It’s Only Money

The Bond Market Doesn't Vote

Washington has a spending problem. This is hardly news. What deserves more attention is how the government finances it.

The Treasury sells bonds to investors who expect to be repaid with interest. Traditionally, those buyers included banks, pension funds, insurance companies, and foreign governments. Increasingly, hedge funds have become important participants.

Not necessarily because they want to own Treasury bonds.

Many are exploiting small differences between the prices of Treasury securities and their futures contracts. They borrow heavily to make these relatively small profits worthwhile. It's called the basis trade.

The arrangement provides buyers and liquidity to the Treasury market. But it also introduces a peculiar vulnerability. When financing costs rise or markets become unsettled, these investors may be forced to unwind their positions, selling the very securities they helped support.

We've seen what that can look like. In March 2020, leveraged Treasury trading contributed to a disorderly market in which even government bonds came under selling pressure. The Federal Reserve intervened on an extraordinary scale.

Meanwhile, Washington continues borrowing, regardless of which party occupies the White House. The Federal Reserve can influence short-term interest rates, but it cannot dictate what investors will demand to lend money for ten or thirty years.

And those investors are changing.

The United States increasingly relies, in part, on borrowed money to find buyers for its borrowed money.

There's something wonderfully circular about that arrangement. Unfortunately, circular financing has a habit of becoming considerably less amusing when everyone wants their money back.