The Basis Of Basis

Basis is something, that in the mortgage world is usually followed by the word point. We all know what a basis point is. 1/100 of 1 percent. If you don’t know that, then you ought to call up your brokerage, and make arrangements to surrender your mortgage license.

But, basis can mean many thing to many different financial professionals. While the chaos that has been happening in global markets the last few weeks has gotten a lot of attention, one thing that hasn’t gotten any attention is the basis. I am going to try and break down why all hell is breaking loose in the financial markets, and also try to not put you to sleep at the same time. Bond market analysis is something that is usually best reserved for the sleep clinic to put people out. I have even heard of it being used to put insomniacs to sleep.

Over the last few weeks, we have witnessed what will probably be the biggest bout of volatility we will see in our lives ( notwithstanding WW3 breaking out ), but there seems to be a lot of confusion as to the “why” part. I am going to attempt to break down a very complex, archaic principle below, and explain what is going on to make the turmoil make a little sense. The concept of basis is something that is usually reserved for 4th year university courses – and even then I don’t think a year is enough to learn it, but we are gonna give it a go anyways. This is a very rudimentary break down, but it will give you broad strokes at least.

We all know that bonds are traded. We all know we can look up the bond yields on the computer. We know, or at least we ought to know that bonds work inverse, so when price goes up – yield goes down, and when price goes down – yield goes up. That is about as far as most mortgage people go into the bond world. Personally I am a bond guy, I have always loved the bond market at heart ( sad, I know ) and I have always felt the bond market is far smarter than the stock market. Since baseball is back in season, let’s use a bit of a baseball analogy here : When your favourite player hits a grand slam home run, they get all the praise and glory, but it was the manager in the dug out that called the play, and got the bases loaded in the first place. The bond market is that manager. The stock market takes its que from the bond market – even though the stock market gets all the attention.

Okay, back to the topic at hand – basis. Bonds are a very complex instrument, and are traded at levels that most of us have no idea about. The bond market is about 10 times the size of the stock market, and what happens in bonds – and by default interest rates has more impact on our day to day lives. If interest rates go up 5% overnight, far more people are affected tomorrow than if the stock market drops 3%. Because bonds are so very important to the financial system, and their interest rates impact so many people, bonds are heavily traded, watched, and used for all types of different strategies. Because bonds are backed by something, they are seen as more secure that a stock. That ‘ something ‘ could be a revenue stream like in the case of a water utility that issues a bond to build part of their distribution system and the revenue generated by the water distribution system backs the bond, or it could be something as easy as a promise. Almost everyone that has been to a US bank in their life has probably seen the slogan plastered everywhere that states the currency is backed by ” The full faith and credit of the US Government “. In that case, it is simply a promise that backs that bond. US Government bonds are considered to be almost risk free, because the US government backs them. Now, we can argue about the US governments ability to pay, but the market sees them are virtually risk free. For the record, risk means risk of default on either the interest of principle of the bond. Risk free does not mean the value won’t or can’t change, it just means that there is virtually no risk in losing either your interest payments, or your principle back at maturity. In bond pits around the world, bond traders are constantly looking to get an advantage and make a buck. One of the most popular ways to make money on bonds is to use arbitrage, whereby your exploit differences between similar items. This is where basis can come in. There is often a discrepancy in bond pricing between today, and a date on the future. When traders go into the market to hedge their positions – usually around the release of a big report like inflation or employment, their buying or selling to hedge can create a discrepancy in pricing. You may see a US government 10 year bond trading for more in the futures market than the comparable bond trades for at a “cash” price today. This can happen for thousands of reasons, and I won’t go into them all, but just know it happens hundreds of times a day. The discrepancy can be small, but Wall St is the master at exploiting even the smallest amount. So, if the future bond is trading for more than a cash bond today, a bond trader would go into the market and short the future bond, while also buying up the current bond. Within a small window of time – could be seconds, could be minutes, or could be a few days, the discrepancy is usually hedged back out by the buying and shorting, and the prices fall back in line. This is called an efficient market. However, during that time that the bond trader bought the current bond up, while selling or shorting the futures bond, he or she created some arbitrage on their position. They probably made a bit shorting the futures bond, and a bit buying the cash bond. Spreads are so small that it literally might be only a basis point or two of total profit. This works because the US Treasury market is the largest and deepest pool of liquid capital in the world – no other country even comes close to the depth and liquidity of the US Treasury market. Okay, so we see why the trade is done, but now we need to see how it is done, or more importantly why it is worth it for only a basis point or two. We are basically talking about .001% after all.

Rocket fuel. Yep, rocket fuel is how this strategy is done. Well, not actual rocket fuel, but rocket fuel for financials – leverage. Leverage is Wall St.’s favourite thing. Since US Treasuries are considered risk free, and are so easily traded, traders can lever up their arbitrage strategy. Typically if you are trading governments, then you can lever up 50 to 1, or even 100 to 1. So, if a traders has 1 million of trading capital, they can buy 100 million worth of government bonds. So, a little math says that even if you make 2 basis points, on a 100 million dollar trade, then the trader cleared a profit of $200,000.00, minus the cost of leverage for a trade that may have been on for 45 seconds, or 4 days. Not bad cake. Now imagine the trader made 10 basis points!! That is a cool million in profit. This all works because traders know, or at least think they know that anomalies in pricing should resolve themselves eventually since a pricing discrepancy is bound to be found out. Think of it like this: If a gas station started selling gas for 50 cents a liter, pretty soon the lines would be around the block, and the station would realize the error and put the price back to where it should be.

This exploitation of the bonds is basically your basis trade. Trillions of dollars every day are traded around the world in bonds on the fact that traders can make a few basis points here or there to arbitrage out pricing differences – even if for a short time period. But, what happens when the anomalies don’t correct themselves because there is external forces playing havoc with the bond market? This is what we have witnessed for the last 2 weeks. The bond prices are not going back to where they should be. Too many people are trying to hedge out too many scenarios around tariffs and the economy, that you cannot get a reliable indicator or price on where prices should be – let alone trade the damn bond. So, people are getting out of the market until they know more. Traders are afraid to try and exploit pricing differences because they don’t have much confidence if the price is an anomaly, or if the bond market is trying to find a new level. So, a lot of traders are simply dumping positions, or being forced to dump positions because of margin calls on their 100 to 1 levered portfolios. When this happens – you basically break the basis trade. When you break the basis trade, you also break the buyers of bonds, and everyone liquidates. If everyone is liquidating, prices go down, and when prices go down, yields go up. This is how you have had interest rates skyrocketing while equity markets are falling apart. Bond markets are trying to figure out tariffs, how they apply, where they apply, and what – if anything it will do for the US economy, and inflation. Until bond market can get a clearer picture of the economy and inflation with the tariffs ( Are they on again, are they off again, do we know ) you will see a lot of bond market gyrations. If the bond market is unstable, the equity market will follow. Basis matters because the traders who trade these bonds are buying and selling, and setting yields. If you remove these buyers and sellers, yields can run a lot higher – or lower than they would normally be allowed to. If you don’t have someone constantly buying and selling, then price discovery goes away. Generally, if people are less certain of the price ( price discovery ) then traders will demand a higher yield to hold the bond to compensate them for the perceived risk since it is hard to get price discovery. This is why your mortgage rates are going to bounce all around for the next few weeks. No one is certain, so when you lack certainty – you demand a higher rate to hold risk. Mortgages are no exception. in the last week and a half we have had trillions of dollars of bonds being sold until levels are more comfortable, and price discovery is back. Trillions of dollars flowing out of bonds is going to crank yields up.

If 2 weeks ago I had put out a post that told you that bond yields would soar when the stock market was melting down – I would have been called a lot of names, and people would have thought I was off my rocker. Well, here we are, and the Canada 5 year yield has shot about 30 bps higher. Remember last week when I said you may want to lock in those pre approvals? Guess what, lenders are already sending out the rate increase sheets. You are gonna be hard pressed to find a 5 year fixed starting with a 3 next week. Not impossible, but you are going to have to dig.

Today we saw the Dow Jones close up damn near 3000 points ( second best trading day since WW2 ). So, all of those people crying on Monday about your retirement account should be fine now. Stay invested, because if you pulled your money out of the market – you just missed an entire year of returns in 4 hours. I always find it odd when a group blames a certain political party or person for the stock market going down, but that same group never comes out to praise that party or person when the market goes up. Hmmmmmm, how odd. But, we are not through this. Today was a great day and made up a lot of losses, and made the wounds feel better, but it is like the eye of a hurricane – it might seem calm now, but wait for the back half. We will see more volatility and more head spinning moves – of that I am sure. Don’t take anything for granted, the deal today may not be there tomorrow. Keep in constant touch with your borrowers – they might get a rate from you one day, and the next they can get it from the competitor 20 bps cheaper. Make sure you are constantly updating and shopping for clients.

To those who ask if the Chinese selling US government debt is the cause of the bond problem – I really do not think so. If the Chinese were trying to sell US debt to punish the US, then they would also be selling USD, and we have not seen that. Selling US government debt, and then holding onto US dollars doesn’t make a lot of sense, or even really send a message. We also must remember that if the Chines start selling US bonds, they will drop the market, and by default drop the value of the rest of their holdings – so it doesn’t really behoove them to do that. Now, if we saw yields skyrocketing while also seeing the US dollar index plummet – then I would say the Chinese trade is on, but you would need both of those to happen in order to convince me.

Work your ass for for your clients this week ,and the weeks ahead, and you will get them through this but of turmoil.