A hedge fund might be blowing up the economy. Sure, there are real pricing swings based on expectation of the upcoming financial crisis, but the dramatic nature of the swings and the frequency of them is, well, unusual when it comes to being organic.
Long Term Capital Management, among other things, was brought down by a convergence trade strategy gone wrong: The idea to short the expensive on-the-run treasurys and buy the cheaper off-the-run treasurys and wait for them to converge made sense as a low-risk thing to do, even if there wasn’t a lot of money in it. By using a lot of leverage, they could boost the return on something that seemed so safe.
That whole thing blew up when people wanted the safest, most-liquid thing around (i.e. on-the-run treasurys) to the detriment of everything else. That hurt LTCM really bad as the spread grew wider instead of converging.
Let’s look at the 2-year treasury now and the 10-year treasury.
You should need encouragement to lock your money up for longer. Therefore, the yield on the 10-year should be greater than the yield on the 2-year. Historically, that’s the way it’s been:
But that’s not the sitch now, as you see in the chart above. Since July 2022, the spread has flipped. It’s now more lucrative to buy the 2-year than it is to buy the 10-year. You have a disincentive to buy the 10-year just in terms of the yield.
And the spread is more than 50 basis points. Yes, there has been a slight move toward convergence, but this is still out of wack.
It could be a convergence trade a fund has done that has gone horribly, horribly awry–and even more so if it’s a highly levered trade. It could be that they have had to vacate all kinds of short and long positions to meet margin calls. That would explain wild fluctuations in prices of things across sectors and the quick subsequent rebounds.
The economy may still be screwed. But could it be that a hedge fund has blown up in a really bad way and the rest of us just don’t know it yet?
