The next financial crisis trigger: Is the Federal Reserve preparing for the "U.S. debt storm"?

The scale of U.S. Treasury basis arbitrage trading has exploded, and Wall Street warns: the financial market is brewing the next financial crisis.

Currently, hedge funds' bets on U.S. Treasury basis arbitrage trading have reached $1 trillion, a record high. A team of financial experts has warned the Federal Reserve that this could become the trigger for the next financial storm.

According to a report from the Brookings Institution, research co-authored by Anil Kashyap from the University of Chicago, Jeremy Stein (former Federal Reserve governor) from Harvard University, Jonathan Wallen from Harvard Business School, and Joshua Younger from Columbia University indicates that the Federal Reserve should consider establishing an emergency plan to address the potential risks in the U.S. Treasury market, which could reach up to $29 trillion.

Kashyap revealed at a press conference:

“This is a fairly concentrated trade, possibly involving only about 10 or fewer hedge funds.”

“What is concerning is that the current so-called ‘basis arbitrage trading’ has reached $1 trillion, which is double the amount that required Federal Reserve intervention in 2020.”

Trillion-Dollar Arbitrage Trading Becomes a “Time Bomb”

For a long time, hedge funds have exploited the small price differences between U.S. Treasury spot and futures, going long on Treasury securities with one hand while shorting Treasury futures with the other for arbitrage. Under normal market conditions, this type of trading can provide stable but thin returns.

However, to enhance yields, many hedge funds have employed high leverage, causing the total scale of such trades to balloon to a concerning level. Once market volatility increases, these highly leveraged positions may be forced to close, impacting other financial sectors.

Media data shows that the regulatory capital of just six major multi-strategy funds (Millennium, Citadel, Balyasny, Point72, ExodusPoint, and Lighthouse) has reached a record $1.5 trillion, an increase of $300 billion from the previous year.

At the same time, these hedge fund giants are continuously increasing leverage. The average regulatory leverage ratio (the ratio of regulatory assets to managed assets, which is the ratio of leveraged exposure to actual tangible capital) has risen from 6.3 times a year ago to a record 7.8 times.

According to data from the Treasury Borrowing Advisory Committee (TBAC), the inherent leverage ratio of going long on cash and shorting futures is as high as about 20 times.

According to the Federal Reserve's data, this figure has surged to 56 times.

In this context, Jeremy Stein warned at a press conference:

“Hedge funds are in a very aggressive position, and relatively small changes in spreads could push them out of the market. It appears that traders are not well-prepared to handle this situation.”

Resolution of the Debt Ceiling is a Key Moment

CICC's Zhang Jundong, Fan Li, and Zhang Wenlang stated, the essence of hedge fund basis arbitrage trading is shorting volatility, so once volatility rises sharply, it can easily trigger liquidation risks and subsequent asset sell-offs. The catalyst for the global financial market turmoil in March 2020 (selling off all assets for cash) was the unexpected liquidation of basis arbitrage trades at that time, which were at historically high levels.

In the face of this risk, the resolution of the debt ceiling issue could become a key event triggering significant market volatility. Once the debt ceiling issue is resolved, the U.S. Treasury will issue previously unissued U.S. Treasury bonds that were restricted due to the debt ceiling, leading to a sudden increase in the supply of U.S. Treasuries.

This supply shock will have threefold effects: first, an increase in interest rates; second, a liquidity "drain" effect on other assets; and third, it may trigger large-scale liquidations of basis arbitrage trades.

If interest rates fluctuate significantly under the supply shock of U.S. Treasuries, it could trigger liquidations of basis arbitrage trades that are already at historically high levels. Once hedge funds liquidate arbitrage trades, it could lead to cross-asset sell-offs, further exacerbating market volatility.

Compared to the "U.S. Treasury storm" that occurred after the resolution of the debt ceiling in June 2023, CICC believes the situation at that time was relatively better, as the overnight reverse repurchase scale still had over $2 trillion, indicating ample liquidity. However, now, this "reservoir" is nearing depletion, significantly reducing the market's ability to withstand shocks.

According to Xinhua News Agency, the U.S. Congressional Budget Office warned on the 26th that if Congress cannot timely raise the debt ceiling or suspend its effectiveness, the U.S. federal government may face a situation as early as August where it does not have enough funds to pay all its bills on time, potentially leading to a debt default.

Experts: "Hedged Bond Purchases" Can Replace Traditional QE

In 2020, to respond to the negative impact of the pandemic on the economy, the Federal Reserve chose to massively purchase $1.6 trillion in bonds within weeks to "rescue the market." However, experts now suggest adopting a more precise approach—using "hedged bond purchases" to replace traditional QE.

Stein proposed at the briefing:

“If the Federal Reserve leans towards purchasing again, we would prefer them to do so in a hedged manner, as this method could become an important supplement in the Federal Reserve's policy toolbox.” Kashyap added:

"Buying bonds is not a very elegant way of operating."

"This purchasing behavior is very similar to quantitative easing and may affect the term premium—here, the term premium refers to the extra yield that investors require for holding long-term securities compared to rolling over short-term securities."

Stein suggested, if the Federal Reserve wants to intervene in the bond market, it could sell an equivalent amount of futures contracts to hedge while buying U.S. Treasuries (injecting liquidity while avoiding distorting the term premium), which would more specifically address the risks of arbitrage trading.

This proposal can be understood as an emergency exit mechanism aimed at high-leverage hedge funds. However, some believe that once such tools are introduced, they may inadvertently "encourage" hedge funds to take on more risk.

In response, Stein stated:

"The basis for comparison should not be 'zero moral hazard.'"

"The Federal Reserve's direct bond purchases in 2020 have set a precedent, and simply buying U.S. Treasuries has its own costs."

This is because the Federal Reserve purchases securities that mature over time and creates bank reserves, for which overnight interest rates must be paid. This viewpoint suggests that it may blur the lines between financial stability operations and monetary policy.

The expert team proposed that a "bundled auction" approach could be used, allowing primary dealers to simultaneously submit the cash securities they intend to sell and the futures contracts they intend to buy. The Federal Reserve could set a minimum bid price for these bundles, limiting moral hazard by forcing hedge funds to accept punitive discounts