BOND MARKET
The stock market has been in the spotlight since the April 2 announcement for obvious reasons as we got a global selloff due to recessionary fears. In the last couple of days and especially today, another market is getting attention: the bond market.
The yields on long term Treasury bonds are rising fast and the speed of the move suggests that there might be things breaking down. There is no clear reason for this selloff in bonds (when bond prices go down, yields go up) but people have been citing a couple of possible explanations:
- China is dumping Treasuries.
- Basis trade unwind.
I would say the basis trade unwind is the most likely culprit. The basis trade is a popular strategy among hedge funds that involves exploiting small price differences between Treasury bonds and the Treasury futures. It’s an arbitrage strategy. The basis is the difference between the price of a Treasury bond and the price of the corresponding Treasury future.
Hedge funds buy actual Treasuries and sell Treasury futures (or vice versa) to profit from the difference when they converge. Since the spreads are small, it involves lots of leverage. Small price moves against the trade can become big which force traders to liquidate their positions and if there’s stress, they can become disorderly. This is something we’ve already seen during the pandemic.
Back then the Fed stepped in with rate cuts, massive QE and what not to calm markets amid the great stress and panic. Now, the Fed is very unlikely to cut but could smooth things down by intervening in the market or tweak the SLR (Supplementary Leverage Ratio), which is a capital rule for big banks and an easing in the SLR like temporarily exempting Treasuries from the ratio would free up space for banks to absorb more bonds without triggering regulatory problems.
It could also create some facility and what not, but the point is that if yields continue to surge, look up for the Fed to intervene and in that case it could offer an opportunity to buy long term bonds, even if for just a short term trade.
YUAN DEVALUATION
Yesterday, the offshore yuan weakened to a record low against the us dollar and as soon as we broke into a new high in the USD/CNH rate, the stock market topped and started to roll over as traders expected potentially further escalation in the trade war. This is something I warned about here.
The good news is that despite Trump lamenting about China manipulating the yuan, the PBoC today fixed the onshore yuan at a slightly higher rate than the prior day. As Eamonn noted here, they seem to be content at a slow burn devaluation rather than a big
bang at this stage. China is likely holding the threat of a big bang
devaluation as a negotiation tactic.
This removes temporarily the escalation risk as they are just showing but not executing the retaliation against the extra 50% tariff Trump slapped on China on Tuesday. I see this as good-will. Therefore, the focus should be on potential news about US-China negotiations and positive stuff will likely trigger a relief rally in the stock market.
