Treasury investing is a rollercoaster

October 25, 2023

Treasuries are mostly considered cash equivalents from a risk perspective. However, Treasury market liquidity has evaporated on several occasions, including September 2019 and March 2020. During that episode alone, the Fed bought $2tn of Treasury securities and stepped in to finance trillions more. In part, this was due to basis trades gone wrong, and what we’re seeing in late 2023 is that the basis trade is once again in vogue, heightening market risk.

What is the basis trade?

The basis trade involves a short Treasury futures position, coupled with a long spot Treasury, financed by a repo. The trade is typically levered 50-175x, meaning there is risk from (1) repo rollovers; (2) the leverage from repo, which is based on haircuts to Treasury face values; and (3) futures variation margin.

Former Fed personnel have also commented on material liquidity risk in the Treasury market, warning that repeat events will be worse. They point to:

  • Average daily traded volume is declining in relation to the growth of the Treasury market
  • Close cousins, such as MBS and high-grade corporates, are in similar trouble
  • Securities dealers are unable to allocate more balance sheet to the Treasury market due to a decline in participants, Basel III, and similar regulatory changes
  • Worryingly, end investor demand during times of volatility, such as March 2020, simply disappears. Without end investors, dealers should have stepped in but could not. That’s why the Fed was forced to become a participant, spending more than $100bn per day

U.S. Treasury markets are at a 16-year high, with the 10-year yield recently at 4.7%. Because bond yields move inversely to prices (a price below face value means the yield is composed of both the coupon and the capital appreciation), this means prices have dropped.

Bond market volatility

It is difficult to impart just how unusual the bond market’s volatility during the third quarter of 2023 was. Treasury yields across the board rose considerably, in some cases (like the 30-year Treasury) making moves that have been seen very few times since the 1980s. The 30-year Treasury sold in May 2020 now trades at only 45 cents on the dollar, meaning it has lost more than half its value. This type of volatility does not constitute a normal market—it is a warning sign.

As of late 3Q23, the Fed is no longer simply buying bonds en masse. Its $7th+ bond portfolio will roll off at a pace of ~$100m per month (also called “quantitative tightening”, or QT). However, new issuance will amount to ~$8tn in 2024, driven primarily by $5tn of refinancing, $2tn of new issuance, and $1tn of QT. Yields will need to rise to induce investors, which means prices on existing Treasury securities could easily drop, just as we’ve seen during 3Q23. This makes Treasury ladders much riskier and unstable.

The most recent Treasury auction directly exhibits what we’ve been expecting. The chart below shows a material spike in the required yield due to low demand from investors and banks.

If treasury markets carry risk, what should my company invest in?

The importance of asset class mix and positioning is paramount to being a winner in a volatile environment like the one we’re entering now.

Your safest, most liquid high-yield option is cash. We’ve built Mayfair on the principles of low risk, high liquidity, excellent yield, and simplicity. That set of four characteristics is designed to provide high option value during times like these. If you want to know more about how we can help, sign up to talk to us today.

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