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And while we knew that China was selling - and following the record selling of FX reserves in August, so does everyone else - an even more interesting question emerged: who is buying?
Thanks to the WSJ we now have the answer: "A little-known New York hedge fund run by a former Yale University math whiz has been buying tens of billions of dollars of U.S. Treasury debt at recent auctions, drawing attention from the Treasury Department and Wall Street."
The hedge fund in question, Jeffrey Talpins' Element Capital Management, which according to the WSJ has become "the largest purchaser in dozens of government-bond auctions over the past 10 months, people familiar with the matter said. The buying is part of an apparent effort by the fund to use borrowed money to exploit small inefficiencies in the world’s most liquid securities market, a strategy that is delivering sizable profits, said people close to the matter."
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Which brings us back to the "how much leverage is involved" question, because one bad day for Element and suddenly the fund could be forced to unwind its giant Treasury book into what is already a very illiquid market.
Which leads to the question of just what is Element's strategy: "Element had been shorting, or betting against, bonds in anticipation of higher interest rates but has been exiting from that wager, according to someone close to the matter. That is one reason the fund has been a big buyer of Treasurys lately."
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In the 1990s, hedge fund Long Term Capital Management used leverage to profit from small discrepancies in the Treasury market before a market reversal swamped the firm. LTCM used much more leverage than Element does.
Only problem is nobody knows just how much more leverage, and whether Element's leverage isn't slowly but surely creeping up to Merton and Merrywether levels.
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But the biggest risk by far ... if Talpins is indeed very long TSYs, and has lot of leverage embedded in the trade, one may expect a concerted shorting effort to find out just how much leverage is incorporate in the trades, and push it to the point of breaking. After all, hedge funds exposed with massive positions rarely survive an onslaught by their peers who seek to do just that - inflict "max pain" (see Ackman and Herbalife).
If so, China's selling of TSYs may very soon inflict precisely the kind of damage on US paper not because it is selling, but because the biggest "mystery" buyer of US paper has just been revealed and whose continued ability to keep buying unimpeded is now suddenly very much in question.
What's worse, if the result of a coordinated attack on Talpins leads to an LTCM-type blow up, hang on to your hats because the recent volatility in the equity market will be nothing compared to what is coming to the MOVE, TYVIX and US Treasurys...