How the “Art of the Deal” nearly broke the US financial system

Context

Donald Trump’s aggressive tariff policies—hallmarks of his “Art of the Deal” playbook—nearly destabilized the U.S. financial system by triggering a crisis in the basis trade, a $1.2T arbitrage strategy propped up by post-crisis regulations and fragile repo markets. Here’s how it unfolded:

Post-2008 Rules and the Rise of the Basis Trade

After the 2008 crisis, stricter bank regulations forced institutions to hold more capital against loans, reducing liquidity and limiting leverage for big investors. Banks earned lower returns, but hedge funds found a loophole: the basis trade.

This arbitrage involves buying cash Treasury bonds (financed via the repo market) while shorting Treasury futures, pocketing the spread between the two. By 2025, the trade ballooned to $1.2T, relying on cheap repo funding and Treasury collateral.

The Tariff Shock and Hidden Fragility

Trump’s tariffs on China and allies disrupted global trade, driving investors into Treasuries as a haven. Hedge funds doubled down on basis trades to exploit demand, but the strategy’s reliance on repo financing created a house of cards.

How It Works:

Hedge funds borrow cash overnight from Money Market Funds (MMFs)—which dominate the $7 trillion repo market with 60% share —using Treasuries as collateral.

MMFs, like Vanguard or Fidelity, lend cash to funds or primary dealers (e.g., Goldman Sachs) but park excess liquidity at the Fed’s Overnight Reverse Repo (ON RRP) facility, earning a risk-free rate.

When repo rates rise (e.g., during stress), hedge funds’ financing costs spike, erasing profits.

March 2020: Margin Calls and Meltdown

The COVID-19 pandemic triggered a liquidity earthquake. Treasury prices plunged, slashing the value of collateral held by hedge funds. Lenders issued margin calls, seizing assets to cover losses.

But dealers, constrained by post-crisis balance sheet rules, couldn’t absorb the selling. Forced liquidations spiraled: hedge funds dumped Treasuries, driving prices lower and triggering more margin calls. The repo market froze, with rates spiking despite the Fed’s ON RRP floor.

Does the Fed put exist?

The Fed intervened with $1 trillion in bond purchases and repo market injections, halting the crisis. This rescue reinforced a risky assumption: if markets break, central banks will step in.

The Federal Reserve’s ability to intervene in a financial crisis—like a basis trade meltdown—is constrained by today’s high inflation. While the Fed historically deployed tools like QE to stabilize markets (e.g., the $1 trillion bailout in March 2020), already-high inflation now limit its flexibility. Tariffs and fiscal deficits have already introduced stagflationary risks, with core inflation hovering above the Fed’s 2% target. Chair Jerome Powell has emphasized that premature easing could reignite price pressures, forcing the central bank to prioritize inflation control even amid market stress. The takeaway is clear: The era of unconditional Fed rescues is over when inflation is already hot.

Legacy of the Art of the Deal

Trump’s “Art of the Deal” tactics—tariffs as negotiation leverage—have exposed cracks in the U.S. financial system, eroded investor confidence in the US markets and triggered a hostile trade environment, marked by retaliatory tariffs, supply chain disruptions, and heightened global uncertainty that will deter investment in US assets.