Basis trading

So now they're trading at a premium, the futures, okay? Now, hedge funds, they see this premium or this discrepancy, and they step in and they sell the overpriced future, and they buy the cheaper cash or physical bonds, and then they wait for the two to converge eventually at expiration.

My friends, that is called a basis trade.

Because that spread averages roughly about five basis points, give or take, it's like really five one-hundredths of 1%.

The leverage in order to make it worth their while has to be massive.

It only mutates.

And this is what financial media has completely missed.

According to the Fed's own financial stability report, the unwind of the basis trade was largely offset by hedge funds rotating directly into swap spread trades.

And the Bank for International Settlements, BIS, confirmed this month that the swap spread trades went from 100%, $100 billion to $300 billion in 12 months.

So let's talk about the bottleneck real quick and what might actually connect these two Septembers together.

If you're not familiar to something called the basis trade, the basis trade was a bunch of hedge funds realized that there's an inequity between treasury futures and long treasuries that has to converge over time because that's the nature of the futures market.

And the futures market means that this is an arbitrage.

But in order to take advantage of that arbitrage, hedge funds have to short treasury futures and go long treasury bonds.

These are fractions of basis points, which means you got to have a ton of leverage.

So in a ton of leverage means you got to borrow in the repo market.

When the basis trade starts to blow up, which means there's difficulties and illiquidity in repo, you've got dollar problems in repo that leads to forced selling in the US Treasury market.

Last year is a perfect example, late March and really early April 2025, Treasury started to really violently sell off and everybody's like, wait a minute, the Treasury rate should be going down.