A segment of the bond market (^TYX, ^TNX, ^FVX) has been significantly volatile recently, particularly with the basis trade involving leveraged hedge funds buying Treasury bonds while selling related futures contracts. Yahoo Finance Markets and Data Editor Jared Blikre joins Catalysts to discuss how the divergence in prices between these markets led to forced sell-offs and liquidity issues.
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A wonky corner of the bond market has seemingly gone haywire the last few days. So we're digging into the basis trade today. I'm Jared Blikre, host of Stocks in Translation. Let's break this down. And as always, we're going to start with the definition, but I want to start with arbitrage, because that's what this type of trade is. Arbitrage is simply buying and selling the same asset in different markets to profit from differences in prices. And the basis trade is one form of that. That's where a hedge fund is on a leverage basis is buying a government treasury bond, that's in the cash market, so-called, while selling a similar futures contract, aiming to profit when the prices move closer together. So they're buying the cash market, they're selling the futures, and they're hoping that these prices converge. So let's just outline exactly how this works. So you're a leverage hedge fund here, you are buying treasury bonds. And again, when I say the cash market, we have a very liquid cash market for treasury bills, all the way up to treasury bonds. And then we have futures that are based on that. And the futures prices typically don't move as much as the cash market. So what they do is they buy one, sell the others, and they wait for these prices to converge. And in theory, that leads to profit. But sometimes things go wrong. Sometimes the prices move the opposite direction. So, recently, we had treasury yields dropping sharply last week, and this meant that the the prices instead of converging, they were diverging. And so all these hedge funds had to unwind their position. This forced them to sell treasuries, and remember that the price of treasuries moves inversely to yields. So they were selling all these treasuries, suddenly, the yields are skyrocketing when they had been falling before. All of this causes liquidity to dry up. And when the liquidity in the bond market dries up, there's not a lot of cash left over for risk markets. And that's very important here, because we often talk about the dangers of bond market volatility, why it affects risk markets so much. And that's because there's just as not as much juice left over. I think it's instructive that gold was selling off in all of this, and that was because gold is a very high quality item, but even it had to get sold to fund some of these losses here. So, I just want to close by showing you the size of this trade. This truck goes all the way back to before the global financial crisis, which I'm highlighting right here. That was that shaded area. But you can see it wasn't much of a thing back then. We had pretty low interest rates compared to the present, and especially with respect to treasury market volatility. It kind of became a thing in the run-up to 2018. In the pandemic, it really fell off a bit as we saw yields plunge. But it's become bigger than ever, at least bigger in decades. Uh, the highest point on this chart in very recent history, it is an $800 billion trade. And I think, uh, given the structure of the market, it's probably here to stay for a while, and there are definitely echoes of the 1980s. So tune into Stocks in Translation for more jargon-busting deep dives. New episodes on Tuesdays and Thursdays on Yahoo Finance's website or wherever you find your podcast.