There is a danger to financial markets in the first Federal Reserve interest-rate cut promised by Fed Chair Jerome Powell at the annual Jackson Hole bankers’ meeting Aug. 23. That is that the rate of speculation in short-term Treasury securities by non-banks has gone so high, that global “financial instability” could result if any event—for example, an unexpectedly large interest-rate cut in September due to an accelerating slide in the U.S. economy—forces these positions to be unwound. They are much larger than they were just before the global dollar liquidity crisis of March 2020, both in dollar value and in their share of what is called “open interest”—outstanding commitments to buy or sell Treasuries.
According to an interesting commentary, “U.S. Treasury Futures in Unchartered Waters as Fed Cuts Loom,” in Financial Times Aug. 2, pension funds/asset managers/institutional investors have long positions totaling $1.13 trillion (betting on gradual rate cuts which will raise the market price of Treasuries), and hedge funds have $1.05 trillion in short bets. The biggest banks have been withdrawing from the Treasury market directly and providing debt leverage to the funds on both sides to take larger and larger bets, which are now nearly double the volume they were in March 2024. The hedge funds hedge their own “short” futures bets with purchases on the secondary market of Treasuries already issued, which will shortly have higher rates than new issuances and therefore can be bought at slightly less than their face value. The gains from these short-term “basis trades” are tiny, but blown up by a lot of leverage borrowed from the big banks.
Whereas the Fed was putting out reports in March and April that the “basis trade” was dangerous but shrinking slowly, that’s not the case any more. The leverage is being borrowed on the Fed’s overnight repo market as well, which is at record levels. FT on Aug. 1 quoted a former New York Fed trader now at an investment firm: “Repo volumes are surging. This tells me that this is a resurgence of the basis trade.”
Reuters’ commentator, one Jamie McGeever, observes that “falling rates can sustain the basis trade, but rapid or large declines may trigger a disorderly unwind.” This one would be bigger than the March 2024 global dollar crisis.
