Making sense of the forces driving global markets

By Jamie McGeever, Markets Columnist 

A late rally ensured Wall Street's three main indexes rose on Wednesday, as investors digested Fed Chair Jerome Powell's press conference after the central bank left interest rates on hold, a raft of stimulus measures from China and news that high-level US-China trade talks will open on Saturday.

In my column today I shine a light on how the U.S. bond market's resilience has spurred hedge funds to build up their 'basis trade' bets, which are now comfortably back above the $1 trillion mark. More on that below, but first, a roundup of the main market moves.

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If ever a day in financial markets reflected the thick fog of uncertainty surrounding the global trade, growth and policy outlook, Wednesday was that day.

Investors initially welcomed Wednesday's wave of policy easing measures from China and confirmation that high-level US-China trade talks will open this weekend. But skepticism soon set in that Washington and Beijing will make much progress. It's a welcome first step, but the road ahead could be long and difficult.

The Fed's decision was widely expected and Powell's press conference offered little clarity, leaving investors struggling for direction. If there was a thread running through markets, it was difficult to spot.

Wall Street rallied in the last half hour of trading after trading in the red most of the day, yet long-dated Treasuries rose after Powell flagged risks to growth. Gold fell, in part on easing US-China trade tensions, yet oil fell on skepticism these talks will yield much.

Either way, U.S. Treasury Scott Bessent, who along with chief trade negotiator Jamieson Greer will meet China's economic tsar He Lifeng in Switzerland, characterized the meeting as the start of "negotiations". It's a start.

It will be interesting to see how markets in Asia, especially China, open on Thursday in a follow on reaction to the trade developments and stimulus steps. Currency traders will note that China's central bank leaned against mounting downward pressure on the currency on Wednesday and set its daily fix at its strongest yuan level in a month. 

Amid all the uncertainty surrounding U.S. growth, Federal Reserve policy, and the attractiveness of the dollar, the U.S. bond market is remarkably tranquil, calling into question long-held fears about the massive 'basis trade'.

While Treasuries experienced a brief bout of volatility following the Trump administration's 'Liberation Day' tariffs last month, including a spike in long-term yields and dislocation in 30-year swap spreads, the $29 trillion market has withstood everything thrown at it. 

Indeed, positioning in Treasury futures has quietly risen in recent weeks and is now close to a record aggregate peak across two-, five- and 10-year contracts. In the five-year space, both 'long' and 'short' positions have never been higher. 

The Treasury futures market is where hedge funds operate the basis trade, an arbitrage that profits from making highly levered bets on tiny differences between the price of cash bonds and futures. 

Global financial authorities have repeatedly warned that, if suddenly unwound, these positions – levered up to 100 times – could pose a threat to financial stability, as sharp price swings could trigger a devastating dash for cash and scramble to cover.

But that hasn't happened yet, despite all the market volatility over the past month. 

Instead asset managers and leveraged funds are steadily building their 'long' and 'short' positions, respectively. Aggregate holdings across two-, five- and 10-year futures contracts are all comfortably above $1 trillion in notional terms. Speculators seem happy to continue peeling off the pips in the basis trade, and asset managers are happy to lock in yields between 3.80% and 4.20%. 

"It's maybe a little surprising how fast these positions are being rebuilt, but it shows a generally salient view leveraged investors have in the functioning of the repo and Treasury markets," says Steven Zeng at Deutsche Bank.