THE ONGOING BASIS TRADE FALLOUT
EDU DDA Apr. 15, 2025
Summary: While repo and the Treasury market are calm again today, the issue of liquidations in the market continue to be raised. Officials are pointing to a “toolkit” which includes regulatory changes as well as rejiggering bond/note auctions to enhance, supposedly, buying power. Also, we look at the potential for a “hedge fund” bailout and just as importantly why no one will address the real problem as it is at its source. Finally, should more basis trade, reserve-manager selling erupt, we’ll examine what that might mean for rates and Treasuries overall.
THIS IS NOT WHY BONDS GAINED, NOR IS IT ENCOURAGING THOUGH ITS TRUE PURPOSE IS TO BE.
The fact that Treasury officials starting with the Secretary himself continue to talk about the SLR underscores just how much of a problem last week’s selloff in Treasuries is proving to be. There is likely a Federal Reserve program also on the table somewhere, just not officially and publicly. All of it is pure symbolism, a way to establish some cover for all the chatter suddenly alive on what is supposed to be the deepest and most dependably liquid market (though that title really should be reserve for swaps, which might be more of an apples to oranges comparison).
That’s the thing – Treasuries are the most dependable security, so what would that mean for the scale and intensity of the real problem creating the selling in the first place?
With conditions moving to the calmer side this week, market yields have slid all over again if only to prove in the short run what we’ve already seen several times before: the selling is not a fundamental reassessment of financial and economic risks (read: inflation), it is driven by monetary difficulties that continue to go on unaddressed, with the attention to the SLR showing it will continue to be that way into the foreseeable future.
No one wants to point out how Emperor Jay is, first, completely naked, and, more importantly, not actually emperor of anything. He’s just a crazy guy parading around nude and we’re all just supposed to bow and scrape every time he gestures or opens his mouth. This is the key reason behind everything as it relates to the basis trade, Treasuries, even the government’s response, and proposed response, to the matter.
To help clear up these issues, I’ll break them down into four broad categories:
1. What is the SLR and why is anyone offering these three letters as possible relief? Would it be?
2. What are Treasury “buybacks” and what do they have to do with basis trading? Might they be helpful in this context?
3. As to the Fed, will there be a hedge fund bailout? Why are there only ever bailouts?
4. What happens to the Treasury market should there be another round of basis trading, FOI selling?
1.Why do they keep bringing up the SLR?
The Supplementary Leverage Ratio is something authorities came up with following the 2008 crisis once they realized capital ratios were, to put it mildly, inadequate measures of bank risk. The risk-weighted system started out with a logical basis, and it was predictably taken advantage of over its many years of untested operation.
The initial Basel construct itself, as noted yesterday, grew out of the difficulties regulators had trying to manage bank risk from a liability side they no longer understood, and couldn’t monitor effectively even if they did. It used to be that bank examiners needed only to send a postcard to “examine” then assess a bank’s liquidity position, how many lawful reserves were in its possession.
I’m oversimplifying here, too, since even the earliest days of the correspondent system in the 19th century presented numerous complications owing to banks holding deposits with other banks who held deposits with bigger banks aggregating interbank liabilities in the largest institutions. Effectively, you did have some idea how “shaky” a bank might have been given by how much cash it had, plus the various ways it could raise cash in case of emergency.
A REAL EXAMPLE FROM A 19th CENTURY BANK EXAMINER HANDBOOK.
This isn’t to say regulators took little or no notice of a depository’s asset side. They certainly did, and from very early on even came up with quantitative measures to assist in examinations. Banks, keenly aware of those, sought to game them with primitive forms of window dressing right from the start. Human nature never changes even as the forms might get radically redrawn.
What did change, from a government standpoint, was the loss of relevance over bank cash in the dramatic shift to purely ledger formats depending more on wholesale funding including repo. Authorities gave up on that to focus instead almost exclusively on banks’ assets to try and gauge even measure soundness.
Rather than require them to hold a standard amount of capital as a buffer against losses, the Basel rules (building on the Uniform Net Capital Rule developed in the seventies by the American SEC discussed yesterday) naturally gave relief to assets perceived of as relatively low risk. You wouldn’t need to hold much of a capital buffer against a portfolio of something like sovereign bonds issued in their own currency since the potential for default is effectively zero. Understandably, a tiered structure was adopted.
Banks immediately scoured accounting as well as banking rules to find ways which would allow them to turn riskier assets into safer ones, both for investment as well as these regulatory purposes. Like pretty much everything Wall Street comes up with, it started out from legitimate desires and good faith. It just as quickly came to be abused.
Using techniques like VaR assessments or employing credit default swaps (issued by empty balance sheets), risky assets were given very low risk weights so that by 2008, the capital rules made it seem some of the riskiest banks were “well capitalized” right up until the moment they became insolvent. Capital ratios, it turned out, didn’t inform anyone about the true scope of any bank’s activities.
Following the crisis, global regulators came up with a less-engineered framework which removed risk-weightings, thereby taking away the ability of institutions to essentially cheat their way to balance sheet efficiency. The SLR was added to ensure larger firms would be even “safer”, requiring them to hold even more capital once measured “properly” without any changes to measurements of asset compositions.
Assets like Treasuries and even bank reserves held with the Fed were treated the same as any other risky credit.
Banks hate the SLR and have from its inception because it makes their business more costly as they might get bigger. For academics and policymakers, this is a binding constraint. And it might be in reality, if only understanding the real impediment isn’t the regulation, it’s exactly what I focused on in yesterday’s DDA: risk.
There is no position a bank won’t take if they feel the opportunity, the possible return, is worth the risk. If banks decide risks are high, they obviously need more return to jump at the potential. The SLR simply makes that threshold slightly higher.
For low-risk instruments, it’s a consideration though not the overwhelming obstacle it is being made out to be; especially now where Treasuries yield a decent enough coupon plus offer quite a bit of upside as deflationary conditions might continue to develop.
It would be worth the higher SLR constraint…assuming no other parameters. We never live in ceteris paribus.
And that’s just for owning them. There are other considerations, another matter almost entirely, where it comes to making markets in the space, for dealers. But this, too, misses the point. The problem with the basis trade blowup, like that with foreign reserve manager selling, isn’t who might be able to buy, rather why there is so much selling in the first place.
The way officials talk about this, it sounds like they are having to incentivize if not subsidize, in a way, Treasury buying when that’s entirely false. For strictly the basis trade, there is nothing has changed about the trade itself (shorting futures, going long cash Treasuries) or the long portion of the transaction. Hedge funds are not selling because they suddenly discover something wrong with government bonds they didn’t notice yesterday.
It's entirely about repo funding. They can’t dependably maintain the leverage to fund the long side of the basis trade. Period. Full stop. It isn’t about finding buyers; it’s the monetary shortage which creates sellers. All any SLR proposal seeks to do is find a few extra buyers who might be willing to step up and rebalance the economics.
Dealers are, by the nature of this systemic condition, unwilling or unable to do so. If repo is breaking down, since they’d fund warehousing any Treasuries they might buy in the same repo market that is causing the reversal in the basis trade to begin with, they aren’t going to switch to being buyers even if Treasuries are taken out of the SLR calculation.
The same goes for pretty much every other possible Treasury buyer, too. No one (except regular folks like you and me) purchases something like a Treasury note or bond with their own money (equity). There is leverage/funding coming from somewhere, and it’s that funding/leverage which needs everyone’s attention.
It’s always the selling, not lack of buying. Authorities know this, too (see: Question 3 below).
2. Buybacks
Treasury buybacks were reintroduced last year and have been conducted on a regular basis since May 2024. Their purpose is to “enhance liquidity” in what’s supposed to be – and actually is - the deepest market in the financial world (aside from swaps!) Even FRBNY, Treasury’s agent when conducting buybacks, feels compelled to remind everyone of this fact from very nearly the top of its own description of the tactic.
The reason is, as stated above, the problem is really about liquidity, a fancy way of saying money isn’t flowing into the deepest market like it should (since it comes from repo!)
In reality, only a small portion of outstanding Treasuries can be considered “liquid.” For example, a 30-year long bond that was issued twenty-five years ago and has been sitting in some insurance company portfolio (or reserve manage holdings) for all that time might technically count as a five-year maturity, but is in reality nothing like a freshly-issued five-year note which more accurately reflects the financial characteristics of today.
The yield on the 25-year-old 30-year bond might be close to current conditions, but the bond’s price and coupon are likely to be way out of alignment.
In March 2020 like October 2008, foreign sales of these off-the-run (OFR) securities overwhelmed the market’s ability to handle them.
In normal times, a dealer will take the transaction, funding it some way in repo (even going so far as to post some other Treasury the dealer has in its inventory as collateral, or borrowing some other one) only to warehouse the security until another secondary market buyer can be found to take it off its hands. Since OFRs might take a little time for the dealer to offload, the only “liquid” market for OFR instrument is effectively dealer balance sheets.
What Treasury buybacks do is attempt to enhance that aspect. The government intentionally sells more of another kind of debt which is liquid, mainly Treasury bills, than it needs to fund its operations. The Department then uses the additional proceeds to purchase and retire some old OFR securities dealers might have had to warehouse.
Effectively, the government adds more liquid securities the market wants while removing illiquid ones which could become trouble under strained conditions, giving dealers another way to dispose of otherwise illiquid assets which might have been sold to them under stressed conditions.
This isn’t immediate, obviously, and the auctions are handled, as always, in rigidly bureaucratic fashion. In other words, buybacks might help at the margins but are in no way an answer to the problem at hand – even the buyer side of it. Obviously, this does nothing to address the selling.
Secretary Bessent yesterday ominously sounded like the Fed when he said the government has “a big toolkit that we can roll out”, specifically pointing to buybacks as being in it. Also like the Fed, this is mainly for public consumption, to reassure anyone (who doesn’t with to think to deeply on the matter) who might feel wary they shouldn’t worry.
Again, the worry isn’t buyers but sellers.
3. Hedge fund bailout
I have not seen anything which confirms – or denies – the Federal Reserve is working on the so-called hedge fund bailout proposed recently by a group at Brookings which included former Fed Governor Jeremy Stein. For reference, I did an entire YT video on the matter which you can access here.
Its purpose is easy enough to understand: the Fed would buy Treasuries hedge funds are forced into selling. Yes, this is yet another attempt to address the symptoms rather than the overarching cause (SELLING!) However, in many ways this fits perfectly with the Federal Reserve’s actual mission as the former-central bank sees it.
The technical term is market-of-last-resort. In many ways, officials concede they don’t operate a central bank, not one in the traditional mode. There is the emphasis on interest rates rather than money, already a concession to this categorical shift. The point was driven home if very quietly, under the public radar, by the 2008 experience.
A traditional central bank operates under the Bagehot doctrine, or something close to it, attempting to create elasticity in the currency system. As I discussed in some detail here (and will come back to this topic in the near future), there are legitimate questions (no one ever asks) as to whether any central bank in any capacity has ever been successful at the effort.
Regardless, the point is to maintain elasticity which is another way of saying liquidity: to supply currency of whatever kind and format so that markets don’t get hit with selling in the first place. To attack the problem at its source – to address that selling I keep going on about.
This is the lender-of-last-resort.
In order to do that, a central bank would need some way to create and, more importantly, effectively circulate the kind of currency that is in demand. The eurodollar removed that capacity decades ago, even assuming the Fed ever really had it to begin with (see: Florida 1929).
Officials are aware of these limitations, and those who might not have been before August 2007 came to be by March 2009. Confronting them, officials saw they were not, nor could ever really be, the lender-of-last-resort everyone expects. On the contrary, what they set out to do was try to clean up the mess once any serious illiquidity triggered widespread selling in any class.
To therefore limit the fallout from the inelasticity, these “central banks” offer to buy assets that are being sold in an attempt to keep prices stable. The same would be true of Treasuries in any hedge fund “bailout.” The Fed would offer to purchase them rather than have them hit an already-strained marketplace.
In other words, the reason no one is addressing “the selling” is simply because not even the Fed believes that’s part of its own job description any longer. Illiquidity meaning inelasticity is beyond its capabilities, shown repeatedly since 2007. The goal has morphed from trying to stop monetary events from happening before they get going to managing the consequences at a financial level before they might interrupt and harm the real economy.
I don’t know specifically whether or not the FOMC has taken up the idea of a hedge fund bailout. I strongly suspect, starting with the fact one was proposed by someone like Mr. Stein, it has been at least discussed. Moreover, I would also bet there is already a contingency in place, even if not yet formalized and announced.
By “in place”, I mean consultations with lawyers on the legalities (not wishing to fall back on the “emergency” provisions in 13-3), some discussions with FRBNY Open Market staff on the technical details, etc. My impression, however, derived mainly from the Treasury Secretary’s comments on his own “toolkit” is that either the Fed hasn’t progressed far enough along in that process or, if they have, they’ve indicated to him they aren’t willing to turn to it unless conditions in the marketplace get to be truly dire.
Bessent would rather not take that long, so he is effectively taking the lead.
This highlights one of the biggest drawbacks of the market-of-last-resort approach, for it means rigid bureaucratic decision-making all-too-reliant on the whims of those last in line, and last to realize. By the time enough meetings are convened and redlines crosses, the market meltdown may be too far advanced for the tactic to be effective.
4. Does the Treasury market blow up if so?
Short answer: no.
To start with, the fundamentals of the marketplace have not changed. As stated above, the issue with the basis trade (or reserve manager selling) has nothing to do with the assets being sold. It’s not as though the marketplace has shifted on inflation or growth expectations, or that politics has led overseas governments to “ditch the dollar” as is repeatedly claimed (even if demonstrably false).
If anything, a period where the basis trade is being reversed is fundamentally more positive for Treasuries, however counterintuitive this might seem at first. Since selling is being driven by illiquid meaning inelasticity, that’s deflationary money which leads to negative, potentially deflationary consequences for the real economy thereby increasing the demand for assets like Treasuries.
While some harbor concerns basis trade or FOI selling could change those perceptions of the Treasury market, it isn’t about the public or politicians. Rather, the Treasury market remains free from credit risk (sadly) while also featuring, yes, the deepest market for these instruments. Its place in the risk hierarchy isn’t threatened by technical dispositions.
We know this given the performance of the assets following the two worst bouts (October 2008; March 2020) of it, plus the experience from last year (December/January). In all three cases, yields unexpectedly rose sharply as selling amplified, yet once the acute phase of inelasticity (dollar shortage illiquidity) abated, buyers quickly emerged because in all three the fundamentals were only enhanced.
As noted at the top, we’ve seen that on a short run basis here this week, too.
Neither the SLR nor buybacks are likely to do much, and really aren’t intended as anything other than the standard official “toolkit” to reassure “the markets” authorities can handle big problems even though we all know they really can’t.
The real reason why is the same one which limits the response to the aftermath rather than trying to get at the source. The monetary system is out of their reach, therefore the only real hope authorities have is to limit the fallout when something does occur. For the Treasury market, that’s not as much of an issue since the monetary shortage which precipitates the selling is fundamentally positive for the assets.
Buyers are being created, if sitting on the sidelines uncomfortably for a time.
Other markets, however, very different story – as we may have noticed more recently, too.
I’ll write it again one final time (for today, anyway): the problem isn’t with finding more buyers, it’s why there is so much selling in the first place. Understanding the monetary issues means also understanding why no one is addressing them.
