The US Treasury basis trade consists of buying a Treasury bond in the cash market and selling the underlying futures contract. The difference in returns, the arbitrage, is the “basis”.
The cash bond position is financed via overnight repo, while the futures contract has its own leverage built in.
Because the basis spread is very small these positions are in the hundreds of millions, even billions. Therefore, huge leverage is applied 10X, 20X even 50X. The basis trade has become a staple for dozens of hedge funds, most all of them based in the Cayman Islands.
Here’s a chart with ESTIMATED amounts, put together by AI from various sources.
For sure, if the basis arbitrage becomes unprofitable then a huge supply of Treasury bonds will have to find alternative investors.
PS Read the following write up by the Fed - they estimate the size of the basis trade to be around $1.8 trillion.
fascinating post.... let me see if I understand you correctly. There exist a basis arbitrage because people expect Treasury rates to fall, i.e. Treasury bond prices to rise, thus making future bonds more expensive than current bonds. The expectation that Treasury rates will fall thus induces demand for treasuries right now, keeping current treasury prices low, which in turn allows the US govt to function.
ReplyDeleteHowever, this lower rates assumption seems unreasonable because it implies people will consistently accept negative real rates, where for the purpose of this discussion we could use the long term gold price appreciation as a proxy for inflation. Why not just buy gold, a conclusion that many central banks have reached.
Thus, what Hell is saying is that, due to the leverage in the market, when the market wakes up, the interest rates might spike very, very fast, triggering all kinds of interesting events.
I might be reading the post wrong. Feel free to correct if you wish.
ReplyDeleteHi AKOC.. I’m afraid that you are indeed reading me wrong. A Treasury basis trade is the arbitrage between the rate obtained on a cash bond and its futures contract, for example the 10 year bond and the 10 year futures contract.
DeleteSuch a trade does not require a fundamental view about interest rates, per se, but it is a bet on short term rates remaining well below long rates, since the purchase of the long bonds is financed by overnight repo.
ok, I hear you. I guess the 10 year futures is almost identical to the 10 year bond except that it is a derivative instrument, and thus valued slightly less because it has a small counter party risk?
DeleteIf this is so, why would people want to buy the derivative? Because the demand is so high that they cannot get hold of the actual 10-year bond?
There is always a difference between the cash rate and the futures rate, since there is Time Value of Money involved in the futures contract. It is precisely this tiny difference that is captured by the basis trade. But, when leveraged to the max even tiny differences make for sizeable profits - IF EVERYTHING WORKS AS PLANNED. But, there is a measurable risk that things may NOT work out 100% as planned. For example, if the repo rate used to carry the cash bonds moves higher than the break even rate calculated for each trade. If this happens the basis trade turns from profit-making to loss-making and must be unwound. If this happens to a great extent then the whole basis trade "industry" must close out their positions 100%, putting great pressure on the underlying bond market. And, as the chart shows, it is VERY sizeable, maybe up to $1 trillion.
DeleteIn general, such "carry" trades work very well... until they don't.
I got it!!!! I think...
DeleteSo a trader A, borrows money to buy a 10 year bond, then sells a futures contract on it. Since, he has sort of already sold the bond, he does not have money tied up. So he can borrow still more and do the same thing again. Effectively, he is taking very high leverage.
Trader B is buying the futures contracts. Since, he can buy the contracts with very little cash down, trader B is effectively also taking on leverage.
i.e. the current US Treasury market is based on a lot of people taking leverage to buy US debt. Without that leverage, the interest rates will be much higher, possibly unsustainably higher.
Yes, you are basically correct! Leverage for such basis trades is up to 30x sometimes 50x.
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