Off the Rails
Doug Noland
October 25 – Bloomberg (Hema Parmar):
“Citadel founder Ken Griffin rebuffed regulators’ critique of the so-called basis trade, saying their efforts are ‘utterly beyond me.’
Hedge funds and others who employ the strategy are helping to provide liquidity and fund the Treasury market efficiently, reducing costs for taxpayers, Griffin said…
‘This is totally lost on Gary Gensler and totally lost on the Fed,’ Griffin said…
Gensler, the Securities and Exchange Commission chair, and the central bank ‘seem to be more consumed with this theory of systemic risk from this trade than from the fact that we’re saving tens of basis points in cost for the American taxpayer, which is billions of dollars a year by allowing this trade to exist,’ Griffin said.”
“Utterly beyond me.”
“Theory of systemic risk.”
Is Ken Griffin serious?
Leveraged speculation poses a clear and immediate threat to system stability.
It has for years.
The bond market almost came unglued during 1994 deleveraging.
Leverage and derivatives were instrumental in many EM currency and bond market collapses.
The blowup of LTCM leverage pushed global debt markets to the brink in 1998.
De-risking/deleveraging almost sparked global collapse in 2008.
Bond market speculative leverage was instrumental in the 2011/2012 European debt crisis.
Trillions of QE were required in 2020.
More recently, market leverage was at the epicenter of last year’s UK gilts crisis.
I’ve long been frustrated by 1929 historical revisionism.
To read Ben Bernanke (and Milton Friedman before him), one would believe that misguided tightening caused the crash, and the Fed’s post-crash failure to print sufficient money (chiefly for bank recapitalization) was the root cause of the Great Depression.
Let’s be clear on a few key points.
Leveraged speculation played momentous roles both in the “Roaring Twenties” boom and the subsequent crash and Great Depression.
Importantly, broker call loans and trust leverage were key sources of liquidity that inflated asset prices while stoking unsustainable spending and capital investment in the real economy.
And there should be no doubt that the collapse of speculative leverage was instrumental in market crash dynamics.
Moreover, the “Great Crash” abruptly ended what had become the marginal source of liquidity for a maladjusted Credit system and Bubble Economy.
For Ken Griffin to argue that taxpayers benefit from Citadel’s leveraged Treasury position is laughable (“grotesque” more fitting).
Americans and the world have paid a steep price for the instability wrought by an era of leveraged speculation run amok.
Having analyzed this dynamic for more than three decades, there is no doubt that leveraged speculation has been fundamental to a series of ever larger and more dangerous speculative Bubbles.
Importantly, each bursting speculative Bubble induced increasingly forceful monetary easing, stimulus that fueled the next more powerful Bubble dynamic.
What started with Greenspan rate cuts and bailouts morphed into Bernanke actively accommodating mortgage lending and speculative excesses; to $1 TN of 2008 QE (and much bigger bailouts); to Yellen’s policy normalization heel dragging; to Powell’s restart of QE in 2019 and the outrageous $5 TN pandemic monetary fiasco.
If the line between leveraged speculation and today’s inflation and world of acrimony is not direct – it’s pretty darn close.
In a world of unfettered “money” and Credit, speculative leverage has been a leading source of boom-time liquidity excess and monetary disorder.
There will always be a degree of market speculation financed by borrowed money.
But markets over the past thirty years have grown to have commanding effects over economic growth and development.
Moreover, leveraged speculation has ballooned to become the marginal source of trading and market liquidity.
Speculative leverage expanded significantly prior to the Fed’s restart of QE in September 2019 and the March 2020 crisis.
The “repo” market, a key source of funding for leveraged speculation, expanded $1.24 TN, or 31%, in the year ended September 2019 (from Fed Z.1 data).
And it was instability in securities financing markets that induced a restart of QE in September 2019, despite economic and market strength – and an unemployment rate at multi-decade lows.
Not surprisingly, QE further stoked leveraged speculation.
By March 2020, 18-month growth in “repo” assets had hit $1.60 TN, or 41%, to a then record $5.547 TN.
From a March 19, 2020, Wall Street Journal article (Juliet Chung):
“A wide swath of hedge funds was hit by the recent unwinding of the so-called basis trade last week…
Citadel LLC’s global fixed-income unit last week was among those stung by the trade…
The Federal Reserve rushed to repair disorderly trading conditions in the Treasury market last Thursday.
Analysts and investors said conditions had broken down in large part because of unwinding risk-parity and basis trades.
The Fed’s intervention Thursday and over the weekend ended up aiding Citadel and many funds deploying the basis trade, said people familiar with the matter.”
More from Bloomberg’s Wednesday article:
“[Paul Tudor] Jones, who runs hedge fund Tudor Investment Corp., said his firm’s basis trade portfolio ‘was in extreme duress’ in March 2020, and that ‘the Fed’s entrance in the market bailed that particular book out.’”
Recall that the Fed was forced to repeatedly ratchet up its March 2020 QE operations to reverse vigorous de-risking/deleveraging.
If not for the Trillions of speculative leverage (and hundreds of Trillions of notional derivatives exposures), pandemic QE would have been smaller and less destabilizing.
The subsequent Bubble would not have been as powerful, manias not as manic, inflationary pressures not as robust, and economic maladjustment not as deep.
We’re paying a very steep price for the Fed and global central bank community’s repeated bailouts of leveraged speculation.
While graciously saving U.S. taxpayers money, Citadel also managed to eke out (an industry record) $7.5 billion of 2022 returns for Griffin and investors.
For posterity, a Tuesday New York Post headline:
“Inside Ken Griffin’s Property and Art Empire: $1B Palm Beach Spread is Only the Beginning.”
It’s worth updating “repo” market data.
“Repo” assets ended June at $7.734 TN, about 40% larger than March 2020 (then a record).
One-year growth totaled $1.264 TN, or 19.5%.
Broker/Dealer “repo” liabilities posted one-year growth of $521 billion, or 34%, to a record $2.054 TN.
Money Market Fund “repo” assets were up $637 billion, or 24.5%, over the past year.
Money Funds “repo” assets surged $2.0 TN, or 160%, over 14 quarters.
Bloomberg:
“Griffin also addressed his market-making business, Citadel Securities, saying that the largest risk it faces is when pricing correlations between assets go ‘off the rails.’
The firm uses its own balance sheet to facilitate trading across securities including stocks, bonds and rates and takes on an ‘enormous amount of overnight risk’ as it seeks to provide liquidity to the markets, Griffin said.
‘When you see repeated divestitures by market participants in the same direction day in and day out, that really puts a lot of pain into our portfolio.’”
If I were managing a highly levered portfolio of risk assets, I’d be updating my contingency planning for price correlations going “off the rails.”
I guess it’s just me, but if I were right now holding an “enormous amount of overnight risk,” sound sleep would not come easily.
Yet Citadel and the leveraged speculating community, more broadly, have every reason to position portfolio exposures as “too big to fail” market operators.
At this stage of the cycle, financial and market power has become concentrated within the leveraged speculating community.
These are smart, market savvy, masters of technologies, and highly sophisticated operators. They know better than to make big directional bets.
They prefer to play spread trades and market anomalies across markets, gaining the benefits of liquidity and diversification.
But they are highly levered.
Some Treasury basis trades are said to be 50 to 100 times levered.
These operators run incredibly stable money-making machines – that is, until trading goes “off the rails.”
They are well-oiled machines, so long as some development doesn’t throw sand in the gears - force an urgent unwind of popular spread trades across markets.
And the risk of exactly such a scenario is rising.
But despite risk aversion having recently gained momentum throughout global markets, fears of a destabilizing de-risking/deleveraging episode remain well-contained.
Years of bailouts have certainly emboldened the big levered players.
Confidence runs high that central banks would move swiftly to ameliorate market liquidity issues and thwart more systemic de-risking/deleveraging.
Having witnessed the precipice a few times, they’ve developed deep trust in their lifelines.
The old Hyman Minsky “stability can be destabilizing” comes to mind.
There is evidence that speculative leverage today surpasses even March 2020 levels.
I would argue there is more speculative leverage, “Crowded Trades,” and potentially crash-inducing derivative exposures.
Potential for a highly destabilizing de-risking/deleveraging episode exists.
Moreover, an expanding Middle East war, especially in the current fraught geopolitical environment, provides a likely catalyst.
October 27 – Bloomberg (Iain Marlow and Augusta Saraiva):
“Iran’s foreign minister warned that new fronts would open against the US if it keeps up unequivocal support for Israel, and said Prime Minister Benjamin Netanyahu’s government would regret its actions if it proceeds with a full-scale invasion.
Foreign Minister Hossein Amirabdollahian declined to detail the consequences Iran might have in store…
‘The US is advising others to show self-restraint, but it has sided with Israel totally,’ Amirabdollahian said…
‘If the US continues what it has been doing so far, then new fronts will be opened up against the US.’
‘I’d like to warn that the continuation of killing of women and children will make the situation in the region get out of control…
The US side has to decide — does it want to intensify the war?’”
“Amirabdollahian warned that a ground invasion would have dire consequences for Israel.
‘Opening of new fronts will be unavoidable and that will put Israel in a new situation that will make Israel regret its actions…
It has reached the point of explosion. Anything is possible and any front can be opened up.’”
October 26 – New York Times (Ivan Nechepurenko):
“A group of high-ranking members of Hamas arrived in Moscow on Thursday, meeting with a senior Russian official in what looked like an affront to the West aimed at demonstrating how the Kremlin still holds sway over key players in the bloody conflict in the Middle East.
A deputy foreign minister of Iran… was also in Moscow on Thursday…
The meetings highlighted how, despite a slow start, Russia is trying to retain the role of an important power broker in the Middle East, presenting itself as an alternative platform for possible mediation.
They also underscored President Vladimir V. Putin’s vision of international conflicts as an extension of the grand collision between Western states and the rest of the world, with Moscow at the forefront of that fight.”
Writing here on Friday night, the IDF has launched a significant operation into Gaza.
Hours of heavy bombardment, along with the loss of telephone and Internet service, suggest a major escalation.
An Israeli reporter has said thousands of IDF military have entered northern Gaza.
It is unclear how much information will come out of Gaza over the coming days.
Whether this is the start of the much-anticipated full invasion, or something less, seems almost moot.
Israel is moving forward with its Gaza operation, regardless of calls for a ceasefire, threats from Iran and others, and condemnation from around the globe.
Odds that this erupts into a multi-front war increased tonight.
The odds that Hezbollah and other militant groups further ratchet up attacks – against Israel and the U.S. - certainly jumped.
The likelihood that the U.S. is pulled deeper into this conflict rose.
An expanding regional conflict, where Israel and the U.S. clash with Iranian-sponsored groups, drawing in Iran – with its tightening alliance with Russia and China – does not seem like a low probability scenario tonight.
One doesn’t need to resort to “World War III” terminology to state the obvious: This is an extremely dangerous situation that could easily spiral into a major geopolitical crisis.
Risks are highly elevated – and the nature of this risk is unlike anything the world has faced in decades.
As for the markets, this is not the time to be highly levered in global financial assets.
I would expect de-risking/deleveraging to gain further momentum.
As such, we can assume there will be mounting concerns for liquidity and market function.
And it’s this unfolding backdrop that has me worried about the likes of “basis trades,” derivative hedging, and levered speculation more generally.
I’ll also suggest that currency markets have been in the proverbial calm before the storm.
Disorderly currency markets are problematic for highly levered “carry trades,” especially in EM debt markets.
Of late, currency markets have been relatively subdued.
It has certainly helped that two major currency fault lines have been temporarily stabilized.
The Japanese yen has been locked near 150 to the dollar, with markets respecting the threat of Japanese intervention.
Meanwhile, China’s currency has been similarly locked around 7.32 to the dollar, apparently Beijing’s red line, as signs of stress mount.
In the event of a forceful global “risk off” dynamic, jolts to these key currencies could unleash the type of general currency instability that causes havoc for levered trades across markets.
It’s worth highlighting that EM “carry trades” have been under pressure.
Many players are nursing losses and surely have “weak hands.”
This increases the likelihood of de-risking/deleveraging contagion, along with more systemic market liquidity issues.
And this is how deleveraging and illiquidity turn systemic and trading goes “Off the Rails.”
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