In recent developments, two officials from the Federal Reserve hinted on Friday at the possibility of an additional increase in interest rates. The move is seen as a necessary measure to bring inflation under control and return it to the central bank’s target of 2% in the United States.

These officials also suggested that higher borrowing costs might need to be maintained over an extended period to accomplish this objective. This indicates a potential shift in the monetary policy landscape, with a prolonged period of elevated borrowing costs looming on the horizon.

The decision to increase interest rates is often used by central banks as a tool to manage inflation. By making borrowing more expensive, it reduces the amount of money circulating in the economy, thereby controlling price levels. The Federal Reserve’s current target for inflation is 2%, a figure that it strives to achieve for economic stability.

This latest indication from Federal Reserve officials underscores the ongoing challenges faced by the central bank in managing inflationary pressures in the United States. It also highlights their commitment to deploying necessary measures, including potential interest rate hikes and sustained higher borrowing costs, to achieve their stated inflation targets.

This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.

By Jamie McGeever

ORLANDO, Florida (Reuters) – The Federal Reserve’s hawkish stance on interest rates, and determination to reduce its balance sheet, may inadvertently be stoking financial stability risks by encouraging hedge funds to extend or even increase their “basis trade” bets in the U.S. bond market.

The trade – a leveraged arbitrage play profiting from the price difference between cash bonds and futures – has exploded since the Fed began tightening policy last year, to such a degree that central banks and regulators are now closely monitoring.

The Bank for International Settlements warned this month that the huge build-up in speculators’ short Treasuries position “is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger.”

A Fed paper on Aug. 30 noted that if these positions represent the so-called basis trades, “sustained large exposures by hedge funds present a financial stability vulnerability” warranting “continued and diligent monitoring.”

The trade is often more profitable in an environment of rising and elevated interest rates. The higher rates stay, the longer funds hold the position and the longer a potentially disruptive unwind is put off.

Crucially, though, it also needs stable funding conditions, ample liquidity and relatively low or steady volatility. A “higher-for-longer” steady Fed might tame inflation, but at some point increases the risk of financial shocks.

Policymakers hope tighter money gradually lets the air out of this and other balloons rather than bursting them. Sudden and large reversals in prices or policy rates are undesirable. It is a delicate balance.

As long as rates and yields are manageable, overall liquidity is ample, and funding conditions in the Treasury repurchase market remain favorable, there is every incentive for funds to hold the position.

These stars are still in alignment.

“As QT (quantitative tightening) continues and more liquidity gets drained out of the system, repo rates will move higher, funding will get tighter, and conditions for long-basis positions will become less favorable,” says Steven Zeng, a strategist at Deutsche Bank.

“But we’re not there yet. We’ll perhaps start to see funding pressure develop around the middle of next year,” he reckons.

NICKELS & STEAMROLLER

Estimating the size of hedge funds’ basis trade bets is difficult because transparency and visibility around hedge funds is so low at the best of times, especially with regard to their more complex activities and strategies.

Many analysts look at leveraged funds’ position in Treasuries futures, and the Aug. 30 Fed paper also noted speculators’ repo borrowings.

Hedge funds’ repo borrowing via the Fixed Income Clearing Corporation’s centrally-cleared bilateral repo market more than doubled to a historically high $233 billion between October 2022 and May of this year. This is a fairly reliable sign of basis trade activity, the Aug. 30 Fed paper says.

Overnight repo rates have steadily tracked the fed funds policy rate since March 2022. There has been none of the volatility and price spikes of 2019 or early 2020.

Commodity Futures Trading Commission figures, meanwhile, show that leveraged funds have amassed a huge net short position in two-, five- and 10-year Treasuries futures worth around $700 billion, a position matched by asset managers on the other side.

Worryingly for regulators, funds’ short positions are approaching the previous record in 2019. They are already bigger than early March 2020 when the coronavirus pandemic shut down the economy, a wave of volatility crashed over the U.S. bond market, and the Fed slashed rates to the near-zero level and launched unlimited, open-ended large-scale asset purchases.

Basis trade liquidation, as funds got squeezed out of their positions through margin and collateral calls as volatility rocketed, likely contributed to that dislocation.

It’s impossible to quantify the impact this unwind had, but the ‘s volatility at the time is worth noting: it fell 100 basis points between Feb. 20 and March 9, rebounded 75 basis points over the next nine days, then slumped 65 basis points by the end of the month.

Avoiding a repeat and ensuring as smooth an unwind as possible this time around, whenever it comes, will be crucial to the functioning of the world’s most important financial market.

Christoph Schon, senior principal for applied research at Axioma, says that if the Fed keeps rates around their current level for the next nine months, as rates markets currently indicate, the basis trade balloon will continue to expand.

Asset managers will see strong client demand from investors looking to lock in the highest yields since before the global financial crisis, and hedge funds will “scramble to pick up the nickels in front of the basis trade steamroller.”

(The opinions expressed here are those of the author, a columnist for Reuters)

(By Jamie McGeever; Editing by Paul Simao)

The European Central Bank (ECB) has decided to hold its interest rates at 4% for the foreseeable future, following a hike of 0.25 percentage points last week. This decision comes as the bank seeks to reduce inflation to its target of 2%, according to the ECB’s Chief Economist, Philip Lane.

Lane expressed confidence in the rate increment’s ability to significantly curb inflation, despite acknowledging considerable uncertainty surrounding this decision. He underscored the need to maintain the 4% rate for a substantial period to effectively manage inflation and affirmed that the bank’s decisions will continue to be data-driven.

In a discussion with Jennifer Schonberger last week, Lane provided an assessment of the current economic climate, describing it as stable rather than fragile. He attributed this stability to the robust health of the banking system and improved household and corporate balance sheets in the aftermath of the pandemic.

Addressing concerns about a potential deep recession, Lane stated that the necessary conditions for such an event are currently absent. His insights were part of a broader discussion available on a financial news platform.

This article was generated with the support of AI and reviewed by an editor. For more information see our T&C.