Bubble Kings
Doug Nolan
From an analytical perspective, it’s fascinating how things tend to turn wild at the end of cycles.
While mortgage Credit expanded at double-digit annual rates between 2001 and 2005, terminal phase Bubble excess went into overdrive with 2006’s $1 TN of subprime mortgage derivatives.
Wall Street alchemists worked overtime to create sophisticated structures that intermediated increasingly high-risk mortgage debt into enticing securitizations and derivative instruments.
Articles, books, documentaries and even Hollywood films have documented the chicanery and insanity of it all.
Still, the broad financial, economic, and social impacts of Wall Street’s alchemy have never received the attention they deserve.
Especially late in the cycle, the capacity for Wall Street to intermediate the riskiest mortgage Credit was integral to sustaining the deeply systemic mortgage finance Bubble.
It ensured the marginal home buyer could pay up to purchase a home, providing the seller the wherewithal to leverage up in a bigger, more expensive property.
Inflating home prices ensured only more speculative interest and ongoing mortgage Credit excess.
Strong system Credit growth fueled general asset inflation, market liquidity excesses, and inflated perceived wealth, along with attendant malinvestment, structural maladjustment and corrosive wealth inequality.
Back then, Wall Street firms and their hedge fund clients could have argued that their operations were providing strong support for “the American dream”.
Without their intermediation and leverage, many would-be buyers would not have had access to a mortgage, while millions more would have faced higher mortgage rates.
Home prices would have been lower, the economy and wealth creation slower.
And financial and economic systems would have been more stable and crisis-resistant.
The Wall Street subprime alchemy blew up in the summer of 2007, marking the beginning of the end to the great mortgage finance Bubble.
But during the 15 months between the subprime implosion and the Great Financial Crisis, a collapsing Fed funds rate and sinking bond yields kept the game going.
Trillions of perceived money-like AAA-rated GSE MBS were instrumental in prolonging late-cycle terminal phase Bubble excess.
From post-mortgage finance Bubble reflationary policymaking inflated the great global government finance Bubble.
I have over the years discussed the powerful Bubble fuel attributes of perceived safe and liquid money-like instruments (enjoying idiosyncratic insatiable demand).
This insatiable demand dynamic has been all-powerful – and nothing short of incredible - of late.
The Financial Times’ Gillian Tett was the preeminent journalist reporting on subprime and Wall Street excess during the mortgage finance Bubble period.
At the time, I pondered how closely U.S. and global central bankers/regulators followed her work.
My thoughts returned to Ms. Tett’s investigative reporting this week while reading a Bloomberg article, “The Kings of a Colossal Bond Trade That's Spooking Regulators,” by Nishant Kumar, Donal Griffin, and William Shaw.
The so-called “basis trade” is simultaneously mundane and utterly phenomenal.
Hedge funds buy Treasury bonds while shorting a corresponding Treasury futures contract, capturing a tiny spread between the yields on the two instruments.
Done for decades and not a big deal, except when the moon and stars align late in the cycle, with the “basis trade” inflating into one of history’s greatest levered speculations - in the most important market in the world.
And “late cycle” is paramount.
Late in the cycle ensures that Wall Street has had years and decades to master the processes of lending, intermediation, and speculation through the ups and downs; that the Fed has had years and decades to orchestrate ever more egregious inflations and market bailouts (“coins in the fuse box”); while the public has had years and decades to be conditioned that markets invariably recover to ever higher highs.
Ignoring risk pays.
Taking more risk boosts paydays.
Believe in the wonders of markets and the all-powerful Fed (and disregard analysts like me).
I’ll state up front that the “basis trade” is surely only one facet of leverage that has engulfed Treasury and Agency markets – along with sovereign bond markets around the world.
I can only assume a proliferation of massive global “carry trades,” where cheap borrowings from Japan and elsewhere finance levered holdings in higher-yielding instruments, including U.S. bonds.
Moreover, Treasury short positions are financing huge “carry trade” speculative leverage in higher-yielding corporate debt, with Trillions of leverage embedded in global derivatives.
Yet the “basis trade” has singularly become systemically important.
There were warnings this summer of a “basis trade” that had inflated to $650 billion, exceeding even the level going into the 2020 crisis.
Last month, the Bank of England pegged the size at $850 billion.
Still inflating, a Reuters article from a couple weeks back ran with the headline, “Praying for 'Soft Landing' of $1 Trillion Basis Trade.”
Egregious amounts of speculative leverage accumulated during the mortgage finance Bubble period.
Faulty, to be sure, but there were market constraints on the amount of leverage lenders were willing to offer against risky mortgage Credit.
The Treasury marketplace has evolved into the Wild West of unfettered leverage and speculation.
At $26 TN, the Treasury market is the largest and most liquid marketplace in the solar system.
One can finance Treasury purchases in the “repo” market with minimal margin (“down payment”) requirements.
Hedge funds are said to employ “repo” financing of Treasuries at 50 to 100 times leverage.
From “The Kings of a Colossal Bond Trade That's Spooking Regulators”:
“As part of a core group of 10 or so firms, they rely on vast sums of money borrowed from Wall Street banks — often 50 times what they invest themselves — to pump tens of billions of dollars into the trade and supercharge returns.
So colossal are their bets that some say they’ve become central to the buying and selling of Treasuries, it's the cornerstone of global capital markets.”
The Bloomberg article highlighted ringleaders from three prominent “basis trade” firms, ExodusPoint Capital Management, Millennium Management, and Citadel.
Also mentioned as major players were Capula Investment Management, Symmetry Investments, Balyasny Asset Management, and Kedalion Capital Management.
“A senior Wall Street figure who’s worked for years with the core players estimates they account for roughly 70% of hedge fund basis-trade bets.
The firms and traders named in this piece all declined to comment.”
“Now regulators have the hedge funds in their sights, fearing a repeat of March 2020 when the bet blew up spectacularly — just before the Federal Reserve had to jump in to resuscitate the Treasury market…”
“But regulators are in a bind.
Crack down too hard and they could threaten the orderly running of a US Treasuries market that’s ballooned to $26 trillion since the pandemic…
The size of the traders’ positions means the Fed may have to intervene if they hit trouble again.”
“‘There are only a couple of players and these players have made themselves too big to fail,’ says Kathryn Kaminski, chief research strategist at AlphaSimplex Group...
‘If you limit this arbitrage, you weaken market liquidity.’”
“Because the gap [differences in price between Treasuries and Treasury futures] is usually mere fractions of a penny this is only worth doing at scale, ramping up returns through the use of leverage.
That largely limits the activity to a few trusted individuals at hedge funds with enough clout to borrow big from banks in overnight money markets.
As the availability of this short-term lending has surged this year, the basis trade has boomed.”
“Critics ask whether it’s wise to lean so heavily on a few hedge funds, pointing to Covid’s early days in March 2020 when market turmoil forced them to rapidly unwind their positions…
The Fed had to intervene to keep markets running, pledging trillions of taxpayer dollars…
The 2020 episode may have fed a belief among some in the group that the central bank will always ride to the rescue, market participants say.”
“’There’s an implicit ‘Fed put’,” says Eric Rosenfeld, formerly of Salomon Brothers’ government- arbitrage desk in the 1980s and a cofounder of Long-Term Capital Management…
But it’s not a question of ‘too big to fail,’ he asserts, more that the ‘Fed is responsible for maintaining a liquid, free-flowing Treasury market.’”
“Enabling all this is the group’s abundant access to the magic ingredient that lets it happen: leverage.
Wall Street giants such as JPMorgan… and Bank of America Corp. lend to them in massive volumes in exchange for fees.
Banks have only a fixed amount of leverage to dole out, so they tend to favor their best clients.
Multi-strategy hedge funds such as Millennium, Citadel and ExodusPoint are a perfect match because they have other high-turnover businesses attractive to Wall Street lenders…
For hedge funds, part of basis trading’s beauty is that they often borrow at ‘zero margin’ from banks, meaning no extra collateral has to be put up and they can take more profit.”
Ironically, Fed “tightening” spawned the ideal backdrop for Wall Street Treasury market intermediation and levered speculation - a speculative Bubble that generated liquidity abundance, loosened conditions, and countered higher policy rates and QT.
For starters, significantly higher yields made the spread between Treasury bonds and futures just a little wider, ensuring robust demand from the big “basis trade” hedge funds.
At the same time, the Wall Street firms were seeing strong institutional demand for Treasury futures from mutual/pension fund managers and insurance companies capitalizing on higher market yields (and likely “risk parity” and other levered hedge fund strategies that prefer Treasury futures).
Other clients were dumping Treasury cash bonds to mitigate losses.
The big “basis trade” players were eager to take the opposite sides of these trades, selling Treasury futures and buying cash bonds - and doing so in enormous size.
Meanwhile, money flooded into the money fund complex, generating more fund demand for money market instruments such as repurchase agreements (“repos”).
This created essentially unlimited demand for the other side of hedge fund “repo” borrowings, with the money fund complex providing the critical source of funding for “basis trade” cash Treasury purchases.
It’s the ultimate “Fed put,” “too big to fail” and “Fed secure Treasury and ‘repo’ liquidity’ all neatly wrapped up in a historic Trillion dollar “basis trade” levered speculation.
Wall Street is overjoyed to profit handsomely as middlemen in executing Trillions of Treasury trades in the biggest and most liquid market in the world.
The money fund complex, flush with an extra Trillion of liquidity, is content to lend in the “repo” market with “risk-free” Treasuries as collateral.
And the big “basis trade” players, boy are they rendered speechless while raking in billions utilizing beyond egregious leverage - cocksure the Fed understands it must act immediately to ensure liquid and continuous trading in Treasury and Treasury derivatives markets.
The Fed's restart of QE in the summer of 2019 in response to “repo” market instability emboldened Wall Street and their “basis trade” partners.
And then the Fed’s direct market bailout in March 2020, leading to $5 TN balance sheet expansion, confirmed there were no longer any limits on Federal Reserve market liquidity backstop operations.
Importantly, the Fed/FHLB’s $700 billion liquidity injection this past March assured the levered players that “tightening” would in no way detract the Fed from its backstop commitment.
Indeed, the Fed was prepared to move forcefully and hastily to nip de-risking/deleveraging in the bud.
In a November 5th Financial Times article (Costas Mourselas and Harriet Agnew), “Citadel’s Ken Griffin Warns Against Hedge Fund Clampdown to Curb Basis Trade Risk,” Griffin made a key point:
“He noted that the basis trade brought down the cost of issuing government bonds, as hedge funds buy large quantities of Treasuries to pair against their short futures positions.
‘The ability for asset managers to efficiently gain exposure to Treasuries through futures allows them to free up cash to invest in corporate bonds, residential mortgages and other assets,’ he said.
This is because futures are leveraged products requiring a fraction of the cash posted as collateral to maintain the position, rather than paying full price for a Treasury bond now.”
“Free up cash to invest in corporate bonds, residential mortgages and other assets” – with “other assets” these days certainly including stocks.
Markets awash in liquidity in the face of higher rates and significant Fed QT (balance sheet liquidation) has been an incredible 2023 Bubble manifestation.
Such speculative excess and asset inflation are upshots of some underlying monetary disorder.
Analysts focused on QT and the contraction of M2 would be hard-pressed to explain the monetary inflation behind bubbling equities prices.
The unprecedented $1.129 TN (24%) one-year growth in money market fund assets and the explosion of “basis trade” leverage suggest that levered speculation has become a pivotal source of system liquidity.
As a student of “Roaring Twenties” excesses (culminating in the 1928/29 speculative melt-up and subsequent crash), I worry greatly about how leveraged speculation has evolved into the prevailing marginal source of late-cycle system liquidity excess.
From the September 13th Financial Times article (Kate Duguid, Costas Mourselas and Ortenca Aliaj), “The Debt-Fuelled Bet on US Treasuries That’s Scaring Regulators:
“‘My biggest concern is that if we get a big unwind in this leveraged trade, it could really cause liquidity to dry up in the Treasury market,’ says Matthew Scott, head of rates trading at AllianceBernstein.
In such a situation, it would be highly unlikely for the US central bank to simply stand back and watch.
The executive at the large US bank says: ‘The assumption is that the Fed will step in to save the repo market, which they have in the past, so my view is that they will step in again if anything happens.’
Intervention could involve buying bonds, thus undermining the central bank’s mission to tighten policy until it defeats inflation, and resembles an official safety net for the trade.”
It's a huge problem when leveraged speculation becomes such a prominent source of liquidity for markets and economies.
In contrast to corporate and mortgage finance, there are basically no market constraints on Treasury issuance or levered speculation in Treasury instruments.
The global government finance Bubble has inflated so far beyond all previous Bubble episodes.
I have been concerned for the inflationary consequences when the Fed is again compelled to use its balance sheet (QE) to accommodate speculative deleveraging.
But the immediate risk is that this Bubble has become completely unhinged.
Perhaps “basis trade” blowup worries were a factor in Powell’s dovish pivot, though he only stoked speculation raging in equities and derivatives markets.
It's worth noting that the list of economic data upside surprises is quickly adding up.
This week’s Housing Starts, Consumer Confidence, Initial Jobless Claims, and Durable Goods support the thesis that the dramatic loosening of conditions is working its magic.
A spectacular late-year rally ensured strong 2023 returns for corporate Credit, while salvaging the year for Treasury bonds.
But loosened conditions and all the market euphoria underpin economic activity, while increasing the likelihood for upside 2024 inflation surprises.
The rate market ended the week pricing 156 basis points of rate cuts over the next year.
Not surprisingly, markets are having none of the Fed pushback on rate cut expectations.
On the one hand, six rate cuts are at odds with Fed forecasts and economic prospects following a major loosening of conditions.
On the other hand, with out-of-control speculative Bubbles raising the risk of a crash scenario, it’s not unreasonable for the market to price in probabilities of aggressive Federal Reserve rate cuts.
Could the backdrop heading into 2024 possibly be more unstable?
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