14/04/25: The basis trade, tariff rollback & inflation data

Monday Espresso Podcast - 14th April 2025

[00:00:05] Nathan Sweeney: It is Monday the 14th of April. Today I'm joined by James Athey, Bond fund manager here at the Marlborough Group. Good morning, James. Great to have you on the show.

[00:00:14] James Athey: Hi, Nathan. Yeah, good to be back. Interesting times.

[00:00:17] Nathan Sweeney: Yeah, so I thought it'd be a great time to get you on the show because obviously clearly a lot happening in markets and some of the events actually being blamed on bond markets this week.

[00:00:26] Nathan Sweeney: So we'll try to give you a detailed explanation of what's happening and explain some new terms. But just a quick recap for the week actually, we often talk about it, you know, in the investment world about, you know, the fact that you should remain invested. And one of the reasons we say that is because often you have the biggest down days and updates happen in quick, quick succession.

[00:00:48] Nathan Sweeney: And we've just seen a real live example of that over the course of the last week where we've had two big down days. And then this week we've had one of the biggest updates we've seen since 1950. So we're seeing the US market rebounding by 10%. So this is a gargantuan return. So it really does highlight why we often talk about, you know, staying invested and underneath the surface, you know, there's a lot happening, there's a lot of news, but some of the data that's coming out this week is also quite positive as well. But I think, you know, having James here, we're gonna really delve into what's happening in the bond market and what is the basis trade. So James, let's see if we can explain this one for the audience today.

[00:01:32] James Athey: Yeah, sure thing, Nathan. Yeah, as you say, markets have been incredibly volatile and to your point, we always advise clients to try not to overreact, react to emotion, and that's of course why we advocate diversification because there's so much going on in markets that are moving relative to one another in such dramatic fashion that, you know, it behooves us all to try and diversify our investments across a range of sectors and geographies and asset classes.

[00:01:58] James Athey: And that is solid advice. As much today as it would've been two months ago when markets seem to be very well behaved, as you say, there's a lot particularly going on in the bond market, and unfortunately not necessarily the type of bond market response that we might expect. If you see equities falling by 5 or 10% in the space of a few sessions, you would normally anticipate that investors would seek safety, and safety generally means cash, of course, but bonds, bonds tend to protect your capital well when riskier assets like equities aren't performing as well. We did see that reaction initially around Liberation Day, the announcements from President Trump, but subsequently we've seen bonds performing quite badly.

[00:02:40] James Athey: Yields have risen. Particularly at the longer end of the yield curve. So 10 year bonds, but specifically 30 year bonds performing particularly badly. We never really know on every, any given day why markets are doing what they're doing. It's a very complicated system with lots of different investors, investment styles, but one of the explanations, justifications that we've seen conversations around.

[00:03:04] James Athey: Which might explain the weakness of bonds, does relate to this basis trade. So what is the basis trade, I mean basis, just to sort of define that term generically. It's just a term that refers to the spread between two assets, the spread between two assets in terms of price or in bonds in in terms of yield.

[00:03:24] James Athey: Specifically when we are referring to the basis trade here, it's the difference in price between a government bond. And the equivalent government bond future, and generally speaking, the price difference is very small. It usually takes the form of the future being a little bit expensive relative to the cash bond, and that's because lots of asset managers like to use futures as a liquid and easy to trade expression.

[00:03:55] James Athey: A view on the underlying government bond market. It also, of course, means that you can gain a bit of leverage. You don't need to put the entire cash amount down. You can buy a future using margin. So you put a small amount down and get a larger exposure.

[00:04:10] Nathan Sweeney: So a future. So just for the audience. So what is a future?

[00:04:14] James Athey: Sure thing.Yeah. So a future, a derivative, we hear that term, all of the time term. What does that mean? It essentially means a security whose price is derived from the price of an underlying asset. In the case of a future, it is a standardized contract. In this instance, a standardized contract whose price is based on the price of an underlying government bond.

[00:04:39] James Athey: So it's a synthetic way of gaining exposure to government bonds without actually having to buy the underlying government bond. And again, the, way that these securities work, that means you can put less cash down upfront and gain a greater amount of exposure, what we'd call leverage. So those things are used all of the time by lots of different investors and investment styles.

[00:05:00] James Athey: Lots of asset managers will, if they want to gain a positive exposure to government bonds, they might choose to do so through futures because it's a very easy way and a very liquid way, a cheap way to transact. But what's been happening over recent years is that hedge funds have been trying to profit from that price difference.

[00:05:20] James Athey: So, as I said, futures tend to trade a bit expensive relative to government bonds, and so a hedge fund can sell the more expensive asset, in this case, the future, and buy the cheaper asset, the underlying government bond and profit from that very small difference. Those differences would be a handful of basis points at most, a basis point being at 100th of a percentage point.

[00:05:45] James Athey: And so in order to make that trade worth fair while. They use leverage. So you do that trade over and over again with increasing amounts of leverage and those small basis point, gains on each individual position can add up to something more meaningful. Unfortunately, of course, when markets start to exhibit the sort of volatility that we've seen recently and the way that hedge funds measure their risk and manage their risk, it tends to be the case that when volatility increases, that forces hedge funds to just reduce.

[00:06:23] James Athey: The size of all of their positions and because lots of hedge funds had the basis trade on and lots of them were using significant leverage, the fact that they're all trying to close that position. Together in a short space of time, particularly because in the modern financial system, banks are somewhat constrained in how much they can use their balance sheet to take the other side of that position from hedge funds, you know, to facilitate that, unwind that wrap to the exit door can lead to some really unusual looking price action. It's very much in keeping with something we saw in March, 2020 around the peak of the Covid panic, if you like. In early March in 2020, we saw similar price action where treasury suddenly stopped behaving like a safe asset and started to underperform even at a time where equities were falling.

[00:07:22] James Athey: What we should all remember is that, these short-term disruptions are just that they are short-term disruptions. Ultimately, markets should find clearing prices, and what we know is that central banks have the willingness and capability to provide support and liquidity to markets in the event that, you know, things should become unhinged or become too disruptive.

[00:07:48] James Athey: So it can look concerning, but it's not something we expect to persist. It's not something which really, should be particularly concerning to long-term investors such as ourselves. In fact, you know, we on the bond team would like to see the opportunity in some of these slightly strange looking markets.

[00:08:05] James Athey: So if we can buy a strong asset more cheaply because another investor is being forced to close that position for technical reasons, then of course that's an attractive opportunity for us.

[00:08:17] Nathan Sweeney: Yeah. Okay. So thank you for that. So great explanation of how that works. And you know, clearly this is one of the reasons why Donald Trump, you know, or an expectation of why he came out and rolled back those tariffs because it was creating a pocket of instability within the financial worlds.

[00:08:34] Nathan Sweeney: And if you're pushing up the price of those bond yields, or you know the cost of refinancing for the government, then ultimately that would mean that the US government would have to refinance a lot of its debt at a higher price. And this is one of the reasons being touted as why he came back and rolled those tariffs back.

[00:08:53] Nathan Sweeney: And you know, clearly that led to a really strong bounce in equity markets because that's a positive news for equity markets, seeing those tariffs being rolled back, that 90 day reprieve. So from our perspective, we think we're past this peak bad news when it comes to tariffs, because if you think about it, he put a blanket tariff on the whole world.

[00:09:14] Nathan Sweeney: And going forward from here, there's gonna be individual country negotiations and negotiating with individual countries. Whether that leads to a good or a bad outcome is not as bad as those high tariffs across the whole world. That's the real good news and fundamentally, a couple of releases of data during the week were also good.

[00:09:31] Nathan Sweeney: Let's focus a little bit on the week ahead. So what kind of data do we have to focus on?

[00:09:37] James Athey: Yeah. As you say this last week, we did have a couple of key data points. US inflation came out. It was a little lower than expected, if that's good news for everybody. We had some UK economic activity data, which was also better than expected, which would be great news for the chancellor this coming week.

[00:09:52] James Athey: Certainly in the UK, a couple of big data releases. We get labor market data and we get UK inflation. Of course, these are key inputs for the Bank of England and markets are ultimately expecting the Bank of England along with other central banks to ease policy in this coming year. The extent to which they do so will heavily be influenced by such things as the labor market and inflation.

[00:10:14] James Athey: So key points in the UK ahead. In the US we also have retail sales, which generally speaking is obviously pretty bellwether given how significant the US consumer is for economic activity there. One point I will just make though is that in this type of environment, markets will be a little less sensitive to these sorts of data points than they might usually.

[00:10:36] James Athey: Essentially, this is quite backward looking at a time where there's significant change and significant uncertainty. And so really what's going to happen from here is a lot more front of mind for investors, so we might not see. As much of a reaction to data, good or bad, you know, in this type of environment.

[00:10:56] Nathan Sweeney: Ultimately, anytime we have these unsettling events in markets, they pass, this is part of the course, and generally markets tend to move on and when they do, they can move on quite quickly as we've seen with that strong market events. So if you do have questions, send them in. We'd love to bring them up on the show and have a great week, everybody.