"...there remain vulnerabilities in the system of MBF [market-based finance], which could crystallise in the context of the current interest rate volatility...and pose risks to financial stability."
Those are the somewhat ominous words from a recent Bank of England report, that highlighted one of the bigger vulnerabilities of the global financial system being a US hedge fund trade that is staging a comeback after nearly blowing up the Treasuries market in 2020.
The report comes two months after we highlighted the fact that the familiar systemic crisis ghost has made a surprise re-appearance: the trade that led to the repo crisis in Sept 2019 and also brutally exacerbated the crisis of March 2020 when for several days the Treasury market had zero liquidity, is back and is looking to blow up a whole new generation of clueless rates traders.
That's right: the Treasury cash-futures basis trade, which as we profiled in detail in March 2020, led to record losses among the pair-trading hedge fund community, and prompted the Fed to inject trillions in liquidity into the market to avoid a catastrophic collapse (and where the covid pandemic and crash conveniently served as a perfect "just in time" decoy to allow Powell to do just that), has returned according to BBG's Garfield Reynolds who notes that "the recent surge in leveraged positions betting that Treasury futures will fall ... smacks of so-called basis trading."
The trade, a variant of which first claimed LTCM and its roster of Nobel-prize winning idiots back in 1997, earns tiny nominal returns (when all goes according to plan) so funds use cash borrowed from the repurchase agreement market to leverage up positions and juice their wagers. The problem is that when not everything goes according to plan, the blows up are absolutely epic since this is the same strategy that led to career-ending losses on investors in March 2020, drying up liquidity not just in Treasuries but also in other money markets key to the smooth functioning of the financial system.
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."
It's not just the Bank of England, since as we reported in May, officials in the US at the SEC and The Fed have questioned prime brokers about the basis trade.
While this topic tends to go right over most people's heads, the bottom line is simple enough: wrong-way bets on Treasury futures - inspired by a record pile up in a popular if deadly basis trade - are near the highest they’ve ever been (open interest in the pivotal five-year futures is at a record), while liquidity has almost never been worse.
"In particular, the recent sharp transition to higher interest rates and currently high volatility increases the chance that vulnerabilities in [the market] could crystallise and pose risks to financial stability."
In other words, the Bank of England has a point - brace!!