JPMorgan breaks down how COVID-19 nearly destroyed one of the market's safest trades — and lays out 3 lessons to help investors tackle future crises

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  • A relatively obscure but cushioned part of the bond market nearly collapsed in March amid the coronavirus-induced crisis. 
  • JPMorgan strategists recently detailed the breakdown in so-called basis trading that spurred a rush to the exits among hedge funds.
  • They explained how the Fed intervened to prevent a wider liquidity crisis, and listed three lessons for investors to hold for future crises. 
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The historic market action that investors endured earlier this year nearly took down an erstwhile safe part of the fixed-income market had the Fed not intervened. 

Interest-rate derivatives strategists at JPMorgan arrived at this conclusion after conducting a postmortem into the crash, and penned their biggest takeaways for investors.

They had no shortage of superlatives to describe what the coronavirus outbreak spurred in the bond market. For one, consider that the move in 10-year swaps — instruments designed to protect from volatility in interest rates — moved by nearly six times more than what had been priced in by the options market. 

But that is not even the most unnerving development that caught JPMorgan’s eye. The team, led by Joshua Younger flagged strategies that traditionally help traders reconcile the differences between bond futures and spot prices, otherwise known as basis trading. 

Here’s an example of how it works: if a bond becomes much cheaper than its relative futures contract, a trader can buy it through a repurchase agreement and then use a futures contract betting on its decline as collateral. If the bond’s price comes in line with the futures contract, the trader profits. If not, the futures contract on other end of the trade wins. 

If this all sounds niche and somewhat wonky, you’re not alone. Even Younger, JPMorgan’s head of US interest rate derivatives strategy, said as much in a recent note.

The market’s relative obscurity is a key reason why it came under dire strain. Its low-risk nature meant that traders made ample use of leverage that in turn gave them access to more attractive opportunities in other parts of the market.

Additionally, the belief that basis trading was safe led to a massive build-up in net-short positions against Treasuries. This meant that during the crisis, traders became saddled with huge bets against Treasuries that were never intended as bets against the asset class itself. 

“These non-economic cash/futures basis positions were, in our view, the epicenter of the historic breakdown in market functioning in March — one which threatened to transform an economic event into a financial crisis which was likely only avoided with an equally historic Fed intervention,” Younger said in a recent note. 

As is often the case in markets, there was widespread fear of a rush to the exit signs. For one, the transition to remote work stoked concerns that the repo market would lose some functionality just like it did after the 9/11 attacks.

In the waiting game to see what happened at an operational level, there were also risk-management concerns. If you acted too late, you would have been among the last out the door with far worse prices than if you de-levered early. 

Treasury data compiled by JPMorgan show that there was roughly $450 billion in net selling of Treasuries in the year through April. Nearly half of it originated in the Cayman Islands, a tax haven that has become the domicile of many hedge funds.

JPMorgan

This was far from the first liquidity crunch in the fixed income market. But what made it even more threatening was that several other parts of the market were under strain at the same time.  

Thankfully, the Fed intervened decisively by expanding its asset purchases and increasing the size of its repo operations. And therein lies one of three lessons Younger deduced from the recent episode: the Fed is willing to do whatever it takes to solve liquidity crises in the bond market. 

The second lesson is that the post-2008 regulations that were put in place substituted liquidity crises for credit crises. While neither is desirable, at least the Fed has shown that it can and will decisively combat liquidity crunches in the future. The 2008 credit crisis, on the other hand, nearly collapsed the entire financial system.

And finally, Younger says this episode should spur a more flexible way of thinking about the Fed’s regulation of banks in the future.