Odd Lots - Lots More with Matt Levine and Mike Mackenzie

Episode Date: September 29, 2023

For those who can't get enough Odd Lots, we're now offering you... "Lots More." This new podcast show, appearing on Fridays, will see hosts Tracy Alloway and Joe Weisenthal chatting with some of your favorite Odd Lots guests about the latest breaking news and the biggest themes on their minds in markets, finance and economics. Joe’s away for this episode. So Tracy gathers two of her favorite Bloomberg colleagues — Matt Levine and Mike Mackenzie — to talk about the basis trade that’s got regulators worried, plus the recent bond market selloff, reminiscences over Tokyo in the 1990s and much more.See omnystudio.com/listener for privacy information.

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Let's do that. Matt, you've been writing about this. I have. You have to. I feel like you've been writing about it for years. Well, so can I just say I commissioned the first story about the basis trade when it blew up in March 2020. And Stephen Spratt actually wrote it.

but I, like, helped him with it and gave him a bunch of stuff from Josh Younger at J.P. Morgan at the time, actually. I kind of regret not putting my name on that story because, of course, it became this huge thing that everyone's talking about. Yeah, everything I know about the basis trade I got from Josh Younger. That's not really true. But, like, as a sort of, like, philosopher of treasury markets, I feel like he, like, his philosophy of treasury markets has really influenced how I think about the basis trade. So everyone seems up in arms about it, and there's all this media attention, but I feel. feel like there's also a lot of pushback at the same time because things are different to the way they were in March 2020 when no one was expecting the kind of interest rate volatility that we saw. Yeah, you know, I think that everything always, the sort of great meta story of financial media is everyone

like overlearns the lessons of the last crisis and is like, oh, this blew up once, it'll blub again, but actually a different thing always blows up again. I did a deadlift. One, two, three. Hedgeimine. Hedgemi. Okay, good. Okay.

What's the other? Marges. This is an after-school special except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid ink pasta? These are the important questions. Is it robots taking over the world? No, I think that like in a couple of years, the AI will do a really good job of making the odd lots podcast.

And people will say, I don't really need to listen to Joe and Tracy anymore. We do have... have the perfect guest. Well, in the meantime, this is lots more. A weekly chat about whatever is on our mouth. Matt Levine, Bloomberg Opinion columnist, is here with us. We also have Mike McKenzie, who I have worked with for a very long time at the Financial Times, and who is now at Bloomberg, Mike. It's so nice to have you here.

Thanks for having me. Are you enjoying Bloomberg versus the FT? Yes, I am. Short and sweet. say that without a straight face. I'm going to make a bunch of edited out comments about bedbugs now. Oh, the bed bugs. Oh, dear.

Apart from the bed bugs. Well, I was also thinking Joe's not here today. So we can really geek out on the bond market, but we can also just gossip about Joe. The email that I got about this was like, we're going to talk about Joe taking a self-driving car. But then, of course, we're not here. So now you can just tell me about Joe's experience taking a self-driving car. Oh, yeah. I should say Joe's not here today.

he's really, really sick, which is why I have two guests with me, Matt and Mike. Joe and I were in Austin recently, and that was really fun. We ate a lot of barbecue, a lot of Tex-Mex, and yes, Joe went in a self-driving car for the first time. We were all a little bit scared because he left late at night from this line dancing club that we were in. And we didn't hear from him until about 12 hours later. But apparently he got home safely, if somewhat circuitously, Apparently the car took a really long route and he was asking people why that was. And they said it's because the car tends to take the roads that it's most familiar with or the ones that are like less risk. And it ends up taking a while.

But seems to have been a good experience. It's like it's like really like capturing the human experience of being a student driver. It's like it doesn't go on the highway. I'm not going to go on the highway. I'm just going to take the back roads. How is Joe's line dancing? I feel like he might be an expert line dancer. I did not see him line dance that night.

What kind of gossip about Joe episode is this? Yeah, fair enough. Mike, have you been in a self-driving car? No, not yet. Do you want to? Well, there's someone who takes four hours to drive to the Mon on a Friday night to go skiing on the weekends in winter, being able to sit in a self-driving car for four hours and get a nap or do something else.

It would be great. Matt, do you want to? Oh, yeah. I'm like a sort of disgruntled recent transplant suburbanite and like really you're like get me out of this driving all the time like it's really like really diminishes my quality of life to like have to drive everywhere and if like a robot was driving me it would make it slightly better do you drive into the office every day oh no no okay but I but I drive to the train station right okay actually this reminds me I wanted to ask like what is your workday like nowadays because everyone knows you write the newsletter

How early do you get up to do that? Depends. I, you know, I used to say 4.30, but then I got kind of lazy. So now it's like, now it's like I'm doing more of the newsletter during like regular working hours. And as a result, it comes out at like 2.30 instead of like noon. Yeah. Which is embarrassing. But here we are.

I think that's okay. I think people can wait two hours for the newsletter. Yeah. There's something to be said for like hidden people. during their lunch break, but it is driven by my ability rather than anything, rather than any conscious plans. So it comes out when it comes out. Okay. And how do you decide what to write about? So we were talking earlier that you were talking about the basis trade, but you write about all sorts of things. Yeah. I try to write about things that I find interesting and that I feel

like I can say something funny about or fun. Like, you know, I try to have some sort of balance of topics. I try not to write about crypto too much. But mostly I just, you know, like, I try to write about things where I can say something and I try to avoid like big issues where I'm just like, you know, just would say what everyone else says. Mike, how do you decide what to write about? I know you have a beat, but there's a lot going on on the bond beat at the moment. Exactly. And actually, ever since I came to Bloomberg in late 21 and the bond market's been really big stories. So you come in every day and something's happening. And I mean, this week, for example, was great. everyone was coming in thinking, okay, the bomb market's going to settle down.

We've got quarter end month end coming up, so we should see buyers. And right out the gate on Monday morning, big block trades in futures. People are hedging for higher rates, and it just hasn't stopped. So it gives you plenty to write about. And we've seen some really big, interesting moves this week. And things like geeky things like term premium, for example, it's had the biggest rise. It's actually outpaced the rise we saw in May of 2013 when the taper tantrum kicked off. That's just how big a week it's been.

That's crazy. be a broker as well, right? Swaps broker back in the 90s. I was around, I remember doing swaps in Tokyo in 98 when LTCM blew up and Salomon Smith Barney had to come in and unwind its yen carry trade. And it just, it was ridiculous. They basically filled every other bank on the street in a matter of hours with trades. Wow. And they kept going and going. So it just told you how big it was. And I think the yen, we had a ticker above us showing the spot. yen versus the dollar and it went from I think what 135 down to 110 it was just incredible to see that and that was really the first time in my experience that financial markets were just so

huge I feel like that must have been a really interesting time being like a broker in the 1990s in Tokyo it definitely was it um I also worked the night shift so I'd come in at 2 o'clock in the afternoon and work through to midnight wow and then go to repungi after yes because I'd meet up with all the other expat brokers who are working for rivals and we go and have a beer at Mugumbos and talk about who was doing what. Oh my gosh, I remember that place. Yes, I wonder it's still going. So, Mike, have you been writing about the basis trade as well?

Actually, that's been something to be covered by my colleagues. So I've sort of been an observer. I actually don't think it's that bigger deal this time around. I always find it interesting when regulators start piling on and we've got Gary Gensler lining up hedge funds as the bad guys yet again. It kind of reminds me when I met with Tim Geithner at the New York Fed in 2007 and he was obsessed with hedge funds being the next, who was going to be the next LTCM and didn't really think repo was a problem.

Oh, wow. And I just came away thinking they always fight the last war. And I just wonder whether they're doing the same again. And also I think the basis trade this time is somewhat different. I mean, I think Goldman and other banks have pointed out that the amount of leverage is less than what we saw. And don't forget, this year in the bond market, you've had a lot of institutional, long-only bond managers piling into futures.

They've had a huge position, long position. So it's natural that the basis trade is going to be big because taking the other side are hedge funds. And given this sort of post-financial crisis regulation, primary dealers don't play that role. They used to. So again, it's the algos, it's likes of vertue, citadel. who are the new market makers, plus these hedge funds who are stepping in. And again, they're picking up steam rolls, pennies in front of a steamroller. It could go wrong, but I think the real story in the bond market now is a lot of investors

are long bonds and they're underwater. And that, I think, is, and we already saw a first glimpse of it was back in March when the regional banks went under. And right now, if you own 10-year-plus treasuries, you're looking at a loss of nearly 9% year to date. That's up to 29% drop last year. So we're looking at three straight years of losses and bonds, which are supposed to be risky low-vol instrument. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, Leaders with Francine Laqua from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment, but I've

always been curious who are these people as leaders. I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow leaders with Francine Lacois wherever you get your podcasts. I'm always interested in what the basis trade is, right? I mean, I think of the Citadel's and hedge funds of the world as being, in this respect, in the business of manufacturing a product for long-only managers, where the product is like, people want to buy treasury futures and, like, what there is to manufacture those features out of is bonds. And so somebody does the kind of, like, low margin grunt work of turning bonds into futures.

Right. And that work, you know, is sort of necessarily levered because, like, you know, why wouldn't it be? Wait, I should step back and just give like a very quick summary of this trade for people who haven't been, for people who have a life and haven't been following it as intensely as we have. But like the trade is basically you buy treasuries and sell the associated futures contract and you get to pocket the difference or the spread between them, which is usually. minuscule. And so what tends to happen is the people doing this, typically hedge funds or high frequency traders, those types, they lever up. They borrow a lot of money to amplify that spread. And in March 2020, when the treasury market started blowing up, that spread became problematic. A lot of people had to unwind the trades. And then you had this sort of self-reinforcing loop

where people were dumping treasuries. And that was sort of fueling volatility. in the wider market and it just didn't stop until the Fed kind of stepped in. So that was, that was the major concern that this could somehow happen again. But Matt, as you point out, there's a reason this trade exists. Yeah, that story is like, okay, like, why is there, like, why, like, why does someone get long, you know, $900 billion of treasures and short $900 billion of treasures? Like, like, what is that thing? Like, what are the users on either side? And I think the answer is, you know, as Mike said, like, long-only bond managers are getting long, a lot of duration by futures, which I think is a little, I don't know, it's like a little curious to me like just

why that like sociologically exists. But I guess it's like, you know, basically it's a sort of like efficient way to get a lot of treasury. And so, you know, to get that efficiency if you're a pension manager or whatever, like someone's, right? Like you're synthetically borrowing money to buy treasuries and like to get that someone is actually borrowing money to buy treasuries and that someone is a hedge fund. Yeah. And I mean, we mentioned earlier, but like Josh Younger has made this point many times that treasuries exist in the financial system, but they exist in many different forms. And someone has to kind of take on that business of transformation.

In this case, you offer up duration through futures contracts. And it's the hedge funds doing it. But if it wasn't the hedge funds, then the big asset managers would have a harder time doing it. Or potentially someone else could step in and try to provide that service and arbitrage the difference. Yeah. I mean, another thing that Josh Unger and Labmanon point out on their paper, that was something that Mike said, which is that this used to be, you know, the business of like intermediating treasuries, intermediating treasuries

used to be the business of primary dealers. And like post-2007 capital and other regulations have made the primary dealer step back. And now it is the hedge funds and algorithmic traders of the world to do this. And it's like, you know, if you're worried about the basis trade right now, like you're partly worried about like unintended consequences of like, tightening regulation treasury market so that the treasury market migrates to like less regulated pockets of the world. Right. Well, and the other thing, I think Goldman pointed this out. Was it Goldman or J.P. Morgan? I can't remember. But like to Mike's point earlier, when the basis trade

blew up in 2020, it was after a period of relative stability in the bond market. So no one was expecting that suddenly you would have all these initial margin, extra margin requests. But now we've had two years of intense spawn market volatility. So it seems really unlikely that people are going to be completely surprised if something, you know, if there was a big move in the market. I could be wrong. But that does seem like it's a little bit of a cushion. I think that's a good point. Yeah, I agree with that. But I also think that like the notion that like this is a market that is ultimately backstots by someone and that someone is basically the fed. Like I think there's like truth to that. I think if you sort of like trace down like what happens if like people are taken by

surprise and like, you know, initial margin requirements do get a lot heavier. Like, like, yeah, like the ultimate, you know, sort of supporter of the treasury market is the Fed. And like, that's a legitimate thing to worry about. But it's also sort of like the, like, like, I think of like the treasury market as being a sort of like parallel to the banking system where like it is again like a sort of way of, you know, just as the banking system is like a way to turn like people's short term cash like deposits into like long-term mortgages and loans, the Treasury system is kind of a way

to turn short-term cash deposits in the form of repo into like long-term loans to the government, right? And like that is just like inherently a fragile situation, right? It's inherently fragile for people in the repo market to expect to be able to get their money back overnight and like that money is being used to loan money to the government for 30 years. And like that inherent fragility, you deal with it in the same way you do in the banking system

with like equity requirements with like repo, you know, haircuts and like, you know, future's margin. But like that is 99. whatever percent reliable. And you understand that there is a fail state and the fail state is like there's some lender last resort that steps into the market if the market collapses. And I just think that like people don't like to hear that, you know.

People don't like to think about the idea that there's like not 100% reliability, but 99.1 whatever percent reliability. But that's just like sort of, that's like how you get this sort of financial intermediation is you take a certain amount of that kind of run risk? Yeah, and I think another really interesting aspect to this market, since the Fed began

tightening policies, that we did see a surge volatility, a lot of stress and liquidity measures last year. But if you talk to investors, they told you, I can still buy and sell treasuries. And I think given the fact the Fed did a number of jumbo rate hikes last year, for the first time since 94, when they only didn't one 75 basis point hike back then, and that was always seen as the worst ever bond bear market. Well, obviously last year was the worst ever bottom market for investors. But it's remarkable to me that the basis trade hasn't blown up.

It's actually kept functioning. And I think when you step back and look, if he said to someone, hey, the Fed's going to jack rates over 500 basis points, they're going to throw in 75 basis point rate hike shots, and things are going to be fairly orderly. In fact, when I was talking to investors last year and said, how bad is it? more than quite a few of them said, well, actually, it's actually fun because it was so boring for the last 10 years when rates were slumbering around zero. He said, you're coming in every day and you're talking about where rates are going to go. We used to write stories about how boring bonds were and all the traders were complaining about it. There wasn't enough volatility.

It's not boring anymore. But I think it's amazing to me looking at this, how the market has really held in. Now, I look at the credit markets and think they might be whistling past the graveyard here because spreads are still sad. pretty tight. This has been predominantly a rate shock. Yeah. But it's also occurring when the Treasury is going to be selling a lot more treasuries. And that if you want to know what was a trigger for the recent rise in the yields, it really began in late July when the refunding was coming. Yeah. And that was a definite shock. And really, the market just hasn't stopped selling off since then. Yeah, I think this is important because a lot of this is being interpreted as a rate

shock post the recent FOMC meeting, the sort of higher for longer narrative, but it seems like it's more of a supply demand issue. It's really interesting because normally when you ask people that question how important the supply, they just shrug the shoulders like, oh, it's only something at the margin. But this is what it kicked this off. And now, last week's Fed meeting, I think, really did nail this because once the Fed said higher for longer, it does seem to be finally registering with bond markets that the Fed is definitely serious about this.

And this week's pickup in oil prices is only added to that sort of anxiety that, well, if inflation isn't really going to come back to 2%, where are, just how much can the Fed conceivably cut rates from here? So I think there's a lot of anxiety now. And the realization is that when you combine supply with a Fed that is on perma hold at higher levels, that's you mean the treasury curve is still below the funds rate that's not a good look if you think back to 2007 eventually that 10 year did get to 525 bang in line with the with the then fed funds rate of 5 and quarter I think it's really interesting what you said about you can still buy and sell treasuries because I think that there was

in addition to the narrative of it being boring I think there was a real narrative in rates but also in credit and kind of everywhere that as like banks retreated from providing balance sheet and like you know, intermediation was being done by like high frequency traders who have no balance sheet that the market wouldn't work anymore and that it was like,

it's fine now that the market is boring and rates never move, but if rates go up, like these high frequency traders won't be there to provide liquidity and like everything will break down and you're right, that just didn't happen at all.

And it turns out that like the modern sort of system of treasury intermediation can work even in a volatile rates environment. People are worried about bond market liquidity. They really were. I have a confession, Matt. I used to write about this a lot, and your section, your title annoyed me.

Well, it was meant to. Because we're legitimate concerns at the time. It was meant to be annoying. Although I will say, I think a lot of people used liquidity as a synonym for price. So, you know, like, I completely agree with that. I'm angry about the price I have to trade these at, not really that I can't trade them at all. Right. Like, there's like a thing where it's like, like, liquidity, like bad liquidity means like wide

bit ass spreads. But there's another thing where bad liquidity means like the price has gone down. Right. And like, you know, and that's like your thing you say, right? That's not a real liquidity thing. But yeah, no, I was, people were very worried about bond market liquidity and I enjoyed making fun of them. And I feel like, you know, there's like, there's like ups and downs, but more or less I feel vindicated than making fun of them for like 10 years or whatever it was. Well, now, wait a second. Wait. I mean, it's not like this was a complete non-issue. Yeah, thank you. Thank you, for rescuing that. It's not like this was a complete non-issue, though, because in March 2020, again, we saw Treasury's seize up in one way or another. We saw the Fed announce a corporate bond buying

program that it's never done before. In the end, it didn't actually have to buy that many bonds. The announcement was enough to kind of, you know, calm the market. But that was, I mean, that was the worst case scenario. You know, in 2015, when we were talking about a credit market blow up, The end game was always, oh, well, maybe one day the Fed will have to buy corporate bonds. Okay. That's fair. That's fair. Well, it wasn't Arpagetan trade, though.

Everyone was depleting treasuries to get cash. It became a cash well. You needed to have cash. So when they start selling treasuries for that reason, getting back to Matt's earlier point, that's when the Fed does step in. Yeah. That didn't feel like, you know, the market functioning that people had said up just didn't work, you know? It felt more like, you know, there was an Arrigand trade.

But yeah, I hear you. Okay, fair enough. We need another credit blow up to test this thesis, and we might get one. Well, okay, wait. Yeah, that's true. I mean, that's a real point, right? I mean, like, you know, as Mike said, like, rates have gapped out and credit really hasn't. And, like, one, there's a wave of bankruptcies or whatever.

Like, you know, how will that market function? So, Mike, you brought up SVB earlier. And I've seen at least two research. notes this week, one from TD, and I think one from Victor Schwetz over at McCory, talking about the notion that maybe this is the point at which we start to see another thing break. Yeah, I'm beginning to hear a bit more talk in that direction from a few people I speak with regularly. I mean, I think the Fed did surprise the bar market by ring fencing, the sovereign bank. It's not the original bank problems. So I think that's one potential wild card as we get

into the fourth quarter. And it's at a time when markets are already down from the the year, which is the case for treasuries. You're going to have some investors going for a hell, Mary, and probably trying to short and get on the momentum. Others are going to have to start keep cutting back. So I think Q4 could be a really interesting time for all kinds of reasons, but particularly given the way it's setting up. So you've got to keep an eye on the regional bank problems. As for credit, I actually think credit markets are completely different to what we've seen before. I think the rise of private equity and own their own internal private credit funds, has changed the game here.

I'm not so sure that you get the kind of credit blowup. Everyone's looking for it. I mean, Howard Marks, they're all looking for this because they all want to come in and buy really, you know, bonds at big discounts like we saw, particularly in the jump bond market at the end of 2008. And in fact, the money that was made by hedge funds who jumped on that trade, like Blue Mountain, for example,

in early 2009 was just enormous. So I think private equities, they've got a stockpile of dry powder. They're now in the credit game. I think the baton was passed when Blackstone's credit fund took apart Goldman Sachs on a credit derrude's trade, circa 2016, 2017, I think. And they're the guys who have all the information now. They have the kind of the edge.

They know these companies. They know what's going on. So I'm just not sure you're going to get the kind of credit blow up people are anticipating. And I think it's a function that private equity is now the big player in credit. Yeah, and they don't have to mark to market as much. Well, that's the illusion of liquidity. Yeah. All right, guys, we're going to wrap up.

Last chance to gossip about Joe. Any complaints you want to offload? No, he's sick. I feel bad. I didn't know. You're like, I thought he had a call, but you're like, he's severely ill. I don't want to send him. Yeah, he is sick.

We should be nice to him. Carmen just put in like five different complaints about Joe in the IB chat. You should run those out. Didn't he like the checkout from Utico or something? thing? Yeah. That was these other big. Yeah, but that's been there for years. He's tweeted that along with the driverless cars. He's being the things that are blowing his mind. He's very impressed by technology

nowadays. Lots More is produced by Carmen Rodriguez and Dashel Bennett with help from Moses Ando. Our sound engineer is Blake Maples. Sage Bauman is our head of podcasts. Catch you next time for lots more. Thanks for listening. You can get the news whenever

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