Once considered the gold standard of safe-haven assets, US Treasuries are now showing signs of vulnerability amidst a volatile macroeconomic environment, raising critical questions about their role in global portfolios.
On April 8, an unusual pattern rattled US markets – equity indices slipped, but long-term Treasury yields surged sharply. The 10-year and 30-year Treasury yields witnessed extreme intraday swings of 20-30 basis points, with closing levels 12-13 bps higher than the previous day. In fact, the 30-year yield has climbed an eye-popping 50 bps in just three trading sessions – a level of volatility not seen since the onset of the pandemic in March 2020.
Basis Trade Unwinding Behind the Volatility?
According to Madhavi Arora, Lead Economist at Emkay Global Financial Services, the unwinding of the so-called basis trade could be behind the recent turbulence in the bond market.
“The highly-leveraged basis trade may be at the heart of this sharp volatility. Hedge funds have loaded up on this trade to exploit minuscule price differences between cash Treasuries and futures, often with leverage up to 100x. It’s estimated that this trade could have ballooned to over $1 trillion – nearly double of 2020 levels,” Arora said.
As these leveraged positions unwind, they may be amplifying price swings, especially in the longer end of the Treasury curve.
Fresh Supply Adding to the Pressure
The US Treasury market is also facing a deluge of supply – $39 billion in 10-year notes and $22 billion in 30-year bonds. Traders may be booking profits in advance of this new issuance, contributing to the recent volatility.
Weak Auction Signals Domestic Demand Strain
Another red flag emerged in the form of weak demand at the latest 3-year Treasury auction.
“Only about 6% of the auction was absorbed by domestic buyers, compared to an average of 19%. This weak demand from domestic institutions does not bode well for the upcoming longer-duration paper,” Arora pointed out.
Structural Stress from High Deficits and QT
Beyond short-term trading dynamics, structural challenges are brewing. High budget deficits and the Fed’s ongoing quantitative tightening (QT) are flooding the market with supply while simultaneously reducing central bank support.
“With more Treasuries hitting the market and fewer buyers stepping up, funding pressures are intensifying. This, in turn, stresses the basis trade further and risks deepening market dislocations,” said Arora.
Foreign Investor Behavior a Key Risk
Adding to the uncertainty is the behavior of foreign investors. Private foreign institutions — unlike official sovereign entities — hold a significant portion of long-duration Treasuries and are more likely to reduce exposure during times of uncertainty.
“Any bond sales by these players — especially in an environment of tariff uncertainty and growth concerns — could accelerate volatility,” Arora said.
Tariffs and Reduced Global Surpluses Could Dent Demand
The looming threat of new tariffs could reduce export surpluses for key trade partners like China, thereby limiting their capacity and willingness to invest in US Treasuries.
“This would further reduce their appetite for US Treasuries,” Arora warned. “It exacerbates the UST funding problem, with domestic participants already shying away.”
With shrinking demand from both domestic and foreign participants, the Federal Reserve’s role in the Treasury market becomes even more central. The Fed has already slowed the pace of QT, possibly in anticipation of these risks.
“The bottomline is that while the highly-leveraged basis trade may lead to bouts of Treasury volatility, it is being exacerbated by growing UST supply and the current tariff-led uncertainty,” Arora concluded.
“In such a scenario, it is easy to imagine Treasuries gradually losing their safe-haven appeal.”
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