Interest rate swap spreads have gone ballistic this month, a sign that things are not well across the eurodollar’s world. And that’s putting it mildly. The 10-year spread which compares the rate for receiving/paying fixed on a 10-year interest rate swap with the 10-year nominal US Treasury yield sunk to a record low, at least for these instruments where the floating side is based on term SOFR (prior to June 30 they had for decades been benchmarked to LIBOR).
A negative swap spread, particularly one becoming highly negative, has been a dependable harbinger of trouble. What kind of trouble? Money dealers’ capacity to intermediate throughout the massive, complex maze of monetary formats making up the global reserve currency system.
It begins as an issue of balance sheet capacity, a constant problem dating back to August 9, 2007. Beyond that singular, historic day you can see how nearly every key money market- from unsecured to cross currency basis swaps - have been altered, negatively and permanently affected by these constraints. The nice, tidy hierarchical arrangement in swap spreads is perhaps the most prominent of these.
A related phenomenon is gaining wide attention and, as usual, for all the wrong reasons. Just as interest rate swaps spreads were being pounded late last month Citadel’s Ken Griffin was firing back at the SEC’s Gary Gensler for the latter’s unhealthy fixation on something called a “basis trade.”
In addition to pushing regulations into the cryptocurrency realm Gensler clearly doesn’t understand, the SEC has been zeroing in on this hedge fund basis trade, too. Griffin responded that the effort was “utterly beyond me.”
Hedge funds aren’t the problem here, lack of dealer capacity is. Citadel and others are filling in what is a vital role; as Griffin said, “This is totally lost on Gary Gensler and totally lost on the Fed.”
What is this basis trade?
It is an inefficiency in the marketplace, an opportunity for anyone with spare monetary capacity – such as hedge funds – to take advantage. They don’t create it, instead by being drawn in they perform a valuable financial service, one which before August 2007 had been ably filled first by money dealers.
In this post-2008 environment, many “real” money participants such as pension funds or insurance companies have preferred to invest in Treasuries using futures contracts. This demand has created an imbalance whereby futures market prices are too often above their cash market counterparts.
Herein steps hedge funds. They arbitrage this basis spread, which isn’t much, by taking a long position in cash Treasuries while shorting futures. Quite simply because the futures price has to eventually converge with the cash price, by taking both sides they will make money no matter what happens along the way.
The catch is repo. At least that is what it appears to be on the surface where all the regulators exist.
To make these tiny spreads workable requires lots of leverage. Thus, when going long the UST funds like Citadel will finance that leg in repo, typically with tiny haircuts given the quality of the instrument. And if done offshore, studies have shown zero haircuts can be common for preferred customers.
A 1% haircut, for example, means Citadel or whomever only needs to finance the Treasury long with a dollar of its own for every $100. Smaller haircuts, more leverage and since 2008 regulatory bodies have come to fear that factor above all others whether they understand it or not.
While you might think like Gensler the haircut leverage is where the problems begin, they don’t really factor. The real problem is what happens to repo because the Federal Reserve is not a central bank.
Being in repo means constantly rolling over funding each and every day. Since the collateral being put up is a long likely unencumbered Treasury bond or note, there should be nothing to it.
There are times when that isn’t the case because the world experiences periodic, near-regular sizable dollar funding disruptions. In response to those, what repeatedly has happened is foreign reserve managers come to sell their reserve assets. Local banks require a constant source of US dollar financing (a global synthetic dollar short), so when faced with serious shortfalls (global dollar shortage) these overseas banks go to their local authorities as a last resort.
Those authorities sell reserve assets to either subsidize other borrowings from the market or to directly provide funds as a temporary substitute for those borrowings.
But who do they sell their reserve assets to?
Money dealing banks which are often obliged to take the sales on their books as an accommodation for these managers who are some of their biggest customers. Dealers finance these purchases (from their perspective) in, you guessed it, repo.
Should there be a wave of foreign reserve selling, as there was in March 2020, the competition for repo funds can leave hedge funds and dealers alike without a chair to fall back on when the music stops during daily rollovers.
Without repo funding, the basis trade has to be unwound compounding the problem because everyone now including the hedge funds is trying to sell Treasuries all at the same time.
This is where authorities have focused their ire; on hedge funds who they blame for complicating liquidity in the Treasury market with all their massive leverage and wholesale funding. If it wasn’t for this dangerous basis trade, the marketplace would be safer, or so their thinking goes.
But as Griffin pointed out, first of all that isn’t true and, second, hedge funds are buying the enormous quantities of debt being sold by the government and doing everyone a huge favor. He said Gensler “seem[s] to be more consumed with this theory of systemic risk from this trade than from the fact that we’re saving tens of basis points in cost for the American taxpayer, which is billions of dollars a year by allowing this trade to exist.”
The whole argument misses the real point which is why there is selling in the first place, not what happens once the selling becomes “too much.”
This was the same problem as subprime mortgages. Regulators came in long afterward and focused exclusively on those instruments making them responsible for the 2008 crisis (the FCIC inquiry report mentions them nearly a thousand times, purposefully drawing attention to those relatively insignificant securities and away from the actual monetary breakdown). Yet, the systemic setback began when, yes, leverage financial participants were forced to sell them, not that they held or owned them in some way.
In the aftermath of March 2020, unlike regulators quite a few scholars recognized the distinction. One key study from April 2021 authored by a couple of researchers from the Treasury Department’s Office of Financial Reserve (Hedge Funds and the Treasury Cash-Futures Disconnect) blatantly laid out effect from cause:
“Large sales from foreign central banks and asset managers put pressure on dealer balance sheets, raising Treasury price volatility, margins on Treasury futures, and increasing uncertainty on repo rates with Treasury collateral. In response, hedge funds appear to have reduced their basis positions, selling cash Treasuries and purchasing offsetting long futures contracts”
Yet, even now authorities want you and me to focus with them on the last part when the problems all stem from the first part, as this unnecessary spat between Gensler and Griffin demonstrates.
One of the Fed’s new “tools” created in the wake of March 2020 was something they called FIMA, or the Foreign and International Monetary Authorities Repo Facility. Its purpose is to allegedly fix exactly this problem; to be an outlet for foreign reserve managers who can obtain cash from the Fed using their UST reserve assets as collateral (thus, repo) rather than having to sell them to dealers who would then have to gum up repo markets.
Problem solved, right?
Of course not. The very fact the basis trade has made its comeback over the past few years is a sign that dealers are constrained, otherwise there would be no basis for hedge funds to strain. FIMA’s purpose is to try to clean up after a large dollar shortage strikes the global eurodollar system rather than, as a real central bank’s first duty, try to prevent that money shortage from taking hold in the first place.
It treats one symptom while ignoring the primary problem. And that problem, global dollar shortage, remains in the same form as the first time we did this more than sixteen years ago; and that is not the amount of bank reserves.
This brings us back to interest rates swap spreads. By being so negative to begin with and then dropping sharply more negative, that tells us a couple key things. Collateral is an issue, yet balance sheet capacities for money dealers must be, too.
Negative spreads are what happens when other large players across the financial system seek to hedge their large exposures but the dealers they contact to do the hedging can’t underwrite or justify the risk unless they’re further incentivized to do so. A fixed receiver for an interest rate swap will have to accept getting paid less of a fixed rate just to get the constrained dealer to take the swap.
That lower fixed rate goes even lower than the same maturity interest rate swap, boom, more negative swap spread.
In every single one of these seemingly complicated financial arrangements, we keep coming back to the same problem. The more dealers become constrained, the more likely another dollar shortage. Symptoms of the first are all over, how long before another major outbreak of the second?
The Fed has its tools and regulators their focus both downstream of those shortages, meaning the shortages are going to happen. Officials merely claim to be able to clean up enough once they do.
We don’t need something like March 2020 or Autumn 2008 to cause substantial damage. Fall 2022 is a good example especially as it set in motion what would become of March 2023.
You might remember how it led to even more new tools from the Fed to try and clean up after that one.
Negative swap spreads along with a whole host of current financial indicators indicate there isn’t a lot of faith around the world for the efficacy of any future cleanup. Many, too many across the eurodollar system right now appear to be taking proactive steps not wanting to go through still another test. Get your interest rate swap now, even at a huge premium (in letting dealers pay comparatively less fixed rates), because things are genuinely stable and the outlook is positively unbothersome?
Yeah, no.
Even regulators pressing hedge fund basis traders are tacitly admitting they’re pretty unsure of “Treasury market liquidity” as a concept.
The entire reason there is a basis trade in the first place is because of dealer and real money bank balance sheet constraints. Combine that with swaps pricing and growing nerves all over the landscape. But don’t worry, the Fed has a nice, shiny barely-used shovel and is expertly positioned right at the bottom of the hill, ready to start digging out for when the avalanche of snow comes sliding down.
