One of the hallmarks of last year’s market crash was the speed with which the Federal Reserve responded to it, stepping in to purchase billions of dollars worth of U.S. government debt within days of the Treasury market seizing up.
A new staff working paper from the Federal Reserve helps explain the urgency behind the central bank’s actions, exploring the mayhem that engulfed the Treasury market in 2020 when the yield on the benchmark 10-year jumped by 65 bps in fewer than 10 days as hedge funds unwound billions of dollars worth of leveraged trades. The trade typically saw hedge funds borrow money in the repo market to arbitrage the difference between Treasuries in the cash market and futures. But in March of 2020, as investors stampeded into the most liquid contracts in the market (Treasury futures), the spread between the two suddenly went haywire, leaving hedge funds to nurse significant losses.
You can see just how painful the trade was in the below excerpt from the paper, which show hedge funds’ average returns over time:
“Given that the mean quarterly return over our sample is 2.3% with a standard deviation of 8.1%, a sector-wide return of -9.9% reflects unprecedented losses for these hedge funds, which is also depicted in Figure 5. This indicates that during the COVID-19 crisis in March, these hedge funds were under a significant amount of stress, to a greater extent than at any point since Form PF reporting started in 2012. Clearly, the current crisis unfolded more precipitously than the global financial crisis in 2007-2009, which was characterized by relatively longer periods of a buildup of uncertainty from 2007 onward.”
By March 15, after yields had been spiking for about seven days, the Fed announced a new U.S. Treasury and mortgage bond purchasing facility aimed at soothing the mayhem in the world’s most important funding market. By the end of the month, the central bank had purchased some $775 billion in U.S. government debt and $291 billion in mortgage-backed securities guaranteed by U.S. housing agencies.
According to the paper, much of the blow-up in basis trades occurred not because of a pullback in repo funding from big dealer-banks trying to protect their balance sheets, but rather as function of good old-fashioned liquidity management in anticipation of investor redemptions. Here, longer lockups on hedge fund money may actually have helped protect the market and prevent the crisis from becoming much worse.
Or, as the authors put it:
“We find evidence that the cutback in hedge fund UST exposures was driven by liquidity management considerations and investor redemption risks. By the end of March 2020, hedge funds with significant Treasury exposures increased their cash holdings by over 20% and scaled down the size and illiquidity of their portfolios. This boost to the precautionary liquidity holdings and the step back from UST market activity were less pronounced for funds with stricter share restrictions and lower redemption risk. Longer share restrictions allowed hedge funds to avoid fire sales and hold onto more of their convergence trades, thereby bolstering both fund and Treasury market stability …
Compared to previous crisis episodes, the March 2020 shock was unprecedented, particularly in the speed and scale at which extreme moves occurred and in its impact on otherwise safe and liquid markets such as the UST market.”
The whole paper is available here. https://www.federalreserve.gov/econres/feds/hedge-fund-treasury-trading-and-funding-fragility-evidence-from-the-covid-19-crisis.htm
Here is the Link to the Bloomberg article: https://www.bloomberg.com/news/articles/2021-06-28/by-one-measure-march-2020-was-worse-than-the-financial-crisis?sref=K5kiE5Jr
Submitted June 27, 2021 at 11:44PM by iggy555 https://ift.tt/3dmrVXr
