Wednesday, April 29, 2020

The fire in Treasurys

Just where was the fire that caused the Federal Reserve to buy $1.3 trillion of treasury debt in a month -- financing all treasury sales and then some? I've been puzzling about this question in a few posts, most recently here. Commenter "unknown" impolitely but usefully points me to a nice paper by Andreas Schrimpf, Hyun Song Shin and Vladyslav Sushko that explains some market mechanics. I am still not persuaded that these gyrations motivate or justify the Fed buying these or more trillions of debt, but there is an interesting story here.

Treasury yields

Their first graph shows stock prices and bond yields. As risk and risk aversion rose, as they always do in bad times, stock prices fell and bond prices rose, with yields falling.

Trouble starts on  9 March when "the market experienced a snapback in yields" Look hard at the graph. The blue line rises a bit while the red line continues to fall.

OK, but still -- is it a disaster that the US treasury, that had been borrowing happily at 1.8% in January, must borrow at 0.8-1.2% in March? Is it such a disaster that the Fed must buy all new issues of debt?

"Arbitrage" redux

What caused the "snapback?" here is where the paper gets interesting. Basically a bunch of hedge funds replayed an age-old strategy and got caught. Plus ├ža change. They bought treasury bonds and simultaneously sold them in futures markets. Since treasury bonds are great collateral they can lever up a small price difference to make a lot with little investment.

But even arbitrage opportunities are not risk free.** Prices that are slightly off can get further off before they eventually converge. And then the hedge funds need to post margin, which they don't have. So, they follow the mother of all financial fallacies -- risk management that consists of selling  positions on the way down, trying to synthesize a put option with a stop loss order. But selling to who? Everyone else is doing the same thing, markets get illiquid in times of stress (no, they've never done that before), so the price difference widens even more.

Once the funds were no longer able to meet variation margins, their positions were unwound by dealers/futures exchanges, pushing prices lower. This in turn gave rise to a classic “margin spiral”
This is similar to the price difference that the funds had been arbitraging. The price widened -- the arbitrage got better. But this means a lot of lost money in the initial positions.

Other almost-arbitrage price relationships widened too, a now familiar phenomenon
Similarly, the market experienced severe mispricing along the yield curve (yield curve fitting errors) and between benchmark bonds and other similar securities.. indicating a breakdown in arbitrage linking various corners of fixed income markets.  

How in the world did this happen again, so soon?  LTCM redux? Metallgesellschaft? In the treasury markets? Didn't 12 years and 100,000 pages of Dodd Frank, and ten times that of academic papers on various "fire sales" and "spirals," and a small army of regulators put a stop to all this? All the massive regulation did, apparently,  was to further restrict dealer and bank balance sheets, as seen in the repo eruption last summer, and make liquidity worse.

Their policy summary: monitoring should look beyond current conditions and ask the “what- if” questions that are relevant for potential market stresses. To be effective, such fully fledged stress tests must assess the potential scope for forced selling and feedback loops, especially in tranquil periods when leverage is building up.
"Should have" is is the right verb tense! Just why in 12 years did none of this perfectly obvious stress testing already happen?

They provide one answer implicit:
In this context, the reaction function of the central bank is an important background factor. 
Yes. Everyone knew the Fed will ride to the rescue, so why keep dry powder around? And the expectation proved true once again. The Fed is fueling the moral hazard as we speak.

The fire? 

So,  a bunch of hedge funds sold volatility, again, and lost money, again. Little apparent arbitrage opportunities arose between similar securities. (Is 12 basis points a financial calamity? four?). Not enough investors with the expertise to arbitrage 4 basis points spreads are around willing take mark-to-market risk in a time of immense volatility and uncertainty. Capital does move slowly. It was harder for a while for other people whose idea of risk management is selling on the way down to dump securities.

Does this justify buying $1.3 trillion of treasury debt? Is it a problem if occasionally some traders can't immediately sell out of these kinds of trades and have to invest just a bit of money? Must no bid/ask spread ever widen? Do we want zero incentive to lurk around and move capital more quickly? 

Financing the treasury and buying the debt

I found interesting insights here
Under normal circumstances, dealers would be able to alleviate market stresses by absorbing sales and building up an inventory of securities. But, dealers’ treasury inventories had already been stretched, especially from 2018 onwards, as they needed to absorb a large amount of issuance (Graph 3, right-hand panel). Far from there being a shortage of safe assets, there was a glut* in the run-up to Covid-19. 
[my emphasis]

I found this comment particularly revealing, but opening a lot of questions. We are so used to the claim of a "global savings glut" "safe asset shortage"  that signs of these stories running out of steam are  interesting.

This could be a question to which massive purchases are the answer -- the treasury is finding it hard to sell more debt. Of course, treasuries that turn to central banks to buy their debt is not a circumstance that usually ends well.
The recent shifts in the investor base of treasury securities from official sector investors (eg foreign central banks) and long-term investors towards leveraged traders and other negative convexity investors give pause for thought regarding potential future volatility from endogenous feedback loops. 
Wow. If this is true, the game is up. We can't sell trillions and trillions to, oh, the central bank of China. But "negative convexity investors" are not a fundamental source of demand. They buy treasurys only to sell futures, and quickly close out their positions. They are not funneling a trillion dollars a month of new savings to treasurys. So if this story is true, there are no fundamental investors, and that's why the Fed is buying. 

The paper attempts to give a different rationale, that the Fed really was buying in order to make the markets more liquid. (Again, just why this is a huge social problem is hard to tell) The paper claims that the markets calmed because the Fed bought up all these extra treasurys from the dealers, removing the treasurys from the dealer's books. In order to get dealers to arbitrage again,
the authorities [Fed] may need to absorb sales directly rather than doing so indirectly by lending to dealers, especially when funding is not the relevant constraint. This may also explain why, on this occasion, the Fed’s rapid purchases of securities out of dealers’ inventories (to the tune of about $670 billion) appeared more effective in stabilising the market than the provision of liquidity via repo operations, where take-up was relatively subdued.
Translation: the big puzzle in all of this is how the Fed by simply buying can restore "liquidity." To restore liquidity you have to buy and sell, take the arbitrage trades.

Normally (and to the tune of trillions right now in other markets) the Fed simply lends money to dealers who can then trade more. (And make more money. Remember the Volcker rule, don't finance trading by deposits? The idea here is to finance trading by borrowing from the Fed!) But if the dealers are capital constrained, or regulation constrained, that doesn't help. So if the fed buys up all the risky assets from the dealers, the dealers can start up all over again.

I presume the last graph doesn't have up to the minute data and would show... -$470 billion on dealer balance sheets? To buy $200 billion from the dealers why did the Fed have to buy $1.3 trillion?

Why did dealers accumulate so much treasury debt in the first place? If they didn't want to hold the treasurys they should have sold them, and prices should have gone down -- interest rates should have gone up. They had to want to hold the treasurys. That proved a wise decision as they made  ton of money as interest rates declined. But after yields went from 2 to 0.5%, in the "de-risking" demand for treasurys, why didn't they sell off their book again? How much more money do they want to make? Why did they finally sell to the Fed (at what price?)

Bottom line

So why did the Fed buy? Is it a  “dealer of last resort” as the paper puts it, or is it the  buyer of last resort? Was there really a fire, or just the usual bunch of hedge funds screaming that they lost money writing out of the money puts, once again?


* Picky comment. Economists should never use the word "shortage" or "glut," at least absent a price control. They carry a pejorative implication that something is wrong about a demand or supply curve shifting, and needs policy response. The original "savings glut" was East Asian countries that decided keeping some liquid assets around was a good idea in case of trouble, a strikingly old fashioned idea that might look mighty good right now as pervasively indebted America looks around to pay bills for a few months.

**Update: I meant this as a joke, which is probably too subtle as Monika points out in a comment. A true  arbitrage opportunity is of course a sure profit, with no chance of losing money. If you buy cash and sell futures at a different price, and hold to expiration, that is an arbitrage. But when you look at the path, this "arbitrage" is not really an arbitrage as we in finance define one, because you may have to post cash collateral along the way if prices go the wrong way. This little detail has ensnared who knows how many clever traders.  The Wall Street use of the word "arbitrage" means exactly the opposite of arbitrage, namely taking bets.


  1. Just a supersized open market operation to lower interest rates?

  2. While I enjoy the Socratic method as much as the next guy, and am pretty sure I understand (and like) your positions, what confounds me is your reluctance just to state your views, which are deeply held and quite compelling.
    Respectfully submitted,
    A Grumpy Follower

  3. One assumes "trillion" is missing from the first sentence. Most of us can afford $1.3 in treasuries.

    Or does this say something about a change in what qualifies as "real money"?

  4. The primary dealers are in the business of slinging tax dollar debt. If the federales have trouble paying interest, the primary dealers are out of a job.

  5. This comment has been removed by the author.

  6. Stephen Williamson at New Monetarist Economics in a March 16th article touches on this topic ( ) briefly, but does not specifically address the hedge-fund issue. He writes in the last sentence of the article, "Now we're back at the zero lower bound, with plans for a substantial Fed balance sheet increase, no solid science telling us why this is a good idea, and no plans for getting out of this once this virus gets out of town."

    The explanation given by A. Schrimpf, et al., has at least a modicum of plausibility to it.

    Could it be that the FOMC, having received word of the government's intention to undertake a large program of fiscal stimulus, was concerned about the ability of the dealers to absorb the treasury debt issues needed to fund the stimulus? The FOMC then wades into the dealer market and tells the dealers that their here to take up every bill and note in their inventories and then some.

    The 'wobble' in the bill and note market and long bond market is evident in the prices of ETFs focused on the treasury issues (e.g., iShares 7-10 yr government notes, "IEF", and iShares 20+ yr government notes, "TLT") from March 9th through to March 31st. Since the 31st, ETF prices have seen a substantial decline in volatility. If it was the intention of the FOMC to reduce price volatility, then it appears to have succeeded in that effort.

    Whether the effort needed to be made at all remains an open question. But, as you point out above, there is some doubt whether foreign sovereign funds would be prepared to lend to the government at this point. 'If not the FOMC, then who?', might well be asked.

  7. Commercial banks have been big buyers of treasuries as another BIS note (link below) shows, mainly to satisfy LCR requirements. I think the problem that Fed faced in March was the uncertainty about just how much purchases would be needed to restore orderly functioning of the treasury market. Absent that sense/understanding, it could be that they preferred to take big step rather than few small ones to find that optimal limit and risk letting volatility persist. Indeed, they have slowed (but not zeroed) the rate of purchases since then. Another benefit of such a decision would be to signal the market that the Fed is committed to calm the markets, come what may.

    Not defending the Fed. I agree, this has probably created/worsened the moral hazard problem but I think it could be driven by past experiences. Recall that back in 2008, when the financial crisis of beginning to unravel, the Fed had bailed out Bear but had to let Lehman go (mainly due to lack of political will), making matters worse. There was a fierce debate on future moral hazard problem and preventing a meltdown of the system while worrying about after-effects later. I suppose the debate has become alive again but the stance inside the government and the Fed seems clear.

  8. The hedge funds that sell out of the money puts are playing the probability game. To wit. Their bet over time is that an out of the money put with a delta of .25, 25% probability the put will expire in the money, is a safe bet. They Use GARCH models that seem to fortify their strategy. But darn. That Black Swan in the form of the VIX at 80 sends them to insolvency. October, 19, 1987, An AMEX options trading firm earned 9 Million dollars thru the year employing that strategy. By the end of the day, they were down 18 million. a 27 million dollar reversal. Volatility peaked at 150 intraday. Some time later several brokerage houses asked some of the traders who made millions that day if they would "disgorge" some of those millions to cover their trading losses. Some of us responded with language not appropriate for this blog.

  9. "This is the price difference that the funds had been arbitraging. The price widened -- the arbitrage got better. But this means a lot of lost money in the initial positions."

    This is decidedly NOT the price difference the funds had been arbitraging. Swap Spreads (Treasuries vs LIBOR Interest Rate Swaps and Treasuries vs Overnight Interest Rate Swaps) is completely different from Treasury Future Basis (which is what you described, also blew out in similar fashion).

  10. A few questions. This post focuses a lot on "arbitrage" specifically in the treasury market, but I would think that the sale of treasuries to cover margin calls would be the much larger market force causing the spread in the first place and with a more potentially devastating spiral. Is that true?

    A second question this post and others has brought to mind is at the volume of trading when the market was *day after day* plunging 7%+, just how much cash was sitting in settlement? Perhaps that's a stupid question, but with enough volume I would think that a lot extra of cash would be *temporarily* tied up in clearing house settlement. My understanding is that at least for individual investors "Under Securities and Exchange Commission Rule T, there is a mandatory three-day waiting period from the time the stock is sold before you can use those funds. All brokerage firms must abide by this regulation and many firms have programs in place that automatically freeze stock sale proceeds."

    Final question, if index investors want to sell an index because certain stocks in the index are crashing, they can't just sell the losers in the index, and practically lack a ready investment vehicle to invest in the broader market cutting out the specific companies that are triggering the sell off, could that also cause large spreads in treasuries as other investors sell them to buy the healthy stocks in the index?

    I guess my overall question is something like in a crisis can there be a sudden and large demand for cash to the point that the market temporarily cannot supply it even for safest long term assets in order for investors to engage in other market operations? I can see an argument for the Fed *very temporarily* purchasing treasuries that is more about the the broader market's liquidity, but of course they're not just temporarily buying the treasuries at which point you're right they're really just propping up asset prices vs. providing liquidity through arbitrage.

  11. So apparently the FREE MARKET IS DEAD! Short Live Crony Capitalism! Don't forget low taxes for these GAMBLERS! in Carried Interest Special tax rules...Washington, DC!!!

    I propose a TAX to encourage actual INVESTING...a 5% National Sales Tax on all financial transactions...stocks, bonds, derivatives, etc. Heck I pay 5% to Invest in a HOUSE to the REALTOR!

    If I buy a product I pay a sales taxes...why not Investors?

    I am a LONG TIME FISCAL CONSERVATIVE...but today's financiers are just outright criminals who have BOUGHT WASHINGTON, DC...and the overthrow of this will be the UGLY stuff of HISTORY!!!

  12. The observation that disparities between the prices and fair values of futures contracts cannot be arbitraged away in a continuous-time economy, due to collateral constraints, implies the non-existence of an equivalent risk-neutral probability measure.

  13. "Why did dealers accumulate so much treasury debt in the first place? If they didn't want to hold the treasurys they should have sold them, and prices should have gone down -- interest rates should have gone up. They had to want to hold the treasurys. That proved a wise decision as they made ton of money as interest rates declined. But after yields went from 2 to 0.5%, in the "de-risking" demand for treasurys, why didn't they sell off their book again? How much more money do they want to make? Why did they finally sell to the Fed (at what price?)"

    This would suggest that the dealers were somehow collectively hoarding treasuries even in the face of demand. This is turn should mean a higher price charged to customers to compensate for higher expected returns, controlling for inventory costs. Do we have any evidence for this? Dealer competition should prevent this from happening. The more plausible explanation seems to be an excess supply of Treasuries.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.