An emergency fee reduce from the Fed? | USAEMALL.com

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As we wrote overnight, there are growing signs of stresses in the bond market. It’s hard to say whether swap spread or basis trades getting liquidated is the biggest contributor, but Treasury markets are unusually and unnervingly turbulent.

At pixel time the 10-year Treasury yield has climbed another 9 basis points to trade at 4.35 per cent and the 30-year yield has risen 12 bps to 4.83 per cent — taking the rise for both from the April 4 low to about 50 bps.

This is not what should happen when other financial markets are in turmoil, and is eerily reminiscent of the scarier bits of the Covid-19 market meltdown. It’s just not a good thing when a market that is supposed to be the ultimate safe port in a storm is suffering from its own tempest.

As a result, markets are beginning to price in the possibility that the Federal Reserve will once again have to ride to the rescue. From Deutsche Bank’s morning note, with their analysts’ emphasis below:

Given the scale of the rout, that’s raising questions about whether the Federal Reserve might need to respond to stabilise market conditions, and we can even see from fed funds futures that markets are pricing a growing probability of an emergency cut, just as we saw during the Covid turmoil and the height of the GFC in 2008.

Unfortunately, Alphaville’s Refinitiv account is on the fritz so we can’t check out exactly how likely markets are indicating this is, but it’s very understandable given the myriad signs of stress in financial markets.

Some analysts are attributing the most recent Treasury sell-off to yesterday’s weak auction of three-year notes, which raises concerns that some big investors are becoming more reluctant to keep funding the US. That might bode badly for the auction of $39bn worth of 10-year Treasuries later today, and a 30-year auction on Thursday.

However, the fact that this is a continuation of a trend ever since Friday afternoon suggests that the bad-auction explanation is itself weak. To Alphaville, this smells more like leveraged hedge fund Treasury trades getting liquidated. As a Wall Street trader told our MainFT colleagues last night: “It’s a proper, full-on hedge fund deleveraging.”

We spent most of yesterday’s post explaining the by-now infamous Treasury basis trade, but it increasingly looks like the unwind of a popular swap spread trade could also be a major contributing factor.

As you can see, the spread between Treasuries and SOFR — the Secured Overnight Financing Rate that has replaced Libor as the dominant measure of overnight borrowing costs — has become pretty extreme. This reeks of some hedge funds getting walloped:

In short, here’s how we gather this trade worked (let us know if we’ve screwed something up in the comments though):

Because of various bits of post-GFC regulation, US banks are constrained in how many Treasuries they can hold. Meanwhile, cleared interest rate swaps are less capital-intensive, which has led to swap spreads — the difference between the fixed rate bit of an interest rate swap and the comparable government bond yield — to mostly stay in negative territory for many years. Here’s a good BIS explainer.

However, at the start of the year, a lot of people were getting excited by the prospect of the new Trump administration unwinding a lot of the post-crisis regulatory edifice. In February, Barclays estimated that the scrapping of the “supplementary leverage ratio” alone could create about $6tn of “leverage exposure capacity”, which would in particular help Treasuries.

As a result, hedge funds went long Treasuries and short swaps in the expectation that the spread would flip from being deeply negative to closer to zero. But the convergence trade only works with lots of leverage. And the recent volatility will have ratcheted up margins across the board, forcing some to unwind these trades. That in turn turns the swap spread even more negative, and leads to another round of margin calls, and so on.

Aaaanyways . . . Alphaville suspect that the Fed will be loath to unveil an emergency rate cut simply to bail out mega-leveraged Treasury arbitrage trades, like it did in March 2020. After all, that was a unique threat to the financial system. This is just them being positioned foolishly ahead of a tragicomically predictable tariff shock.

However, if Treasuries keep getting caned like this the Fed might have to do something, given how troubles in the US government debt market can easily ricochet elsewhere. As Deutsche Bank noted, this is “an incredibly aggressive sell-off”.