Basis trade freakout (low key)

SPEAKER_1 (0:01)

Bonds are back.

And so is All the Credit, P. Jim Fixed Incomes Monthly Podcast Series. From the latest trends to long-term perspectives, you'll get timely fixed income insights from leading economists, research analysts and investment professionals. Whether you're new to bonds or a seasoned investor, tune in to All the Credit wherever you get your podcasts. This podcast is intended solely for professional investor use. Past performance is not a guarantee of future results.

Ethan Wu (0:36)

Thank Pushkin.

There is approximately one way that finance blows up the world, and it is with borrowed money. Someone in the investing world decides, I've got a really good idea, but I want to do it not just one time, not just two times, but actually 50 times. And then something changes, and the market moves against them, and then all that borrowed money has to be paid back, and oops, there's no money to pay it back, and then everything explodes. This has happened many times in finance, it will happen again, and on today's show, the hot new trade that's going to blow everything up, the basis trade.

This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu, back from my one show hiatus, joined today by my heroic substitute host, Katie Martin. Katie, are you sweating in your Birkenstocks about the basis trade?

Katie Martin (1:27)

This is an extremely contrived combination of themes.

No, I'm not. I'm keeping a level head, but I'm also keeping a very close eye on what should be a fairly sort of humdrum corner of the debt markets, but that is drawing the attention of lots and lots of regulators at the moment.

Ethan Wu (1:50)

Yeah. This is a complicated trade with a lot of mechanics that I think are relevant to a broader discussion. So, I'm going to take a crack at it, and you tell me if I've missed anything.

So basis, right? In general, a basis is the difference between two very similar types of assets that are slightly different. In this particular case, we are talking about a treasury paper bond that everyone knows about, everyone loves, we talked about on the show a million times, and treasury futures, which are a contract that are linked to treasury bonds for purchase or sale at some point in the future. The basis is the difference in price between what a treasury bond is worth and what a treasury future is worth.

Now, pension funds, our dear friends, they like buying treasury futures. Treasury futures are more flexible, you can buy more of them with less money, they allow you to balance out like a big portfolio, and just generally they're attractive to pension fund investors.

Katie Martin (2:47)

You can do all sorts with them. You can do some hedging with them to smooth out your risks. They have lots of uses.

Ethan Wu (2:52)

Absolutely. All kinds of stuff. So, they're attractive for pension funds, and because they're attractive, there is structural demand for treasury futures.

That creates a pricing difference between the paper treasury bond and the treasury future. That's the basis, right? That little pricing difference.

And so, if you're a very smart hedge fund, you look at the paper treasury bond market trading at $100, and you look at the treasury futures market trading at $100.05, and you say, there's an arbitrage, there's free money sitting right there for me to take it. However, $0.05 is not very much money, right? Especially if you're putting up $100 to do it. So, instead of using your own $100, you use two of your own dollars and 98 of somebody else's dollars, and you have a profitable trade. There you go. Presto.

The problem is, those $98 are borrowed money. Did I get that all, Katie? Anything you would add?

Katie Martin (3:44)

Yeah. So basically, this is the practice of taking two incredibly similar, but slightly different numbers and playing them off against each other, but bolting a load of borrowed money or leverage in the kind of market parlance onto it. And it's that L word that really gets people worried, because when you get situations where a trade moves against you, and you've got products that are levered, very often hedge funds or whoever it is will have to not only get out of their bet, but will also potentially, in this case, have to sell treasuries very quickly to plug the gap and make sure that they can meet margin calls. This is the bit that's getting regulators hot under the collar, or potentially even hot under their Birkenstocks, I wouldn't like to know.

Because the scale of the basis trade has really rocked up recently. So the Fed put out a paper not so long ago talking about, you know, is the basis trade back? Because it had a moment where it got pretty big and it didn't end terribly well. So they're saying, has it come back? And the answer ominously is probably. Probably.