FED : Federal Reserve Navigates Risky Waters : Quantitative Easing Resumes Amidst Concerns Over Hedge Fund Basis Trade

Federal Reserve Navigates Risky Waters: Quantitative Easing Resumes Amidst Concerns Over Hedge Fund Basis Trade 

The Federal Reserve has initiated the process of returning to quantitative easing. The key question is whether they will do so before or after disrupting the heavily leveraged hedge fund "basis trade" that has been supporting the Treasury market.

In 2018, the unwinding of Fed asset purchases, known as quantitative tightening (QT), was a straightforward process. As bonds matured on the Fed's balance sheet, banks used reserves to buy bonds. The challenge was to determine how low reserves could go before becoming scarce, prompting the Fed to halt QT. However, the Fed went too far, causing market strains, and in 2019, they reversed course and resumed quantitative easing (QE) to maintain a "floor" system for setting rates.

This time, QT is complicated by the presence of substantial money market fund cash in the Fed's Overnight Reverse Repurchase Facility (ON RRP). In 2023, the ON RRP decreased alongside Fed assets, while bank reserves increased. The assumption has been that ON RRP drainage protected bank reserves, and concerns would only arise if reserves started to decline, echoing the issues of 2018. Additionally, the Fed now has a backstop for banks, the Standing Repo Facility, which can be utilized in unexpected liquidity squeezes.

However, the ON RRP might have played a riskier role in bond markets by financing the proliferation of the hedge fund "basis trade." In this trade, hedge funds borrow to buy Treasuries and sell Treasury futures for a small return, leveraged multiple times. Regulators on both sides of the Atlantic are monitoring this trade closely.

The problem arises from the fact that the basis trade is financed in private repo markets, with money market funds using their ON RRP cash to fund it. This setup creates the potential for a chain reaction, starting from the Fed's balance sheet, passing through money market funds and the private repo market, affecting the basis trade, and impacting the demand for Treasuries—particularly concerning as the U.S. government plans massive issuances.

Unlike the previous scenario of scarce bank reserves causing liquidity problems and forcing the Fed to stop QT, the current risk lies in the depletion of the ON RRP and the disruption of the hedge fund basis trade in 2024. The concerning aspect is that there is no Fed backstop for hedge funds, and the high leverage in the trade could lead to the rapid spread of liquidity problems throughout the financial system.

It appears that the Fed is not oblivious to this issue, as there is a noticeable shift in its messaging on QT. Dallas Fed President Lorie Logan has suggested that QT should taper once the ON RRP is depleted. However, this may be too late to prevent a severe bout of bond market volatility.

In any case, the Fed is set to conclude QT and resume QE in the coming months amid loose fiscal policy and a resilient economy. This move opens the door to the resurgence of inflationary pressures, and the Fed may find itself with limited appetite or ability to restrain them.