Hooked on Hedge Fund Leverage
Doug Nolan
After three decades, I remain as skeptical as ever.
Unconstrained Credit is destabilizing.
Market-based (as opposed to traditional bank) finance took hold during the nineties and never looked back.
Between July 1990 and September 1992, the Greenspan Fed slashed rates 525 bps to an at the time unprecedented 3.0%.
It was desperate times.
The eighties Bubble had burst, leaving the economy in recession and the banking system deeply impaired.
With a huge S&L bailout contributing to ballooning federal deficits, a major banking system recapitalization risked pushing Washington’s finances over the edge.
What on earth does this have to do with the current environment?
Alan Greenspan orchestrated a surreptitious banking system recapitalization that unleashed a financial revolution, a fundamental transformation of market and financial structure that I believe is now in the process of what could prove a momentous test.
Greenspan created an artificially steep yield curve, allowing banks to borrow inexpensively while leveraging higher-yielding government bonds (and other Credit instruments).
Importantly, this free “money” bonanza was manna from heaven for the fledgling hedge fund community.
Meanwhile, collapsing deposit rates spurred disintermediation from the banking system, with an enterprising Wall Street fixated on “harvesting assets.”
Rapid money market growth accelerated, with money market fund assets surging 19% in 1992 (to $570bn). “Money” flooded into equities.
Awash in “cheap money”, “Wall Street finance” hit overdrive.
Broker/Dealer Assets (from Fed’s Z.1) surged 19% in 1991, 20% in 1992, and 24% in 1993.
System “repo” liabilities jumped 18% in 1992 and 14% in 1993, surpassing $1 TN for the first time in 1993.
Assets-backed securities surged a record $82.5 billion, or 22%, in 1993, capping off unprecedented four-year growth of $256 billion, or 122%.
GSE securities also ballooned, posting record four-year growth of $640 billion, or 51%.
The latent instabilities of this new financial structure were laid bare on February 4th, 1994, when the Fed raised rates a “baby step” 25 bps to 3.25%.
Beginning the month at 5.64%, 10-year Treasuries ended February at 6.13% - on the way to a May peak of 7.48% and November high of 8.03%.
The first major hedge fund deleveraging was painfully destabilizing.
Hedge fund losses were enormous, including major drawdowns for funds managed by “masters of the universe” Michael Steinhart and Julian Robertson.
Major dislocations in the fledging derivatives marketplace took down Askin Capital Management.
The effects of U.S. bond market deleveraging were felt globally, most painfully with the December 1994 Mexican peso and bond (tesobonos) collapse.
April 24 – Financial Times (Robin Wigglesworth, Kate Duguid, Costas Mourselas and Ian Smith):
“Over the past few weeks, the bond market has done what many of Donald Trump’s opponents have failed to do.
It has forced the American president into a partial retreat on tariffs, after a rout in US government debt threatened to spill over into a financial calamity….
Many stress that the turmoil was also exacerbated by highly leveraged hedge fund strategies.
These ‘relative-value’ trades usually seek to take advantage of often tiny differences in prices between Treasury bonds and various derivatives contracts linked to them.
Using short-term funding markets to borrow extreme amounts of money, they can transform small profits into large ones.
These trades have helped turn the club of big hedge funds that pursue them into vital pillars of the $29tn Treasury market…
However, many fear that they also make Treasuries vulnerable to sudden shocks.
Even the Federal Reserve has argued that the growth of these leveraged hedge fund strategies — such as so-called ‘basis trades’ or ‘swap spread trades’ — is a risky development for a market that funds the US government, historically acts as a safe shelter for global finance and influences the pricing of virtually every other security on the planet…
The gross US government bond holdings of all hedge funds that report to the SEC stood at nearly $3.4tn at the end of 2024, and has roughly doubled just since the beginning of 2023…
Much of this will be held through myriad other strategies, but judging by the size of the short Treasury futures positions, most estimates are that fixed-income relative-value hedge funds in aggregate probably hold roughly $1tn of Treasuries.”
Looking back, 1994 was the first of a series of crises where the wrong lessons were learned and later reinforced.
Hedge fund speculative leveraged had become a serious issue.
The money market, “repos” in particular, was the epicenter of destabilizing leveraging.
More generally, “Wall Street finance” was inherently unstable, promoting Credit excess and boom and bust dynamics.
Celebrated as instruments to manage and control myriad risks, the proliferation of derivatives strategies created innate systemic vulnerability.
Why weren’t critical lessons learned in 1994 – or with the 1997 “Asian Tiger” Bubble collapses; the ’98 LTCM/Russia meltdowns; the 2000/2001 “Dot.com” Bubble collapse; the 2008 mortgage finance Bubble collapse; the 2012 European bond crisis; the 2020 pandemic panic; or even the March 2023 bank run mini-crisis? Bailouts.
The GSEs (Fannie, Freddie, FHLB) expanded their balance sheets an unprecedented $150 billion in 1994, providing a powerful central bank-like liquidity backstop.
With speculative leverage surging following the 1994 reliquefication and Mexico bailout (U.S. Treasury/IMF), GSE balance sheets ballooned an incredible $300 during crisis-year 1998 market liquidity support – a record that would be broken by 2001’s $345 billion.
In a feat that fundamentally changed finance and altered the course of history, GSE assets expanded $1.7 TN, or 154%, in six years ended 2003.
While GSE balance sheets would expand another $300 billion during 2007, accounting fraud at Fannie and Freddie essentially ended their spectacular run as furtive quasi-central banks.
A much bigger Bubble required a $1 TN Fed bailout in 2008.
An only bigger one saw a $5 TN pandemic period ballooning of the Fed’s balance sheet.
A quick $700 liquidity response (Fed/FHLB) to the March 2023 mini banking crisis ensured leveraged speculation blow-off excess didn’t miss a beat.
Three decades and skeptical as ever.
Monstrous contemporary “Wall Street” market-based finance is as inherently unstable as ever.
The proliferation of leveraged speculation ensures acute fragility.
And, to be sure, faith in liquidity backstops and market bailouts is absolutely fundamental to market structure.
Each bailout further emboldened risk-taking and leveraging, ensuring ever larger future bailouts.
The size and scope of the next round of bailouts will astound.
From the above FT article excerpt:
“Gross US government bond holdings of all hedge funds that report to the SEC stood at nearly $3.4tn at the end of 2024, and has roughly doubled just since the beginning of 2023.”
When it comes to leveraged speculation, general excess appears to have “doubled” over recent years.
The multi-decade speculative “blow-off” thesis is supported by a reported doubling of the “basis trade” since the pandemic and a near doubling of interest-rate derivatives.
I take note of the acute instability that has recently erupted in interest-rate and currency “swaps” markets.
From the earliest CBBs (starting in 1999), I questioned the fundamental derivatives market presumption of “liquid and continuous markets.”
After all, history is strewn with bouts of illiquid and discontinuous markets – with panics often following on the heels of manic excess.
Crisis dynamics have repeatedly exposed this derivatives market fallacy.
And for three decades, ever-ballooning liquidity backstops and bailouts provide derivative operators assurance that liquidity and market continuity will remain forever safeguarded.
I view recent market instability as the initial phase of what will be a momentous test of market structure.
Derivatives markets will be at the epicenter.
Way too much late-cycle market risk has been (or there are plans to) transferred to listed and over-the-counter derivatives markets, including “swaps” and myriad hedging vehicles (listed put option being the simplest).
As for put options, in the event of a market drop, sellers/writers of these derivatives must short sell instruments (i.e. stocks, ETFs, Treasuries) to hedge exposures (establishing positions that would generate the necessary cash-flow to settle bearish derivatives sold in a down market).
Central to my Bubble analysis framework is that systemic risk expands exponentially during “terminal phase excess.”
“Blow offs” are characterized by rapid late-cycle growth of Credit of deteriorating quality, along with speculative excess that sees asset prices detach perilously from underlying fundamentals.
Importantly, levered speculation spurs destabilizing liquidity overabundance - rocket fuel for asset price inflation and manic melt-up dynamics.
Moreover, liquidity excess, booming markets, and general exuberance ensure over-spending, resource misallocation, and deepening economic maladjustment.
Pandemic-related fiscal and monetary stimulus unleashed historic “terminal phase excess” – certainly including freakish levered speculation.
Over five years, Non-Financial Debt (NFD) inflated $21.6 TN, or 39%, to $76.7 TN.
While corporate debt surged $2.9 TN (22%), outstanding Treasuries and Agency Securities ballooned $14.3 TN, or 55%, to $40.4 TN.
Reckless over-issuance fundamentally debased Treasury and Agency debt obligations – the foundation of global finance.
Market blow-offs are invariably vulnerable to a reversal of speculative flows.
They are sustained only by increasing amounts of leverage, liquidity, rising prices, and risk embracement.
Flow reversals set in motion deleveraging, illiquidity, deflating prices, and risk aversion.
Ebbs and flows – fits and starts - are typical.
Wall Street will certainly not give up without one hell of a fight.
The stakes couldn’t be higher.
But I believe Bubbles are succumbing.
The great reversal in speculative flows has commenced.
It’s worth again recalling that the mortgage finance Bubble was initially pierced in the summer of 2007, with the eruption of deleveraging and instability at the subprime “periphery.”
It was not until some 15 months later that all hell broke loose (at the “core”).
I doubt crisis dynamics can be held at bay as long this time around.
Treasury/Agency debt markets have provided key crisis-period system stabilization over recent decades.
After trading as high at 5.30% in June 2007, 10-year Treasury yields were more than 200 bps lower by March 2008.
Benchmark MBS yields sank from 6.40% to as low as 4.80% in January 2008, with the surge in MBS prices underpinning leveraged speculating community performance.
Moreover, sinking prime mortgage rates extended housing Bubble excess.
Bubble deflation was somewhat hindered by eight rates cuts between September 2007 and April 2008 – rates slashed 325 bps to 2.00%.
Different dynamics are at play today.
Treasury Securities expanded $271 billion in 2007 (up from 2006’s $220bn) to $6.051 TN.
Treasury Securities inflated $1.3 TN over the five years ended 2007, versus the historic $11.5 TN surge over the past five years, to $28.1 TN.
Rather than a source of stabilization, the Treasury and related derivatives markets are today key sources of systemic fragility and instability.
Importantly, the Treasury market became the epicenter of post-pandemic levered speculation blow-off excess – providing the marginal source of marketplace liquidity creation. “Repo” borrowings have been a primary source of speculative Credit.
Not coincidently, the surge in hedge fund Treasury holdings coincides with the incredible $2.5 TN inflation in money market fund assets (MMFA) since mid-2022 (system “repo” assets up $2.571 TN over 19 quarters).
While MMFA recovered $32 billion last week, the previous week’s $125 billion drop, the largest decline since September 2008, suggested aggressive deleveraging.
More from the FT’s, “How the Treasury Market Got Hooked on Hedge Fund Leverage.” “…Given the scale of US government debt issuance, [hedge fund] involvement is necessary.
‘In a world where people can’t put on those trades… Treasury yields would be much higher and US taxpayers would pay far more to borrow money,’ [a senior executive at one of the world’s largest trading firms] says.”
Impacts go far beyond Treasury yields.
“Blow-off” speculative Bubble liquidity effects have been nothing short of historic.
For starters, I don’t think the U.S. runs fiscal deficits of 6 to 7% of GDP without hedge fund levered purchases.
It would have been a bond vigilantes “Liz Truss moment” – even before the Prime Minister’s brief stint at 10 Downing Street.
Instead, it was liquidity over-abundance enough to fuel a historic stock market boom, including epic AI and crypto manias.
Liquidity more than sufficient to power ongoing booms in non-bank finance, including historic Bubbles in “decentralized finance,” “private Credit,” and leveraged lending.
Without “blow-off” speculative leverage and resulting liquidity excess, “American exceptionalism” wouldn’t have become such ritualized conventional wisdom.
Market-based finance, leveraged speculation, asset inflation, and Bubble dynamics are fundamental to “American exceptionalism.”
By definition, historic Bubbles must radiate greatness – great technological advancement, great narratives, and seemingly great prospects.
The “Roaring Twenties” had it all.
And all the greatness is not remotely possible without a great deal of destabilizing Credit and financial excess.
The fledgling Federal Reserve was integral to the twenties Bubble.
A century later, an experimental Federal Reserve (and global central bank community) and runaway market-based finance have been central to history’s greatest Bubble.
No nation can compete with our $40 TN government (Treasuries/Agencies) securities market – history’s greatest marketplace for leveraged speculation and risk hedging.
With total debt and equities securities of $150 TN, there’s no comparable market depth anywhere.
Our $7 TN perceived safe and liquid money market fund complex has no equals, and we also lead the world in perceived liquid ETFs.
And a $7 TN “repo” market to finance leveraged speculation is the very essence of “American exceptionalism.”
Ditto for U.S.-based derivatives markets, unrivaled both for speculation and risk management.
The entire structure is backstopped by the world’s preeminent central bank for ensuring liquidity abundance – forcefully underpinned by confidence in the world’s reverse currency.
Moreover, massive Treasury issuance underpins incomes, corporate earnings, asset prices, economic activity, and the Credit system more generally.
“American exceptionalism” built on a fragile market structure hooked on hedge fund leverage.
Having succumbed to parabolic “terminal phase excess,” the great Bubble was on borrowed time with or without Donald Trump’s return to the White House.
But he certainly fast-tracked crises of confidence dynamics.
Uncertainties associated with a historic trade war are too much to bear.
Too much uncertainty to remain highly levered.
Too much uncertainty for a stock market mania.
Too much uncertainty for a vulnerable Bubble economy.
Too much risky Credit for an economy susceptible to shocks to consumer, business and market confidence.
Too much uncertainty for a Federal Reserve that recently so botched its price stability mandate.
Bloomberg: “Trump’s Trade War Shaking Pillars of Financial System, IMF Warns.”
From wheels coming off Monday to the blaring of “all’s clear” by Friday, it was quite a week.
The administration was, understandably, in full-fledged damage control mode.
“Major loser” notwithstanding, Powell’s job is safe.
Trump: “The press runs away with things.”
U.S./China trade war de-escalation.
“We’re meeting with China.
We’re doing fine with everybody.”
“The Trump administration is considering slashing its steep tariffs on Chinese imports…”
“Bessent Expects Tariff Standoff With China to De-Escalate.”
Trump: “[Xi has] called. And I don’t think that’s a sign of weakness on his behalf.”
China: “Fake news.” China foreign ministry spokesman: “China and the U.S. have not held consultations or negotiations on the issue of tariffs. The United States should not confuse the public.”
I’ll assume more market-friendly trade headlines in the offing.
Trump: “I would say, over the next three to four weeks, and we’re finished, by the way.
I’ll be finished.”
If I were the leader of Japan, South Korea, or other nations, I’d confidently give my negotiators a little pep talk.
It will be interesting to see how amenable the administration is to backpedaling.
Hard to believe the President will respond well to comments mocking his climb down.
FT: “Trump and the Art of Retreat.”
Chinese trolls out in force.
And the further stocks and Treasuries rally, the more forceful I’d expect the President to come back swinging.
Other trade deals will be mostly noise.
There’s major trouble unless the President retreats from his trade war with China.
Everything points to “fight to the end.”
April 25 – Bloomberg:
“President Donald Trump misjudged Beijing by calculating that it would cave into economic pressure, leaving the US unprepared to handle the current tariff standoff, according to an adviser to China’s Foreign Ministry.
‘The mainstream narrative within the Trump team is that because the Chinese economy is bad, if the US plays the tariff card, then China will have no choice but to surrender,’ said Wu Xinbo, director at Fudan University’s Center for American Studies…
‘But surprisingly to them China didn’t collapse and surrender,’ Wu said…
‘The US side misjudged the situation and also is not well-prepared for the confrontation with China’…
‘We are witnessing a highly confrontational stalemate relationship between our two countries and there is a risk of further escalation,’ said Wu, pointing to finance, technology, security and people-to-people exchanges as areas that could be impacted by the spiraling trade war…
‘China is determined to take on the US to the end,’ Wu said.
‘It’s not a slogan,’ he added, referencing a vow from Chinese officials to ‘fight to the end.’
Wu warned against being optimistic about quickly reaching a deal, saying it ‘won’t be an easy process.’
It could take several months before the two sides agree to talk and years before they arrive at an agreement on trade, he added.
‘Time is on China’s side,’ said Wu.
‘It’s up to the US to decide to fight or not fight.’”
“Risk off” was in retreat.
Stocks rallied big this week.
The VIX closed below 25 for the first time in three weeks.
High yield CDS dropped, and spreads narrowed.
Junk bond and leveraged loan markets mustered limited re-openings.
Treasuries rallied, though the swaps market remained notably unstable.
But when it comes to crisis of confidence dynamics, the dollar’s meager 0.2% gain didn’t allay concerns.
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