The $18 trillion US Treasury market broke last week! As of today, no one knows for sure all of the reasons for its collapse, but everyone agrees it is a severe problem. 

One of the main culprits seems to be caused by the pricing of older off-the-run treasury securities. US Treasuries are purchased in size by participants in the leverage basis trade – where you buy cash securities while simultaneously selling the futures contracts to profit from the basis difference. The basis is small, so participants use leverage to earn a profit. Recent market dislocation has forced the weak hands to unwind their position in size. 

It is estimated that the risk parity trade is half a trillion dollars. Risk parity depends on the negative correlation between stocks and US Treasures to generate lower volatility. The word on the street is that some sizable players are having to unwind their positions. 

Until the dust settles, no one will know for sure all of the causes and effects. We believe it is a series of cascading problems that are systemically ripping through the market. With 20/20 hindsight, it will make for some fascinating reading. 

The New York Fed announced on Thursday, March 12th, that it would step in and begin buying Treasury bills and bonds across all maturities to bring liquidity and stability back into the US Treasury market https://www.newyorkfed.org/markets/opolicy/operating_policy_200312a?mod=article_inline. 

Open market operations began on Friday, March 13th. The Fed’s purchase of off-the-run treasuries was massively over-subscribed with the first operation (7-20 year treasuries) getting 9.175B in subscriptions – 5B accepted by the Fed – and the second (4.5-7 year treasuries) having 26.8B in subscriptions, with only 8B being purchased. In total, the Fed carried out six emergency market operations Friday, buying 37B+ worth of treasuries. Unfortunately, this did not move the needle as the yield curve continued to steepen in the face of the Fed’s activity. 

As we prepare this letter for publication, the Fed just announced, three days after its first announcement on March 12th, another emergency rate cut and injection of capital. By the time you read this on Monday, this will be old news, but 30 minutes after the announcement, my hair was still standing up on the back of my neck. Below are the highlights of the Fed’s statement: 

  • Purchase at least 500 billion US Treasures over the upcoming months 
  • Purchase at least 200 billion agency-backed mortgage securities over the forthcoming months 
  • Reduce the rates on the discount window by 1.25% to .25% and extend the window to 90 days 
  • Increase the swap lines to central banks and extend the window 
  • Eliminated reserve requirements for banks 
  • The Fed is expecting negative GDP for the 2nd quarter 

In the announcement, Chairman Powel emphasized that the Fed will be aggressive in asset purchases to normalize the US Treasury market in any amounts they deem necessary. The Fed will not allow markets to decline because of illiquidity, so don’t be surprised to see them purchase S&P 500 futures contracts in the future. We expect to see the S&P 500 hit a lock limit of -13% today. God forbid we hit -20%. 

Below is a brief description of the dislocation that occurred last week: 

The 30-day Fed fund rate futures forward contract (ZQ) ended the week at 99.845, increasing almost 20 basis points from Monday and forecasting a Fed fund rate in April of 0.155%, which implies a 100+ basis point cut from the current level (1.25%). Note that the ZQ contract value is priced as 100 minus the Fed fund rate, which means larger values correspond to lower predicted Fed fund rates. Both 10-year and 30-year treasury futures faced substantial losses during this same period (9.7% for the 30-year and 3.7% for the 10-year forward futures contracts). This is highly abnormal as increases in the fed fund rate contract are highly correlated with gains in the treasury contracts (as lower interest rates should predictably increase the price of bonds, especially at the long end of the curve). 

There were very significant disconnections throughout the week in the relationship between bonds at the long end of the curve. The largest 7-10-year ETF (IEF) moved at substantially lower beta to the largest 20+ year ETF (TLT). This was caused because of selective selling pressure in the long end of the curve; the TLT ETF reached a record discount to NAV value of 4.94% while IEF reached 0.91%. Investors were, at some point, willing to take a 4%+ additional loss relative to the fair value of the underlying bonds to get out of their ETF bond positions in TLT. This was also reflected in strong disconnections between price movements in the UB contract and the TLT ETF. There were many instances of +10-20 basis point minute bars moving in entirely opposite directions when comparing the futures and ETF instruments. 

The volatility of the long end of the treasury curve was also exceedingly high. The 5-day Average True Range of TLT reached a value of 6.9% during Friday, almost seven times the average volatility of the instrument and unprecedented since the inception of this instrument in 2002. For perspective, this measure of volatility never exceeded 4% during the financial crisis. Other measures of volatility, such as the TYVIX index (which measures the volatility of 10Y notes), also reached values not seen since the financial crisis.