[Column] Trump’s folly

The US hedge fund Long-Term Capital Management, which rattled the world’s financial markets when it was forced into bankruptcy in 1998, had previously made a name for itself with its “long/short” investment strategy. This approach involved making profits by buying undervalued bonds and selling overvalued ones.

To inflate its small profits, the company drew on massive investments of other people’s money. But when the Russian bonds it had gone into debt to buy ended up in default, 14 bond institutions had to pour out US$3.6 billion in bailout funds, with the New York Federal Reserve Bank at the lead.

Massive borrowing-based investment by hedge funds was also chiefly to blame for the chaos that erupted on the US government bond market in March 2020, around the time that the COVID-19 pandemic was entering full swing.

When a crisis like a pandemic causes stock prices to fall sharply, funds tend to concentrate on government bonds, which are seen as safe assets, and the price of those bonds would normally increase.

But the basis trading practices of hedge funds — trading around the difference between spot prices and derivatives — ended up causing the price of government bonds to plummet. The funds had inflated their assets by a factor of ten or more by taking out loans and using high collateral value US bonds as collateral with banks in order to purchase government bonds.

They sold their collateral government bond futures at a premium, but when the price of government bonds went down, the creditor banks began disposing of their collateral. At the time, the Fed put out the immediate fire by purchasing US$67 billion in bonds.

This sort of debt-based investment by hedge funds is also one of the reasons why the “liberation day” declared by the US with President Donald Trump’s announcement of reciprocal tariffs ended up turning into a day of collapse for government bonds. As the market grew volatile in response to the shock of these unprecedented protectionist tariff measures from the US, a vicious cycle began in which declining government bond value forced the settlement of hedge fund transactions, leading to a selloff of government bonds, the value of which fell even further.

When government bond prices drop sharply, this translates into a direct hit for ordinary people due to the increases in interest rates for the bonds and various other loans tied to them.

Having removed so many financial regulations, it would be difficult for Trump to have a change of heart now and apply regulations to arbitrage trading once again. The hedge funds are key investors in US bonds and suppliers of liquidity, and restricting their gambles would lead to skyrocketing bond issuance costs for the US government — a burden that would end up falling on the American people.

Arbitrage trading by hedge funds is estimated to account for around US$800 billion of the roughly US$28.6 trillion balance of US bond issuance. Trump’s bizarre economic policy — based on the notion that tariffs alone can resolve the US’ astronomical trade and fiscal deficits — has ended up checkmating itself from the first move.

By Park Jong-o, economy and business reporter

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