oh, it's only something at the margin. But 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 pick up in oil prices has only added to that sort of anxiety that, well, if inflation isn't really going to come back to two percent, where 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, that's the treasury curve is still below the funds rate. That's not a good look.
If you think back to two thousand and seven, eventually that tenure you'd get to five twenty five, bang in line with it. Then FED funds rate of five on a quarter.
Things 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 like banks retreated from providing balance sheet and like you know, intermediation was being done by like high frequency traders who have no balance sheet, that the market wouldn't work anymore, and
that it was like, it's fine now that the market is boring and rates never moved, but if rates go up, like these hyper council traders won't be there to provide liquidity, and like everything will break down. And you're right, that just didn't happen at all. And it turns out that like the modern sort of system of treasure, intermediation can work even in a volatle rates environment.
People are worried about on market.
Like I really were.
I have a confession, Matt. I used to write about this a lot and your 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 liquid like bad liquidity means like bad like wide bit ass spreads. There's another thing where bad liquidity means like the price has gone down, right, like you know, and that's like your thing. You say, right, that's not that's not a real liquidity thing. But but yeah, no, I was. People were very worried about bound luck at 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 making in front of them for like ten years or whatever.
Well now wait a second, wait, I mean, it's not like this was a complete non ish. Yeah, thank you, thank you Matt for rescuing that. It's not like this was a complete non issue though, because in March twenty twenty, again we saw treasury sees 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 twenty fifteen, 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.
Well it wasn't on the getting droid though. Everyone, Yeah, your treasures to get cash. It became a cash well he needed to have cash. So when they started selling treasures for that reason, getting back to Matt's earlier point, that's when the Fed does step in.
Yeah, that didn't feel like, you know, the market functioning that people had set up just it didn't work. You know. It felt more like, you know, there was an hour get in trade.
But yeah, I hear you fair enough, but we need another credit blow up to test this thesis and we might get one. Well okay, wait, yeah that's true.
I mean that's a real point, right, I mean, like you know, as I said, like rates have got that and credit really hasn't. And like one there's a wave of bankruptcies or whatever, like you know, well how will that market function.
So, 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 maccrory 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 bar market by ring fencing the sovereign bank. It's not not the original bank problems, So I think that's one potential wild card. As we get into the fourth quarter and set a time when markets are already down for the year, which is the case for treasuries, You're going to have some investors going for a Hall Mary and probably trying to
short get on the momentum. Others are going to have to start keep cutting back. So I think Q four 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 own 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 everyone'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 the jump bomb market at the end of two thousand and eight, And in fact, the money that was made by hedgehoons you jumped onto that trade like Blue Mountain for example, in earlier nine was just enormous.
So I think private equities they've got to stockpile of dry powder. They're now in the credit game. I think that the toon was passed when Blackstone's credit fund took a part Goldman Sachs on a on a credit through his trade circ at twenty sixteen, twenty seventeen. I think and that they're they're the they're the guys who have all the information now, they 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 and credit.
Yeah, and they don't have to mark to market 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 sick, I feel bad. I thought he had a call that.
You're like, it's really yeah, he is sick. We should be nice to him. Carmen just put in like five different complaints about show in the IB channel.
Didn he like the check out from Nico or something? Yeah, that was Yeah, that's been there. That along with the driverless carse the things that he's.
Very impressed by technology nowadays. Lots More is produced by Carmen Rodriguez and dash Ol Bennett, with help from Moses Anda. Our sound engineer is Blake Maple.
Sage Bauman is our head of Podcasts.
We'll catch you next time for lots More.
Thanks for listening.