Odd Lots - How The Crisis Nearly Blew Up One Of The World’s Safest Trades

Episode Date: March 26, 2020

In normal times, U.S. Treasuries are the ultimate safe haven. They are highly liquid and guaranteed to pay out. So when people want to hide out during periods of economic and financial market volatility, you can typically count on there being a strong bid for them. But in the last couple of weeks, the volatility has been so extreme, and the flight-to-cash so severe, that the market stopped behaving as normal. And popular trades involving arbing Treasuries and Treasury bond futures started to fail. On today’s episode, we speak with Josh Younger, a managing director at JPMorgan, who explains how and why it started to fall apart.See omnystudio.com/listener for privacy information.

Thanks for listening to OddLots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, OddLots on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a very big. It's a lot. It's a firm. It's a lot. It's a lot. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode. of the Oddlots podcast. I'm Tracy Allo Way. And I'm Joe Wisenthal. So Joe, I know there's a lot to talk about when it comes to the recent market turmoil, but I have to say there's one thing that stands out to me, and that is what we've seen in the U.S. Treasury. Can I just back up for one second? I just had a thought. You know it would be funny when, well, I don't know if funny is exactly the right word here. Okay. But it would be very interesting to compile a complete compendium of all of our podcast intros over the last couple months and through this as things get crazier and crazier

because I feel like in the beginning, it was like, well, let's talk a little bit about disruptions to the Chinese supply chain. And then we're at the point of, let's talk about how suddenly the safest asset in the world isn't trading, like how it's supposed to be. And I feel like we could track the course of the entire crisis just by comparing our little intros here day after day. So maybe that's a project we'll do one day. Yeah, definitely not funny, but probably noteworthy. That's for sure. Right, that's funny. But darkly funny, maybe. Yeah, I don't know why I'm laughing, actually. Um, okay, but you're exactly right because the crazy thing about the big sell-off in the treasury market, people complaining about a lack of liquidity in the

treasury market is that it is supposed to be the most liquid market in the world and a safe asset in times of turmoil. It's supposed to be cash-like, and we haven't necessarily seen that over the past few weeks. Right. This is a very key and important thing to understand, which is that U.S. Treasuries, they have the full faith and credit of the United States in a normal stressful scenario, In a normal period where people are worried about the economy or worried about, you know, whatever worried about the financial system because they are almost, they're essentially money, money that pays an interest rate, people tend to buy them and people tend to hoard them during dark times.

But what we've seen in recent weeks is such an extreme dislocation and such extreme anxiety that even an asset that's arguably the safest asset in the world, U.S. Treasuries, has at times been gotten sold. Even at times it's perceived as not being safe enough. And understanding why that is the mechanics of our financial markets or understanding why there have been periods of stress where they've gotten sold can really tell us a lot about the plumbing of the U.S. financial system. Well, I think the issue is not only have U.S. Treasury sold off,

but the actual selling process wasn't as smooth as many people. might have expected. So for instance, we saw bid-ask spreads in off-the-run treasuries much, much higher than they would normally be. But even on the run securities were higher as well. And market depth, basically across the treasury curve really plunged all the way back, I think, to the 2008 crisis lows. And as we've discussed on previous episodes, the thing about U.S. Treasuries is they're basically the funding market for everything in the global financial system. So if you have trouble in treasuries, if you have illiquidity, and if you have a sell-off, then it can feed into all sorts of things, including financial conditions.

And that's probably the way that it starts to affect the real economy as well. So we're going to be talking about the U.S. Treasury market. We're going to be talking about plumbing issues. But the thing to keep in mind is that all of this really impacts the world. the pain now being felt across Main Street. And I just want to, as we have to do these days, we didn't have used to have to do it so much, but we always have to have this caveat in the beginning of every episode where we point out the exact date that we're recording this, because again, things can change so much by the time

recording has happened so the time people listen to it. We were recording this on Tuesday, March 24th. And I also want to just point out, the Fed has always. already done a number of things to ease some of this tension a little bit. So we'll talk a little bit more about what the breakdown was, what the Fed has already done to relieve some of these tensions we're seeing in the treasury market, in the funding market, and of course whether it's enough and what that tells us about how the system works. But just again, whenever you're listening to this, Tuesday, March 24th, 9 a.m. Eastern time is when we're recording it.

It's kind of worrying that we have to provide the hour nowadays as well. Yeah, exactly right. Okay, well, without further ado, we're going to talk to someone who has been on top of a lot of the troubles in the treasury market for some time. He's someone whose research I've been following closely for years now, and I have to say he's really come out on top in the recent volatility. His stuff has been excellent and lots of people are reading it. Josh Younger is a strategist over at J.P. Morgan. Thanks so much for coming on, Josh. Thanks for having me.

Josh, I just want to, I just for listeners, before we get started, I want to point out several people have suggested in the past that we should have you on. So I'm really excited about this. And of course, your name came up in one of our best episodes that we did with Brad Setser, where we talked about the Taiwanese life insurers and how they were hedging their currency risk. He mentioned that you were one of the best on this. So you are definitely a sort of a long-time high wishless guest for us and for a lot of our listeners. So really appreciate it. I'm excited to be on. I'm a fan of the show.

So it's always great to participate. All right. Awesome. So, Josh, just to begin with, I want to start out with the troubles that we've seen in the treasury market. So I spoke a little bit about the liquidity issues. But I wondered if we could maybe zoom in on one thing in particular, which was, this notion of levered U.S. Treasury trade. So one thing that happened recently in the market sell-off was that we suddenly got a big

difference between futures contracts for U.S. Treasuries and the cash U.S. Treasuries. Can you explain exactly why that happened? Yeah, sure. So with anything like this, a crisis of this magnitude, it always starts in a place you really recognize immediately, and then it accelerates in a place you didn't really expect. And so back in 2008, that was the subprime mortgage market, was the accelerant. And in this case, the accelerant turned out to be not a risky asset, not credit markets, but like you mentioned

earlier, you know, risk-free assets, things with no credit risk, treasury bonds. And so the question is sort of why was this divergence that you mentioned really important and where did it come from? So the initial phase of this was really a shift in fundamentals. So any economists will tell you that long-term interest rates should have a lot to do with long-term potential growth, and to some extent, a flight to quality. And as the COVID-19 outbreak accelerated, there was a real shift in expectations. This is real fundamentals here.

Growth expectations came down. The set of risks around those growth expectations increased, and so there was a natural flight to quality, and interest rates naturally go lower, especially as the Fed starts to cut rates. So the question is, you know, how can you access the market? Like, how effectively can you access the market? And treasuries have usually been this highly liquid, you know, cash-like asset that trades at very

tight bid-dask, very low transaction costs. The issue arose really from the, initially, the velocity of this move because expectations were changing so rapidly that you had two things happen. The first is it's just very hard to be the buyer to the sellers and the seller to the buyers if prices are moving around all over the place every day. It's just a very difficult exercise. And so that means your willingness to participate in those transactions is a little less. That's particularly true of high frequency traders who are really trying to monetize the very small difference between the bid and the ask price. And when things are highly volatile, there's this risk that a bunch of orders you had outstanding that you thought weren't

necessarily going to get hit, end up getting hit because the prices moves rapidly. And so high frequency traders or something like 80 percent have looked at. liquidity in the Treasury market, and that dropped to 30 or 40% at times when prices were moving around that violently. In that kind of environment, really, there's a flight to liquidity among products. So we think of this as liquidity tiering. And if I need quick access at low transaction cost, futures are the best outlet for that. Just go to the exchange. Treasury futures are going to be the tightest, the lowest transaction cost, the largest size, the biggest group of participants.

mostly because they don't require balance sheet and they're traded on an exchange so they're pretty transparent in their pricing. And so because rates are moving lower, you know, lower yields, higher prices, the futures led that move and they started to diverge a bit from the bonds into which you can deliver the futures contract. So you think of a Treasury futures contract, it's just like an oil contract. You have an agreement to sell at some future date, which gives you economic exposure to the price of that thing.

in the case of treasuries, you have a bond that's part of a deliverable basket. And at the expiry of the future, I give the bond to whoever bought, to whoever I sold the future to. So in principle, those things should be really tightly correlated, just simply because I could hold the futures contract to expiry and deliver the bond. So I have a guarantee buyer for my bond. But over the course of that period before expiry, you can get these sharp discrepancies. And in this case, because of the liquidity value of that futures contract, they started to rich in relative to the cash bonds. That could have been contained that's happened in the past. That's pretty common, actually.

There's sort of an old adage in treasury trading that if you don't know why prices are moving, you just say it's futures led because that's the most opaque part of the market. So when prices are going down, futures prices tend to go down more. And when prices are going up, futures prices tend to go up more. In this case, it was a little more severe than it was typical, but it wasn't completely outside the range of possibility, but it did put a lot of pressure on two groups, which are key to this whole thing. The first is the relative value active manager community who really are holding a lot of positions where they're long, the bonds and short the futures contract. And the second is the dealers themselves, because when they are asked to bid on off their on treasuries, it's hard to find the

buyer for that bond immediately. And so the tendency is to sell a futures contract to reduce your exposure as quickly as possible. And so both hedge funds and dealers were in this very large futures basis position by which we mean they own the bonds generally on a levered basis. And they're short the futures contract. So in the futures contract, Richens relative to the bonds, they face losses. There's a lot of, I want to break down here. But talk to us about the significance of the discrepancy that always exists, basically, in any market between an on-the-run treasury and an off-the-red treasury. So I take that a freshly, the treasury issues an auction, a fresh auction of 10-year treasuries. Those are on the run. But a previous 30-year auction that

was done 20 years ago, it's the same length that's technically should trade around the same prices at 10-year auction today would be less liquid. And there are entities that take advantage of these discrepancies. Talk to us a little bit about the mechanics of why that phenomenon exists and then why that continue, why that sort of distress that we've seen of late, this dash for liquidity exacerbated. Yeah. So generally speaking, those discrepancies are pretty small. They arise from a bunch of different things. But in the case that you're talking about, if you had an old 30 year, originally 30 year bond, it's rolled down to 10 years. It probably had a much higher coupon back in the day.

And so rates are lower now than they were 10 years ago. And that means that that bond is trading at high premium. So when rates go down and the coupon stays the same, there's a lot of value in that, say, 4% coupon, if today's coupon would be 2 or 1% or today even lower potentially. So it's not going to be $100 for the bond. it's going to be more. And so there are some participants that don't like to buy premium bonds because it doesn't have as friendly accounting treatment or they don't want to put up that much cash for the same income. The yield is the same. The dollar price is different. So there are other

there are different incentives that people face both economically in accounting and otherwise. And so there might be less demand for that bond than the on the run treasury, the on the run tenure, even though the maturities are the same, the issuers the same, et cetera. So those little features matter. And the liquidity in the on the run tends to be better just because we had an auction. We know we're priced. And there's a lot of it outstanding. One of the issues you run into with off the runs is the Fed is maybe bought up a bunch of this bond too. So you don't really have a ton of pricing transparency.

So all these little things matter. Under normal circumstances, it's worth a couple hundredths of a percentage point, which for some people in the market is a lot. But in general, it's really a very small pricing difference. And that reflects the fact that at the end of the day, these are really the same instrument fundamentally. It's just these small differences change the price. What we've seen recently is much larger discrepancies in the pricing and especially volatility in those discrepancies. So the issue for a dealer is less whether or not this bond is trading at a lower price than you would expect, given the yield on some more recent liquid issue.

it's the fact that if those prices are moving relative to each other rapidly, it's very hard to manage the volatility in their book, because generally speaking, a dealer is going to be long owning a bunch of these off-thrun issues, and they're going to try to hedge their first order risk, which is just the level of rates, with something much more liquid. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy.

Bond markets are massive. murky and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk Vanguard marketing corporation distributor. So just going back to the levered U.S. Treasury trade that we were

discussing, I mean, you mentioned that a lot of these relative value players were obviously borrowing money. They were levered in that position. I guess the clue is in the name of the trade, levered U.S. Treasury trading. And you also mentioned the dealers being less able to, to intermediate some of those trades. Can you talk about the relationship between hedge funds and dealers and where the repo market actually comes into this? Yeah, totally. So the repo market comes in simply because these price discrepancies are very small.

So if you want to make a certain amount of money, you have to take out loans. You need to lever it up. And so that was generally case. That's been the case for a very long time. There's a couple of big differences now. And it arises from the interaction of market, and regulatory changes and the way that banks have been incentivized to manage their own balance

sheets. So one of the big lessons of the crisis in 2008 was clearly too big to fail as a problem. And so the regulatory suite that was introduced was partly meant to address this too big to fail issue. And in doing so, we need to define bigness because that's not an obvious thing to define. The easiest way to think about it is simply size. And it doesn't really matter what you own. you could own just treasuries, and that's a low risk risk, weight assets anymore if we're trying to control bigness in general, so we want to think about it holistically, so that we put a limit on leverage in general at banks. And the implication of that is that the space on your balance sheet taken up by anything

has value because you're using it instead of doing something else. And in particular for a bank, it means you have to think about your balance sheet ahead at time. You need to plan ahead. Increasing your leverage as a dealer to take on more treasury bonds in your inventory, that didn't necessarily add to your cost of capital. But in the case of a bank now, we have to allocate balance sheet because it's a scarce commodity. And so we need to think ahead. That means you have to plan ahead, which means you have to make allocations in advance. So generally speaking, the strategy has been to look at a list of clients, think about how much they've utilized balance sheet in the past, how they've utilized balance sheet, and repo is definitely the most significant source of that usage. And so you say, look, you used a billion dollars last year, we'll give you a billion dollars this year.

You use $2 billion last year, we'll give you $2 billion this year. And if you don't use it, well, you might not get as much next year, which is a very reasonable way to think about it. are losing. I just think it as a budgeting exercise. So that created a different set of incentives that were less economic. If I'm a relative value trader, I've got two things that I need to think about. One is, what is the set of actual opportunities, the economic incentives, which bonds are trading a price that's too low versus other bonds and what bonds are trading a price is too high relative to other bonds? How am I going to make money? The second thing is how do I maintain access to the leverage I need to make those trades interesting in the first place.

So if the opportunity set is not particularly appealing right now, how do I make sure that I'm using my balance sheet, my balance sheet allocation, simply to have access to it when something more interesting comes up in the future? And so one way to do that is to find a trade that has limited downside. It's almost an arbitrage, if not a zero limited downside position. It uses a lot of balance sheet, and it's something I'm familiar with in general. that's where this futures basis position comes in because it is balance sheet intensive. So I'm going to buy a bond.

I'm going to lever it with repo. And then I'm going to sell the future against it. And the way I think about it, worst case scenario, I'll just give the bond to whoever bought the future for me at Exbury. So I have limited downside. And I've taken up that allocation. So before we get to how everything started breaking down a little bit more, I want to go back to one quick thing.

you said, which is, you know, part of the post-crisis shift in the sort of regulatory regime was to try to avoid too big to fail, move risk away from the banking sector until now we have all of these, you know, non-bank entities engaging in all these trades. And, you know, so far there's a claim, and we talked about this before, there's a claim that maybe if you look at what's going out of the market, there's some vindication of the post-crisis regulations because, although there's a lot of fragility in the financial market, so far, there is not particularly much concern about the banks themselves. Why does it make sense, just for this, just for my own education, why does it make sense to count risk-free assets, treasuries against any entities

balance sheet when evaluating its size? Does that make sense? Yeah. So, Just being bigger makes you more complicated if you've got big issues. So in the case of Lehman, a lot of the disruptions that were caused by the bankruptcy were not necessarily just their credit portfolio. It was unwinding the whole institution. So they had a very large swap book that was mostly collateralized with stuff like Treasuries and Cash. And that was such a large position to move to somebody else.

I mean, you have to find someone else to take the other side of those trades. that's a very complicated exercises. Why, when you look at things like global systemically important banking scores, which are used to evaluate capital surcharges and other things, basically an assessment of cost to being big to society, it's not just size, it's also complexity. So if I'm relatively small, but highly complex, and that's, Lehman was another great example of that.

It was not the Bigs Bank in the world by any measure, but it was highly complex. that creates issues as well for markets in the event of a, it's really on one. So it's both size and complexity? Yeah, it's all these different components of bigness, which is why I'm sort of not calling it size. I'm calling it bigness because bigness takes on many forms. And one of them is simply the size of the institution. The other is the risk they take, just like back in the day.

And there's other things like my reliance on short-term wholesale funding, my complexity, the level of exposure to things like exotic derivatives, is, things like that, which can be very disruptive if things go bad. Okay, so we've sort of touched on the levered U.S. Treasury trade and what was happening there. But describe for us just how badly things actually went in the U.S. Treasury market over the past few weeks. Yeah, so over time, this position got quite large simply because people wanted to reserve balance sheet. So the situation I'm describing before where I'm doing treasury basis trading simply to

park balance sheet and maintain my my access to it, that grew to a very large position. So at most, it was probably as much as to $600 billion. We think it's not necessarily that large and that's just from public data. But even if it was half of that, that's a $300 billion lever position that is non-economic. And under normal circumstances, that would be fine. It would actually reduce the risk of that kind of levered position, but two things started going wrong. The first was this liquidity tiering led to market losses on the futures basis position because futures were outpacing treasuries as rates declined. And that was, again, mostly about fundamentals. It was mostly about a shift in the economic outlook and a very rapid shift in how people price interest rate risk and things

like that. So that was, I wouldn't say expected, but understandable and expected under these circumstances. And there was a, it was at least a sense that at worst, like we talked about before, I could just deliver the bond at the expiry of the futures contract. My downside was limited. I'm not going to actually realize these market losses. It's just a passing thing. And I just have to be a little patient and weather it for a few weeks. The problem became, as more of these banks started to do work from home arrangements, operational risk started to be an important consideration, which is to say these levered positions are very operationally intensive simply because you have to source funding. There's a lot of underlying transactions to getting that much repo leverage in the system.

When everyone's at their desk, that's not a problem at all. It might be a little bit of an operational cost, but it's something that can happen quite easily. But as everyone's starting to migrate to work from home, there's a concern that those mark-to-market losses, which in theory our passing might end up being realized simply because the operational issues forced me out of a position at a bad level. And that became a risk to manage, not because it was necessarily happening because, A, if I think it might happen, I might want to reduce my exposure, especially if it's not an economically driven position in the first place.

And B, and this is a financial markets thing that happens a lot, I might be worried that the next guy thinks it might happen. So I want to be in the first. So the perception, so the perception that operational risk was important. And to me, it potentially to others, caused a little bit of an acceleration in that process at precisely the wrong time because that was when dealers were already using most of their balance sheets for the activity that already occurred. And all of a sudden, you'd have an influx of selling from these highly levered positions. The important thing here is if you take even small loss, on a futures basis position, most of them are levered 50 to 1. So you could end up eating through capital pretty quickly. And so there was an added incentive to reduce exposure to that. That involves the sale of bonds to dealers who are now taking up even more balance sheet. And that created a bit of a vicious cycle that infected other areas of the Treasury market and caused market debt deployment even more. So just to press on this idea of operational risk, because clearly,

it was on a lot of people's minds. And I actually wrote a little bit about this at the time based on your research. And one of the pushbacks I got from some readers was that operational risk wasn't really a thing in the financial system because banks all did, you know, exercises and stress tests. And they were all supposed to be able to work remotely from home. And it just wasn't as big an issue as some people were making it out to be. What would you say in response to that criticism? So it may not be, it may not end up being a significant risk. It's more about the perception of those risks and the willingness of particularly a levered position that's already taken losses to rely on those operational issues. So I guess the way I would think about it is

if the perception is that this might be a problem. And I totally agree that stress testing is an important part of this, that planning for these types of scenarios is a big part of it. Banks are much better capitalized than they used to be. They have many more people. in the operational positions. They're much more efficient in doing so. And in principle, they had plans for work from home. But if it all goes according to plan, then it's no problem. And business as usual, if or close to it, if it goes wrong, I have a much bigger problem, especially because at best, I'm not even looking to make money on these trades. So I'm trying to maintain access to balance sheet. I'm not necessarily trying to put on a large directional

position. So the upside is limited or zero. and the downside becomes very large. So I'm totally fascinated by this. So obviously, from a just sort of pure abstract markets perspective, what we know that over the last several weeks has been this historic attempt to grab cash or grab liquidity in any scenario. And we see this from individuals. We see this from companies.

We see it from companies drawn down revolving credit lines. we know it exists. People who've talked to say they've never really seen anything like this. So that accelerates selling that blows out some of these trades because, okay, you know, it is not time to do. We need to sell treasures. We need to get liquid assets. Talk to us a little bit more about the specific operational concerns because I don't think

many people understand this at all. And I know Tracy just asked you about this and you mentioned it. But when you say that just from an operational standpoint, executing these trades, obtaining the liquidity you need to hold onto the trade until they become profitable is necessary, just talk to it. What is that involved? What's that like? What makes it operationally intensive to hold on to the trade? So really, it's because a lot of this funding tends to be overnight. So repo markets are very strongly skewed towards. overnight funding. Part of that is because it's easier for banks to do overnight funding. It's

harder to have funding that's locked over statement dates and things like that when all of these regulatory charges are assessed. And so if you keep the funding you offer as a lender overnight, you have a lot more flexibility going forward. And that means that the client side is going to be pushed in the same direction. That's the accommodation that's made. The problem is to to roll your trades overnight, you have to do no trade every day. And there's a risk that there's no one on the other side of the phone. And we saw this most acutely in 2001. Excuse me, just to go back, you mean phone literally, right? Literally, yeah. And maybe call farting doesn't work. Right. So people who have this view that like all markets are just done over the computer,

and you enter some keys and you make a trade, this is key part of the financial plumbing over the phone. Yeah, a lot of this, a lot of stuff still happens over the phone or at a minimum over chat or things like that. And there's confirms that go back and forth. Banking is still a very or dealing is still a very paper-intensive business. Even if that paper is digital, it goes back and forth a lot. And so it's A to have someone on the other side of the phone and B to make sure there's someone to put a price on it. No, I only ask that because again, I do think a lot of people have this imagination that it's all algos and keystrokes and. logging into an account and I think an important facet to drive home. Totally. And there are parts of the market that are very electronic, but these things are plumbing oriented tend not to be. Got it. Okay. So just to sum up, we had this levered treasury

position or basically a basis trade between the futures and the cash contracts. That got strained in the recent route, partly because dealers weren't able to come in and intermediate through the repo market. And at the same time, we had all these liquidity strains, like huge bid ask spreads and things like that emerging in what, again, was supposed to be the most liquid market in the world. Fast forward a little bit. And we have seen this issue pop up with the Federal Reserve. And in fact, Jerome Powell was talking about what had happened in the Treasury market in one of his emergency Sunday announcements. What do you think about, the Fed's moves so far. How much of this is on their radar, are they understanding the concerns

correctly and are they doing the right things to fix it? Yeah, so they're definitely aware of it. They're definitely responding with the kind of magnitude they need to. And it's interesting to think about these asset purchases that they've announced. Initially, it was 500 billion of treasury purchases and an unspecified pace. And now it's essentially unlimited. The reason why they're responding like that is not because it's QE in the usual sense. I think Powell was asked if this is QE and he basically said, call it whatever you want. QE is quantitative easing is, is really a monetary policy tool to take term premium out of rates and incentivize people to take credit risk. So when you think about investing in fixed income products, I can take term risk. I can

lock my money up for longer. I should receive some sort of premium for that or I can take credit risk in the sense that I might not get my money back. And so if you reduce the returns I get simply by locking up my money for longer, well, maybe I might want to do take more credit risk. And that was the original intent of quantitative easing. This is not about that at all. One, because the treasure curve is already quite flat. There's very little term premium. In fact, by many measures, it's negative. So we certainly don't need to take term premium out of the curve. it's much more about operational and market structure issues, and they're quite clear on that. So the question comes up, why respond with this kind of size to something that really what we've

been talking about is a group of relative value hedge funds, the market making in treasuries specifically, and all pretty arcane topics. I mean, this has been a pretty technical conversation. So why is the Fed doing unlimited QE to address this rather technical issue, which is important to a lot of people, but not necessarily to most participants in financial markets. So, of course, there have been several different Fed operations that we've seen just over the last week. So again, today is March 24th. Yesterday, March 23rd was when we saw the announcement of all kinds of new lending operations plus the alphabet soup of the programs and the unlimited QE.

The Sunday before that was when Powell made the surprise announcement to cut rates to basically zero and the $700 billion in asset purchases, which almost didn't do anything for risk assets. And the week before that, we saw a technical announcement out of the New York Fed talking about how they were massively expanding the repo operations. When that New York Fed announcement came out, they're like, okay, I don't know, this is QE. this is a major boom for these relative value funds that we've been talking about, the ones that arbitrage the difference in pricing between futures and treasuries, and this sort of saved them to some extent or really protected them. And what I'm wondering is, do we need them? Are they essential to the way the financial system works that we need entities out there

levering themselves 50 to 1 to take advantage of minor price discrepancies? between all the run treasuries and futures, or is this just, could we live without these entities performing this function? We certainly need somebody to police these relationships, but the moment is less about what we need in the financial system and more about what we don't need, which is a disorderly and rapid unwind of these positions. So what the Fed is doing is they're putting up firebreaks, and they're saying, I want to isolate this issue to a certain segment of the market, and I really want to prevent de-levering in one sector from turning into de-levering in other sectors, in particular, de-levering the banking system more broadly. So the risk was that the pace and

ferocity of this unwind took up so much dealer balance sheet that they were unable to intermediate other markets as well. And so you started seeing issues in credit markets, particularly in short-term credit markets. You also saw this dislocation becoming so acute that you could do riskless, both credit risk-free and interest rate risk-free, unlevered trades and make more doing that, buying the bond unlevered, selling the futures. You can make more money doing that than buying bank CP. So you had two risks. One was severe intermediation frictions in other markets, and the other being a demand shock

to the credit market, particularly the short-term credit market, which is really the lifeblood of a lot of institutions. And if you follow that chain, there's... There's a scenario that starts to become not necessarily based case, but certainly more likely, where corporations lose access to capital markets because of these market structure issues, and they're forced to draw in their bank revolvers. And that becomes an incentive for banks to start selling assets to fund those draws. And we've actually seen over $130 billion of those draws already based on public information. So that's when you encircle the banking system, when you force corporations who need liquidity for real economy reasons to tap their banking lines rather than capital markets and now banks have to sell assets. So now I have hedge fund selling assets, credit funds selling assets, bank selling assets.

And there's a risk that's materialized in part where you start seeing the redemption of money market shares. So prime money market funds, particularly those owned by institutions, have lost more than 20% of, assets in a week. And that's the kind of scenario where you start to see echoes of the 2008 crisis. We're not there yet, but that was the epicenter of 2008, was this run on the prime funds. And you're starting to see some contagion from, again, a relatively arcane world through the accelerant of the dealer complex and the constraints that they have and into the credit markets. Right. And a lot of the programs that the Fed has announced so far are, I don't want to say rip-offs, but replicants of some of the stuff that we saw in 2008. So they have announced a plan to

support money market funds. And they've also announced another iteration of the asset purchase program TAF, which I'm sure anyone who is around in 2009 will remember that one. One thing they haven't done, and maybe this is important since we're talking so much about the balance sheet constraints for dealer banks, but one thing they haven't done is loosen regulatory constraints on banks. And I just wonder if that's something that you would ever expect to happen. Here in Hong Kong, we have seen some of this. The financial regulator here actually lowered some capital buffer requirements for banks to help them get through this and help them keep lending to the economy. So is that something that we could see?

in the U.S.? It's possible. They've taken two, or they floated two approaches to this. This is kind of the supervisory angle. When we think about Fed intervention, there's direct intervention in markets through open market operations. That's the purchase program that you described

and also offering repo at a below market price. There's facilities that are temporary emergency facilities like the commercial paper funding facility and the various other acronyms that I won't do a laundry list of that right now. But lots of 2008, type stuff, which are really about providing a buyer of last resort for various assets, at least on a temporary basis.

And then you also have these supervisory solutions, which are to say, we need to change the incentives and the costs that we assess banks to enable them to perform their function more efficiently, particularly under these circumstances. So in that statement, I don't even remember what it was at this point, but there was floated the idea that we need to reassess capital and liquidity requirements. and they dropped required reserves to zero and things like that. So it's certainly under consideration, it's a lot easier to intervene in markets than it is to change bank regulations,

simply because regulations create all kinds of different incentives. And in principle, you could pretty rapidly change that incentive structure, but you want to be careful about it in a couple of ways. The first is one of the things they mentioned was reducing liquidity requirements. So banks, as a consequence of this liquidity coverage ratio rule, are required to hold high, quality liquid assets in a certain amount to cover potential outflows. So what the regulators do is they say, this kind of liability has this kind of run risk, and this kind of liability has this kind of run risk.

And we go through the bank balance sheet on the liability side, and we say, you need to be able to cover your 30-day stressed outflows with what we deem to be high-quality liquid assets, which are functionally just treasuries and cash for the most part. So in principle, what they could say is to banks, you can just hold less of those liquid assets. We kind of told you to hold liquidity for precisely this situation, right? You're facing a demand for cash. You have high-quality liquid assets that you're supposed to be able to monetize at a reasonable cost. And so why don't you just sell those assets and fund whatever draws on your cash you need? That was the point of this thing in the first place. The issue is this particular,

particular crisis is localized to the high quality liquid asset market. So large scale sales of high quality liquid assets, particularly treasuries, to fund, draws, and credit facilities are just going to make the problem worse. So that's not necessarily the right supervisory solution. The other thing you could do is you could say, well, remember when we said all assets count towards your leverage, well, now cash and treasuries don't. So those are no longer contributors to your leverage because they are risk-free and therefore you can intermediate as much as you want and you won't incur balance you cost. That's a big change to how banks do business. And it's something people have talked about. We don't have a sense of whether or not that's likely,

but that's one thing under consideration. And I guess the last way to think about it is with these facilities, they can get special treatment under regulation. So the money market liquidity funding facility that you mentioned earlier, that's to provide secondary markets, support for sales of short-term credit instruments. So if a prime fund is facing redemptions, they need to sell commercial paper to fund them or to maintain their liquidity requirements. Dealers need to be able to both purchase those, hold them on their balance sheet, and finance them. And what the Fed has done is they provided this facility to offer funding. So they take as collateral assets sold by prime money market funds preferentially. And they offer cash for that. And they

carved that out of existing regulations. So they said, this doesn't count towards your leverage. This doesn't count towards your risk-based capital. So through these emergency facilities, you can offer prefer preferential treatment that lets the firebreaks work more effectively without changing the whole incentive structure of bank regulations. How much have what we seen so far in terms of the response to the crisis, as well as the fact that the crisis has not infected the core banks, particularly much, a sort of vindication in your view of the system, the regulations that were passed by Congress in the wake of the great financial crisis and the facilities that Ben Bernanke and others built at the Fed during

it. So the way I think about it is what we're facing here is a cash shortage in the real economy. So if you don't have enough cash and the sole producer of cash, namely the Fed, can simply produce more cash, that should really solve the problem. So you're going to see a lot of volatility in the meantime because the demand for cash and the creation of cash will be offset in timing. Sometimes the Fed will offer a certain amount of cash and the market actually needs more than that, so you'll see more stress. But over time, if you average that over the next few months, this is a problem the Fed can solve. So it's less about the existence of credit products that were much riskier than they were thought to be.

That was the issue in 2008. Right now it's just a demand for cash that can't be met by the markets themselves for a variety of reasons. But the Fed can solve that. So I think it's a vindication of a bunch of things, but the most important being the willingness of the Fed to provide liquidity in these kinds of episodes. to avoid the fire sale of money, good assets, like things like treasuries, you're going to get your principal back. But it's simply a matter of piping it through the right plumbing, and the Fed can help alleviate those stressors.

And in doing so, they can avoid bigger liquidity issues turning into credit events. Because the issue is we don't have a credit problem necessarily right now, at least at the scale of the economy. But if capital markets are shut and there's no access to cash and there's still a need for it, especially if we're going to shut down the economy for a couple of months. And the Fed is not providing that cash, then it can turn into something much more sort of deep within the financial system. I guess the trade-off of constraining bank balance sheets so that they can withstand this kind of thing is that it means that you have to rely on the Fed a little bit more to provide that sort of last stop liquidity.

Just on that note, Josh, you've been writing about this for a long time. In fact, I think this week you published a five-part series on the Fed's emergency measures and how those are playing out in the U.S. Treasury market. Just to sum it all up, how long do you expect these stresses to continue? It's really hard to say. I wouldn't be surprised if it's a few weeks simply because the size of the position that ultimately might be unwound is quite large and it has to go through a relatively narrow pipe. And that's if we keep it isolated to that futures basis trade. And it's obviously gone into

other areas as well at this point. But over a few weeks to a couple of months, like the Fed should be able to manage this process. I think the thing to keep in mind is that at least from my perspective, Fed intervention is not about making things normally. It's about avoiding the more catastrophic outcomes. So the Fed is not supposed to intervene and make everything look like it did six months ago when liquidity was bountiful and markets were trading very liquidly with zero transaction costs in some cases and like very large size and it was easy to do anything and so forth. That's not the Fed's mandate. They're supposed to be an emergency, a crisis manager. And in that sense, I think they'll get control of the situation reasonably quickly. They already have to some extent,

And at least in the futures market where things have really been most acute, there are some incremental issues there. Margin requirements going up in futures is one of them, which exacerbates the problem. But fundamentally, that situation, I think, is mostly at least under control in the sense that it's unlikely to accelerate in a bad way. I mean, if the real economy side of the situation continues to deteriorate at the speed that we've seen, then the number of any sort of credit-needing institutions, including companies that right now, today might be considered high-grade and high-quality or investment grade, could in theory continue to deteriorate. And so a company who, okay, we can issue them commercial paper because it's high-quality, we don't have to worry about their creditworthiness.

is eventually the economic degradation could limit anyone from really being able to make cash flows if other things don't stabilize. Does that eventually become a problem that essentially the Fed can't get under control if they start to, whether it's municipal markets, companies, et cetera, where we start to see a real problem where we doubt anyone's ability to make their payment? Totally. If things keep going at the pace they've been going, we're going to have big credit problem But there's something fundamentally different about this recession than prior recessions, and especially 2008.

And the key here is that it's a totally exogenous event. So this is not about companies that appear to be viable enterprises that were actually inviable, and we just didn't realize it, and it's not actually a reasonable business model, and those companies have to go. It's creative destruction. It's just happening too quickly. This is not that. This is a pure stoppage, and it's a liquidity issue.

So if you have a company that would otherwise be a going concern under normal circumstances and you just stop the economy for three months, the Fed can bridge that gap and the government can bridge that gap under the assumption that when everybody leaves their houses, the world is not as it was, but at least it's reasonably similar. It resembles it. Yeah. And so if that's the case, it's really literally a liquidity issue. And that's precisely the kind of thing the Fed can solve.

If the interventions are structured in a way that doesn't necessarily solve the core problem or otherwise too small or delayed, you could end up with real credit problems as liquidity becomes credit stress. The Fed has clearly shown a couple of things. One is they're willing to act in size at a minimum. When you have open-ended purchase operations, they're going to buy more than $600 billion for the Treasury this week. So this is a massive pace of intervention. There's $5 trillion of liquidity through repo operations. They're talking about a small business lending facility that could reach $4 trillion.

They're talking about really big numbers. So I don't think size is an issue here. The structuring of these programs is something they've been quite dynamic about. So the commercial paper funding facility announced last week, price was too high. They brought it down this week. They went from 200 over OIS rates or 200 over Fed funds to 100, 110 over. So they're willing to adjust the scope and the pricing of these programs to make sure they're effective and they're willing to roll out new things.

And this money market liquidity funding facility was a new thing. So it resembled something else, but it still was a new thing. So as long as they are being creative and being big and being timely, it should be something that can be kept under control. The risk is always that the longer-term economic consequences of an advance of these magnets do it are very hard to have a sense. We don't have a lot of examples of that. No. Josh, that was an absolutely fascinating conversation.

We really appreciate both your research and you coming on to have this conversation. Finally, we were able to have you. So thank you so much. Yeah, it's been fun. Thanks, Josh. So, Joe, you can probably tell I really enjoyed that conversation. I love digging into this, you know, treasury basis trade because it's one of those things that not many people were looking at or writing about except and please allow me this one small victory lap. I love that something that had the potential to blow up is kind of doing so in an expected way.

But, you know, again, the big deal when it comes to the U.S. Treasury market is that it's not supposed to be a risky market. You're not supposed to get these big sell-off events and this type of volatility. And yet, that's what we've just seen. One day we'll do an episode where it was something I was writing about a few years ago and it all happens, but I don't know what that's going to be. I thought he was great because I thought that was, yeah, something like that. Maybe when the coin finally gets minted, we'll do an episode on that. two things. One, his explanation of what these futures, triest, trades are are incredibly clear and simple, and I appreciate that. Also, like, I have to say, I just sort of appreciated his calm demeanor at this time because, you know, this is a crazy time.

He was probably the most chill, relaxed, clear person I've talked to in a while. So I really appreciated that as well. Yeah. And his point about the perception of operational risk, I think, is another one of those things that doesn't necessarily make it into models of how the financial system works. Like, people think that banks are always going to be there to sponsor repo trades and intermediate the financial system. But as we've seen time and time again, in a big crisis, there are times when, you know, like in 2008, people just, just didn't pick up the phone because they were scared and they didn't know what to do. And now in 2020, people possibly aren't picking up the phone because they're all working from home and I don't know, their phones run out of batteries or they don't hear it or whatever. And that type of real world quirk, I think, is really important to consider. Totally. And I think it's something that, you know, I've learned a lot about from some of our

episodes with Chris White talking about how the bond market works. And I sort of, I'm always interested in this topic that so much of our financial markets operates this way, whether it's through a chat room. Hopefully they're using Bloomberg IB plugging that or a picking up the phone that, you know, people have this idea that the, all of our financial markets, it's just robots and algorithms out there and everyone can just go home. And actually for the most important thing, including like finding liquidity to buy the most safe asset in the world, that's still done by phone is a really striking fact. And it helps me understand some of the dislocations and breakdowns and correlations that we've seen over the last couple of weeks. Yes, indeed. So this has been

another episode of the Oddlots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy All the way. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. And you should follow our producer on Twitter. Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcasts on Twitter, Francesca Levy at Francesca Today. And check out all of the Bloomberg podcasts under the handle at podcast. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gura. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines, in-depth analysis, and big interviews.

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