Vice-chair Randal Quarles writes in a note that the Fed will focus on ‘reinforcing resilient non-bank financial intermediation’ after vulnerabilities emerged © REUTERS

The note sent on July 14 by the Federal Reserve’s vice-chair Randal Quarles to other central bank governors and finance ministers reads like one of those anodyne diplomatic demarches that trade hands just before a major war.

The note, written on the heading of the Financial Stability Board, is a warning directed against hedge funds, big asset managers and anyone else Quarles and the Fed believe to be responsible for the approaching apocalypse in the fixed income markets.

Like submariners watching the depth gauge swing down to crush depth, bond traders and the Fed are trying to calculate when sinking yields on five and 10-year bonds will get within 10 or 20 points of zero. Right now they are about 60 basis points, having reached a high of 90 after the March Covid-19 crisis.

When the 10-year gets close to zero, transaction costs will keep even the big banks from making any margin by buying Treasuries. Then the system breaks down. Maybe just after Election Day. Nobody is sure.

The July 14 Quarles letter lays out a plan for who will take the blame when that happens.

After the usual niceties for fellow FSB regulators, Mr Quarles gets down to the point, which is “reinforcing resilient non-bank financial intermediation (NBFI)”. As Mr Quarles puts it, the Covid-19 crisis “has highlighted vulnerabilities in the NBFI sector related to liquidity mismatches, leverage, and interconnectedness, and investor behaviour to certain funds that they treat as cash equivalents during economic calm, but not during crisis”.

Here is what that means: since the liquidity crisis in the short-term funding markets that started last August, fixed income investors, some of them in very large hedge funds in Chicago and New York, saw that they could make a steady income by using strategies such as “gamma scalping”, or selling offsetting puts and calls on Treasuries on the assumption that the Fed would support the market and suppress volatility.

Gamma scalping like positions dribble out lots of small profits from option premium less the loss of time value. The risk is of a sudden move in Treasuries prices out of the range set by the option contracts, which can expose the house to catastrophic loss. But since the assumption was that the Fed would continue to suppress volatility, the strategy was like an annuity.

Until coronavirus. In March, as the panic and lockdowns hit the world, emerging market central banks had to sell lots of Treasuries to get cash. Treasuries prices plunged out of the range the hedge funds and other leveraged investors had bet on with all that gamma scalping. The multibillion investors were, technically, close to broke and the market was shutting down. So the Fed came in and bought the market. Prices recovered, and the hedge funds were back in the money.

The Fed bailout left so much short-term dollar cash available around the world — against Treasury collateral, that is — that the funds turned around and decided to put on another bet at the Fed’s expense. Collectively, through various mechanisms, since March, leveraged investors have put on a giant carry trade on the Treasury curve.

You can see traces of this in the first-quarter results from the banks, where fixed income trading has brought in fortunes nearly as large as what will be lost from commercial real estate.

Fed chair Jay Powell and his confreres wanted the added liquidity to go to restarting the real economy. But Covid-19, corporate restructuring, trade wars and low oil prices keep that from happening. Instead, there’s speculation on the Treasury carry trade and buying valueless shares on a Robinhood app.

So even conservatives like Mr Quarles are looking for someone’s blood. As he writes: “By the G20 summit this November the group (within the Financial Stability Board) will carry out a holistic review of the market turmoil in March . . . to improve the resiliency of the NBFI sector while preserving its benefits.”

Translated into English, the Fed and its international friends will go along with Democrats’ plans to limit hedge fund leverage, tax transactions to reduce runaway liquidity and bring large, public facing asset managers under much heavier regulation.

Elizabeth Warren may have lost the nomination, but her people are on their way to winning the war.

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