One year ago, a pocket of borrowed money on the edge of UK bond markets imploded with enough force to topple a prime minister and draw the Bank of England into an emergency rescue. Now the world’s most influential regulators are intensifying their scrutiny of a mounting potential risk to the gilt market’s much bigger cousin: the $25tn US government bond market.
Over the past month, the Bank for International Settlements, a convening body for the world’s central banks, and the US Federal Reserve have both pointed to a rapid build-up in hedge fund bets in the Treasury market. The so-called basis trade involves playing two very similar debt prices against each other — selling futures and buying bonds — and extracting gains from the small gap between the two using borrowed money.
Both the protagonists and the strategy itself are different from those involved in the UK’s liability-driven investment meltdown last year; however, they have one thing in common: the collision of heavy leverage with sudden and unexpected market movements, and the speed with which that can cause potentially serious problems.
The scale of the basis trade is hard to pin down, and even the Fed lacks precise data. However, leveraged funds’ short positions in the most liquid futures contracts reached an all-time high of almost $900bn in late August, according to Commodity Futures Trading Commission data. Even if not all of that is used for the basis trade, the Fed has said the strategy poses a “financial stability vulnerability” while the BIS said it had the potential to “dislocate” trading.
Source: Financial Times