Chartbook 371: Is a "Treasury market unwind" in progress? Wednesday morning and the overnight fin-fi panic. (Part 2)

A specter is stalking global financial markets.

On Tuesday evening rumors began to intensify. “Something is unwinding in the Treasury market”.

Everyone in the commentary game knows the script. It was defined by the events of March 2020 and subsequent investigations. Chartbook 369 (renamed #1 in this mini-series) rehearsed it on Monday morning.

• An exogenous shock that is not fully priced into the market (pandemic, Trump chaos) hits financial markets. Stocks and oil sell off.

• At first, the normal safe haven mechanisms seem to function. Folks run from crisis-stricken equities into bonds and above all into Treasuries. Bond prices go up and yields go down.

• But then panic-selling hits the market that is supposed to act as the great liquid stabilizer of the financial system, the $28 trillion Treasury market. Frantic selling into the Treasury market causes the price of US Treasuries to plunge along with everything else, sending yields i.e. interest rates surging.

• This market action is abnormal in that it involves actors who would normally not be in engaged in panicky unwinds (hedge funds or foreign reserve managers) and it overwhelms the market-making capacity of actors (big banks, notably JP Morgan) who normally act as stabilizers in the market.

• The Treasury market becomes disorderly, with unpredictable movements and moments of “seizing up” when there are no buyers for packets of Treasuries that are offered for sale. The problem now is not just the price of Treasuries and the losses that they are inflicting but the liquidity of the market. Your ability to command a price for safe haven assets at all.

• Treasuries no longer offer a safe haven. The only place to run to is cash. The entire financial system begins to worry about the safety of its piggy bank, causing a comprehensive liquidation.

• The normal metabolism which “funds” the US government by way of Treasury market ceases to function.

• The point of direct Fed intervention approaches.

This is the script for a truly existential financial crisis. This is not a market correction that inflicts pain and losses, but an unwinding that threatens the stability of the entire financial system.

This scenario is more serious than 2008. The Treasury market is a deeper foundation of the financial system than the privately issued asset backed securities that imploded during the mortgage crisis.

The script above is a crisis that is so lethal that it cannot be allowed to play out to its very end. If it did, all accounts of the crisis would be full-blown postmortems. The system would have collapsed. For life to continue anything like normally, this narrative must remain, to a degree, a fear rather than a reality.

In 2020 the threat was so great that the Fed stepped in with absolutely massive purchases. Jerome Powell used asset purchases ten times the size of those employed by Ben Bernanke to stabilize the system in 2008-9. To soak up panicked selling and to put a floor under the Treasury market, the Fed bought $1.6 trillion in a month. For those interested in more details, I told the story of the 2020 crisis in my book on the COVID crisis, Shutdown.

But though it must to a degree remain hypothetical, everyone in the deep end of the financial system knows this script. That shared knowledge marks a significant dividing line between insiders and outsiders in the financial system. The bond market is normally a highly technical place that remains out of sight. It is the plumbing. When the plumbing becomes the story, a different crew takes over. We need to listen not to garish media-savvy pundits pumping Tesla stock, but former astrophysicists overseeing hyper complex trading desks where trillions are at stake.

Both this hierarchy of knowledge and the shared script amongst key actors and commentators are significant facts about the situation. At the end of Tuesday we began to reach the point at which we seemed to be “inside our own story”.

I began to receive late-night communications like this:

The “Treasury market unwind” is at this point an almost cartoonish specter. Stalking us like some childhood nightmare. Fin-fi of the serious variety.

At the time of writing, i.e. early morning on Wednesday, I am still putting the statement “we are inside our own story” in inverted commas.

Personally, I spent the previous weekend plunged into Stuart Hall et al on Policing the Crisis, the classic cultural studies treatment of 1970s moral panics, the rise of what Stuart Hall would later call Thatcherism and the “mugging crisis” in Britain. The resonances of the current moment are extraordinarily intense. This is from page 223 of Policing the Crisis on the logic of “significant spirals”.

Are we caught in one of many significant spirals unleashed by Trump’s first months in office? On Monday a Treasury market unwind was nightmarish “fin-fi”. Then we identify culprits. Issues converge. We cross thresholds. And come Tuesday/Wednesday here we are. The boogeyman is getting more and more real. And the next step will be that we demand “firm steps”. (Clearly these same mechanisms can also be seen at work in other domains of our Trumpified reality).

Anyone who does not have a Bloomberg terminal and does not live in second by second contact with the markets will experience what may or may not be about to happen only secondhand. Even if we end Wednesday in full blown meltdown,“we” will still not fully know what is happening. Five years later, experts are still parsing the drivers of the crisis in March 2020.

But as of 7 am on Wednesday, the signs are not good. There is good reason to think that we may be entering fullblown bond market meltdown. The headlines of Bloomberg and the FT and the WSJ all concur. The bond market is the story. This is not normal. Even on these outlets, the Treasury market is not normally front page news. On Bloomberg it lurks under Markets → Fixed Income. And within Fixed Income you are looking for Treasuries and not high-yield etc.

This morning, bond markets dominate the news.

So what are we worrying about? What may be about to unwind?

On Monday morning after the turmoil in equities and after oil prices plunged, serious eyes were on the bond market. There was some safe haven buying. But in the course of Monday, trading in Treasuries became very unusual indeed. Treasuries started behaving like equities, prices would rise (the normal risk off safe haven trade) and then plunge (suggesting some very large portfolios needed very badly to sell).

A great quote from the FT was the following:

Gennadiy Goldberg at TD Securities said the move reflected “an ‘everything, everywhere all at once’-type trade”. He added: “Multisector funds are trying to deleverage, which leads to a ‘sell everything’ trade.” … “Hedge funds have been liquidating US Treasury basis trades furiously,” said one hedge fund manager. The moves were not limited to hedge funds. Investors across the board sold Treasuries to raise cash, with one fixed-income trader pointing specifically to traditional asset managers. “I think investors are moving to cash and cash-adjacent assets to weather this market volatility,” said Ed Al-Hussainy, senior rates analyst at Columbia Threadneedle Investments. Recommended Instant InsightKatie Martin Markets could get a lot worse — and quickly “The simplest explanation (for the move in yields) is investors selling what they can and hunkering down. Selling equities now will lock in losses so the lowest-hanging fruit is to raise cash by selling Treasuries,” said Al-Hussainy. The hedge fund manager who attributed the moves in yields to the basis trade said the scale of the broader hedge fund selling was “destroying” liquidity — or the ability to easily buy and sell assets — across Treasuries, high-grade corporate bonds and mortgage-backed securities.

That was Monday, below the radar. And then things got worse:

Tuesday started relatively calm, but then over the course of the day Treasury selling predominated over Treasury buying. And, alarmingly, the pressure from sellers intensified at the end of the trading day, suggesting that people needed to sell to unwind trades and get their hands on cash.

By midnight, the graph looked like this h/t Joe Weisenthal.

The market is always two-sided. When someone sells, someone else has to buy. I have not so far seen any dramatic stories about the buy side of this two-sided market. From the point of view of market stability this is good news. If we start seeing stories about key market makers (particularly JP Morgan) being stretched beyond their balance sheet capacity, then the crisis has spilled over to the buy side. Then we have entered the territory of “market disorder” or a liquidity crisis in Treasuries.

So far the story has been mainly about sellers.

Who is selling and why?

In March 2020 foreign holders of dollar exchange reserves were big sellers. COVID was a global shock. People needed liquidity everywhere and the ultimate kind of liquidity is dollar liquidity. So you smash your piggy bank in New York, you sell your Treasuries and retrieve your cash. That puts pressure on the Treasury market in which foreign investors are normally price-insensitive long-term holders not prone to sudden selling.

There might also be other motives. Since the United States began to sell Treasuries on a huge scale to foreign investors in the 1980s - first to Japan and to oil exporters, then to the Chinese - there has been a concern, that in a crisis, aggressive selling by foreign asset holders could be used to put the United States under pressure.

Going back to 2008, there are persistent rumors that Putin tried to orchestrate a “bear raid” together with China. Beijing declined and acted cooperatively with the US throughout the crisis of 2008. It remained a private-sector, real estate-driven crisis.

Could geopolitical forces be in play right now? It is too early to tell. Data on bond markets can be slow and patchy. But who would rule it out? Donald Trump uses power in a fungible way. He ties Fentanyl and defense spending and LNG to tariffs. If someone wanted to give him a taste of his own medicine, it would hardly be surprising.

But this is not the main rumor. The main rumor concerns the unwinding of “basis trades” by hedge funds that arbitrage between the Treasury cash markets, the repo market, where you can use Treasury holdings as collateral for borrowing, and the Treasury futures market, where you can hedge against risk of price fluctuations, but can also engage in speculative bets on future movements in prices.

By and large these trades are harmless. They are bets on safe assets. They involve tiny margins. But the problem is the scale at which they are deployed and the huge leverage that is used to generate large profits.

When commentators talk about the Treasury market unwinding they are referring to trades put on by hedge funds, which involve them in borrowing on a huge scale. In some cases they borrow fifty or even one hundred times the cash they themselves put in the game to make trades that yield tiny margins of profit. At huge volume even small margins yield large profits.

When markets move in unexpected ways, when volatility goes up, lenders who are exposed to the highly leveraged hedge funds demand more security against the loans. The hedge funds need to scramble out of the trades to get the necessary cash. They sell their Treasuries on a scale that far exceeds normal selling and at a pace and at moments in the daily rhythm of the market that overwhelm the appetite or capacity of buyers. The result is that the price of Treasuries lurches downwards and yields surge. That in turn raises fears of market instability. Measures of volatility spike and further margin calls are made, unleashing further waves of selling.

Unwinding of hedge funds trades - the basis trade is one amongst several strategies we may learn about - is the main explanation right now for the market turmoil. Torsten Slock, Apollo’s highly influential chief economist issued an explainer on the hedge fund’s basis trade. By his measures we might be talking about $800 billion in exposure. Not enough to bring the system down, you might think. But perhaps enough to unleash an avalanche.

This was a typical thread from a highly knowledgeable insider.

Serious cracks may be emerging in the trillion-dollar market on which the entire financial system relies as a foundation.

At this point anxiety can further spiral. Is this merely a plumbing issue? Is this merely about hedge fund trading, or is this actually about the excess supply of Treasuries? Is fiscally incontinent America simply getting its comeuppance. One of the destabilizing factors in the Treasury market earlier this week was a bond auction that did not go well for the Treasury. This week, as bond prices gyrate, the Treasury has to find buyers for billions more in new bonds as part of its regular bond sale program.

At this point, long-term anxieties about fiscal sustainability, and democratic dysfunction, merge with concerns about the immediate functioning of the market.

Whether or not fiscal sustainability is in fact a major issue, either now or in the future, the worry about it, and the worry about other people’s worries about it, will help to unsettle the market.

Expect fiscal fundamentals to be mobilized by many earnest commentators, both as an explanation for what is happening and as a “lesson learned” from these events. This is the use to which the Liz Truss moment in UK gilt markets (the Uk equivalent of Treasuries) has been endlessly put. Right on cue, this dropped in the pages of the New York Times, twenty minutes ago:

So far the jury is still out as to whether this will be a fullblown crisis.

As my fantastic colleagues at FT Alphaville pointed out yesterday:

What happened late on Friday and on Monday is nothing near what we saw in March 2020, when for over a week the US Treasury market — the bedrock for the entire global financial system — came close to breaking. But as our colleagues pointed out, the volatility has been high, and that they sold off so violently yesterday is highly suggestive of at least some levered Treasury trades getting forcibly liquidated:

Perhaps the most astonishing thing is that we really do not know.

As I am about to hit send, Joe Weisenthal at Bloomberg checks in to inform us that the midnight spike in 10 year yields has unwound.

So this may actually turn out to be a ghastly fin-fi nightmare, a spiral of signification that runs its course and evaporates. But the most elementary fact is that this is $ 29 trillion market and “we” truly do not know.

There is a 30 year Treasury auction coming up on Thursday. Perhaps that will provide some grounding in “reality”.

But, when French-speakers are circulating, AI-generating images of Fed Chair Powell as a craggy, made for TV fire-fighter we know we are in troubled times.

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