BoE says one of the biggest risks to UK financial stability lurks in the US

The Bank of England’s latest financial stability report landed today, with the main conclusion that UK lenders are in decent shape. But there was a fascinating, more unnerving nugget buried in the report.

The UK central bank reckons that one of the bigger vulnerabilities of the global financial system is a US hedge fund trade that is staging a comeback after nearly blowing up the Treasuries market in 2020.

From the report, with the BoE’s own emphasis:

However, there remain vulnerabilities in the system of MBF [market-based finance], which could crystallise in the context of the current interest rate volatility.

Vulnerabilities remain in the system of MBF. For instance, over recent months, leveraged hedge funds have built up large positions in US Treasury futures, which market intelligence suggests are relative to bonds or swaps. If these markets were to move sharply, deleveraging these positions could further amplify stress.

These risks, and other underlying vulnerabilities in the system of MBF identified by the FPC and financial stability authorities globally, remain largely unaddressed and could resurface rapidly. In particular, the sharp transition to higher interest rates and currently high volatility increases the likelihood that MBF vulnerabilities crystallise and pose risks to financial stability.

Here is the accompanying chart, which shows how short US Treasury futures positioning has returned back to the levels seen in 2019-2020.

This is a subject close to Alphaville’s heart. As the BoE notes, this is not hedge funds placing outright short bets against US government bonds. It is a “basis trade”, where hedge funds take advantage of small pricing differences between economically identical cash bonds and bond futures, often because of different regulatory treatment.

Treasury bonds are usually a bit cheaper than the equivalent futures, so hedge funds buy the bonds and sell futures, and wait until they come due and pocket the difference. The spread between them is small, so they use tons of leverage through the repo market to juice the returns.

It’s a classic arbitrage play that almost ended up causing a cataclysm in March 2020, when Treasury bonds suddenly started selling off, widening the spread rather than narrowing it. That triggered margin calls and forced weaker hands to ditch Treasuries and buy back futures — worsening things further.

Just to hammer home how serious this was, here’s an extract from mainFT’s big read on the calamity:

The wild price swings in March meant many investors struggled to offload even modest Treasury positions at sensible prices. Suddenly, broker screens were going intermittently blank and showing no pricing information for what is considered the world’s risk-free rate.

Deirdre Dunn, global co-head of rates at Citi, says it was the most dysfunctional Treasury market she has seen in her career, surpassing even the global financial crisis of 2008. Layer on top of that the practical complications of many traders working from home and the emotional stress of a pandemic, and things were getting chaotic. “The intensity of everything at that time was remarkable,” she says.

Urgent calls took place between banks and the Federal Reserve as well as the US Treasury department. Rumours of hedge funds collapsing due to imploding Treasury bets went through industry WhatsApp groups like wildfire. Some even fretted that the Treasury might face the previously unimaginable scenario of a failed auction of US government debt.

“There was a point in time when we were wondering if the bond market would really ever function again,” says Nick Maroutsos, co-head of global bonds at Janus Henderson, an investment group. “If it continued for a couple of weeks, we were thinking we were looking at doomsday.”

The Federal Reserve was forced to step in to prevent the doom loop, and since then there have been lots (OFR) and lots (BIS) and lots (FSB) and lots (IMF) and lots (Pimco) and lots (NY Fed) of postmortems.

But as the BoE highlights, there’s been little actual action to address the dangers, and the trade now appears to be back on in scale again. And this is symptomatic of a wider sluggishness to address issues in the broader shadow banking system, the Bank notes:

The underlying vulnerabilities in the system of MBF, identified by the FPC and financial stability authorities globally, remain largely unaddressed and, absent actions to mitigate them, could rapidly resurface. In particular, the recent sharp transition to higher interest rates and currently high volatility increases the chance that vulnerabilities in MBF could crystallise and pose risks to financial stability.

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