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Robert Lambourne: A strange coincidence or the Fed's back-door intervention in Treasuries?
By Robert Lambourne
Sunday, October 22, 2023
1. Introduction
This note considers whether the developing short position in U.S. Treasury futures might be linked to the process of "Quantitative Tightening" (QT) whereby the Federal Reserve has been reducing its holdings of U.S. Treasuries and other assets since the peak reached in March 2022.
The chart at the link below tracks on a weekly basis the level of net short positions in U.S. Treasury futures (in blue) and the decline in the holdings of U.S. Treasuries held by the Federal Reserve from the peak holding on June 8, 2022 -- $5,771.4 billion (in green). The starting date for both lines is the week commencing March 20, 2022, when the Federal Reserve's assets were reported to be at the highest in total at $9,012 billion on March 23, 2022:
https://www.gata.org/sites/default/files/Lambourne-Chart1A.pdf
As can be seen from the chart there appears to be a correlation between the two, and this may of course be a coincidence as this was a time of big changes, including sharp rises in the consumer price index and recurring increases in short-term interest rates commencing at the Federal Reserve's meeting on March 17, 2022.
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But instead of a coincidence it is also possible that the basis trade described further in Section 3 below, whereby hedge funds have built up short positions in Treasury futures together with an offsetting purchase of the underlying Treasury security, has been deliberately developed to increase demand for Treasuries to ease the passage of QT. This is discussed further in Sections 4 and 5 below.
A summary of the interest rate changes made by the Fed and the timing during this period is in Appendix A.
2. Quantitative Tightening (“QT”)
As noted above, the Federal Reserve's peak holdings of U.S. Treasuries was reported to be $5,771.4 billion in its balance sheet for June 8, 2022. Since then the Fed has been selling its holdings and the link below is to a Reuters report published on May 4, 2022, that explains the plans for QT announced by the Fed with the intention of reducing its holdings of U.S. Treasuries from June 2022 onward:
The green line on the chart above records the reduction each week in the Fed's reported holdings of Treasuries based on its published weekly balance sheets as of Wednesday each week. Reuters reported that the Fed was planning to cut its holdings by $60 billion per month. The chart indicates that the reduction through to September 6, 2023, is in line with this plan.
A brief description of the plan to reduce holdings is set out in the Reuters report:
"The plan issued Wednesday indicated officials will rely on redemptions of T-bills, which mature in a year or less, when the redemption of coupon securities, which are notes and bonds with maturities greater than one year, are below the monthly cap.
"Officials generally don't view T-bills as a needed part of their holdings required to ensure an ample supply of reserves for the banking system under their current operating framework."
Hence QT in regard to the Treasuries market was supposed to rely mainly on non-reinvestment in the refinancing of maturing securities, plus sales of short-term debt instruments. No mention was made concerning any efforts to assist QT by assisting the development of extra demand for Treasury securities.
3. Short positions in U.S. Treasury futures and the Basis Trade
On Sept. 18, 2023, the Bank for International Settlements published a report titled “Margin Leverage and Vulnerabilities in U.S. Treasury Futures":
https://www.bis.org/publ/
The BIS report starts as follows:
"Speculative positions by leveraged investors in U.S. Treasuries are back. Over recent months leveraged funds have built up net short positions in U.S. Treasury futures of about $600 billion."
The blue line in the chart above represents the buildup of these short positions. The chart has been prepared using weekly data provided by the BIS in an Excel worksheet that can be accessed here:
https://www.bis.org/statistics/qt2309a_stats.xlsx
The end point of the chart is the week commencing September 3, 2023, which is the end date of the data provided by the BIS in its report of September 18, 2023.
Week 1 of the chart has been chosen for the week of Wednesday, March 23, 2023, the date when the weekly published balance sheet of the Federal Reserve was at its maximum asset value of $9,012 billion. This balance sheet is here.
https://www.federalreserve.
More background to the short positions built up in Treasury futures is set out as follows in the BIS report:
"Back in September 2019 and March 2020, price discrepancies between futures and the underlying cash bonds (the cash-futures 'basis') encouraged highly leveraged funds to engage in relative value trades. Recent evidence suggests that the same type of trade may be driving the current buildup.
"When Treasury futures are priced at a premium relative to cash bonds, a common relative value trading strategy consists of selling futures forward (building short positions in futures), matched by purchases of bonds (long positions in the cash market). Such a trade generates profits because the futures and cash prices eventually converge on the futures contract's expiration date. Since the basis is typically narrow, investors need to boost profits through very high leverage; that is, they commit little of their own capital and borrow the rest. A key way of levering up involves the long positions: Investors borrow cash in the repo market (usually having to roll over daily) by posting their U.S. Treasury holdings as collateral."
The revelation that significant short positions had been built up in U.S. Treasury futures accompanied by high levels of leverage triggered concerns among regulators and the financial press. The Financial Times reported about this:
https://www.ft.com/content/
Further, the Federal Reserve itself had also published an analysis of this buildup in Treasury futures short positions on August 30, 2023, which presumably triggered the BIS report:
The Fed's report expresses concern that these trades may constitute a "financial stability vulnerability" that "warrants continued and diligent monitoring." The report also notes that the increases in interest rates made by the Fed may have been an influence in developing this trade.
Hence the growth of the "basis trade" undertaken by hedge funds was seen as a risk to financial stability in the market in U.S. Treasuries and consequently was not welcomed by regulators, including the Fed.
4. The U.S. Treasuries market
The U.S. Treasuries market is regularly cited as the deepest and most liquid bond market in the world. It has experienced a significant increase in size over the last five years because of the excess of the U.S. government's expenditure over tax receipts. Here are some relevant figures:
----------------------
The U.S. Treasuries market owned by the public, in billions of dollars
Amount outstanding / Increase
28/09/18: 15,761
30/09/19: 16,809 ..... 1,048
30/09/20: 21,019 ..... 4,210
30/09/21: 22,283 ..... 1,264
30/09/22: 24,299 ..... 2,016
29/09/23: 26,330 ..... 2,031
----------------------
As can be seen from this table, in five years the amount of U.S. Treasury bonds owned by the public has risen by $10,569 billion, or 67%. Several reports in recent years have indicated that because of the recurring growth of federal government expenditure in excess of tax receipts, market stresses are evident from time to time.
Here is one such report, by the G30 Working Group on Treasury Market Liquidity, published in July 2021:
Whether the Treasuries market really is as deep and as liquid as is usually claimed is relevant when considering the basis trade described in Section 3 above.
It seems odd that the small discrepancies between futures prices and those of the underlying bonds apparently remain large enough so regularly to offer a sufficient profit opportunity to induce this basis trade being made more or less continuously since June 2022. If the market for U.S. Treasuries was really as deep and liquid (that is, efficient) as claimed, regularly making those trades should be very difficult. In theory, if a market is perfectly efficient, then it should not be possible to make such trades at all.
To obtain an "independent" view on whether basis trades can be made successfully in efficient markets, ChatGPT was requested to confirm whether a basis trade was possible in an efficient market. Here is ChatGPT's answer:
"Basis trades can occur in any market, including efficient markets. Efficient markets are characterized by the rapid and thorough incorporation of all available information into asset prices, making it challenging to consistently profit from discrepancies or mispricings. However, basis trades in efficient markets may not be as common, as the opportunities for significant profits may be limited, and the competition among traders to capture such opportunities can be intense.
"In efficient markets, such as many major stock markets, it's generally more difficult to find discrepancies or mispricings because information is widely available and quickly incorporated into asset prices. However, efficient markets can still exhibit temporary price divergences or basis differences due to various factors, such as liquidity constraints, market participants' differing interpretations of information, or technical trading issues.
"In the context of basis trades involving Treasury securities and futures, which are often traded in highly liquid and efficient markets, traders may look for short-term deviations in the basis. These deviations can arise from factors like supply and demand imbalances, technical trading, or macroeconomic events that temporarily affect the relationship between cash (actual Treasury securities) and futures prices. Traders in these markets closely monitor these discrepancies and may take positions to exploit them, but they need to act quickly because efficient markets tend to correct such discrepancies relatively swiftly.
"In summary, while basis trades can occur in efficient markets, the profit potential may be limited, and traders may need to act swiftly to capture any deviations in the basis. Success in such trades often depends on timing, trading expertise, and a keen understanding of the specific market dynamics."
The facts captured in the chart suggest that it has been possible to continue to trade the basis involving Treasury securities and futures, presumably with a realistic potential to earn profits, since the summer of 2022. Hence there appears to be evidence that the Treasuries market is not as efficient as generally thought.
This raises a number of possibilities, especially since the broad trend of QT and the buildup of short positions in Treasury futures are similar, including apparently starting around the same time in the summer of 2022.
One of these possibilities is that the basis trade opportunity has been created either with the explicit or implicit approval of the Federal Reserve and the U.S. Treasury Department to help provide more general market or specific security demand, thereby enabling the Fed to sell its bonds readily to a class of buyers -- hedge funds -- that would not normally be expected to be natural medium-term holders of these bonds. It would seem entirely feasible for an intermediary to arrange the entire trade including repo finance for a hedge fund with the tacit support of the Fed and Treasury.
If this is the case, then it may highlight the underlying difficulties in funding the ever-growing excess of spending over tax receipts by the U.S. government. This raises the question as to whether U.S. Treasuries are really as safe an investment as is commonly claimed. It strengthens the argument that investors might consider alternatives such as gold and silver.
GATA recently posted a report on gold by Winston Miles of Eight Capital in Toronto that notes that many foreign governments and central banks are now refusing to invest further capital into U.S. Treasuries and are buying gold instead:
https://www.gata.org/sites/
5. Conclusion
The possibility that U.S. monetary authorities have tacitly engineered and supported a policy of encouraging what regulators, including the Fed itself, consider to be a risky trade with hedge funds holding highly leveraged short positions in Treasury futures is perhaps a reason to query whether U.S. Treasury bonds represent the safest investment category globally. The answer perhaps depends on whether the chart reveals a strange coincidence or is a sign of an effort to ease the passage of QT.
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Appendix A:
https://www.gata.org/sites/default/files/Lambourne-Chart3-.png
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Robert Lambourne is a retired business executive in the United Kingdom who consults for GATA about the involvement of the Bank for International Settlements in the gold market.
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