The market for US Treasurys has a strong claim to being the most important of all financial markets. To a greater or lesser extent, most other markets are – to some degree at least – priced in relation to it. It provides the benchmark, or risk-free rate, against which riskier assets are priced. And in recent weeks, it has been volatile.
At the beginning of April, a 10-year U.S. Treasury yielded around 4.2%. In the immediate aftermath of the Liberation Day, tariff announcements fell to just 4% by April 4th before spiking rapidly to a close of almost 4.5% by April 11th. Following President Trump’s 90-day delay of the so-called reciprocal tariffs, it has fallen back to closer to 4.3%.
These are reasonable moves by the standards of the Treasury market, and the pace of the sell-off, which took yields from 4% to 4.5%, was especially rapid even if things appear to have calmed down a little since.
But the really striking thing about recent price action has been not so much the pace of the moves as how they fit in with other markets.
In general, when US share prices are dipping, one would expect the price of US government bonds to rise and the resulting yield to fall. If investors are less confident than they once were in the prospects for equities, their usual reaction is to shift cash into the Treasury market, pushing the price of bonds up.
And the yield on US Treasurys is usually pretty well correlated with moves in the value of the dollar. All things being equal, a higher yield on US Treasurys should make holding the dollar more attractive and push up its value.
But in April, these long-expected correlations began to break down. There were days when equities were down heavily, the dollar was losing value, and yet Treasury yields pushed higher.
According to Sherwood, in the month of April until April 21st, the dollar was down by more than 5% against the currencies of other developed economies, the S&P 500 was down more than 5%, and yet the yield on 10-year Treasurys was up by more than ten basis points. That was the first time this combination had occurred since 1981.
The unusual combination of essentially all major American asset classes selling off at the same time and the sheer pace of the early to mid-month falls in the price of Treasuries prompted much suspicion amongst market participants that something other than macroeconomic fundamentals might be at play.
One frequently discussed candidate was what is known as the basis trade. The FT explained the nature of the cash-futures basis trade earlier this year:
This arises from a disconnect between prices for contracts to buy bonds in the future and the value of bonds eligible for their delivery. It is nearly free money that is available for those with the wherewithal to take it.
The basis trade makes money, but not very much per dollar deployed. To eke out decent returns you need leverage. Before the global financial crisis investment banks took this money. But following systemwide financial meltdown and subsequent bailout, post-crisis regulation was brought in to limit bank leverage, forcing banks to exit some activities… Hedge funds have since stepped into the void, and with gusto. Instead of making calls about the future of monetary policy or geopolitics, fast money has been buying Treasury bonds and selling futures — the Wall Street equivalent of hoovering up nickels on the sidewalk.
However, the scale of this basis trade has also increased leverage in the financial system as volumes of repos have increased substantially over the past year. Basis trade investors rely on low repo haircuts and low repo rates to leverage their positions and increase basis trade profitability. A spike in repo rates—triggered, for example, by surprises in quantitative tightening can render the trade unprofitable and could trigger the forced selling of Treasury securities and a brisk unwinding of futures positions as funds seek to quickly delever…Aggressive use of repo financing also makes the basis trade vulnerable to other shocks, such as upside inflationary surprises that lower the value of funds’ long bond positions, amplified by leverage.
The involvement of a lot of fast money employing a lot of leverage has the potential to amplify shocks in the Treasury market, a sharp move in yields – driven by fundamentals – may lead to margin calls on leveraged investors, which force them to sell Treasuries, driving the price lower still. In the worst-case scenarios, this drives a vicious circle of lower prices, more margin calls, and yet more selling pressure.
It may well be the case that such dynamics came into play on some days around the middle of this month.
But it should always be kept in mind that the ultimate driver of the move was macroeconomic fundamentals. This week, the Clark Center’s Finance Experts Panel was asked, amongst other things, whether “the recent volatility in Treasury market prices is primarily due to concerns about US macroeconomic prospects”?
Weighted by confidence, almost three-quarters of respondents agreed. In other words, financial plumbing issues might occasionally be amplifying market moves – and the potential for leverage to create acute financial stress is worth watching closely – but the real driver of the ‘sell America’ trade, which has sent Treasurys, stocks, and the dollar lower is a real concern with worsening macroeconomic fundamentals.
