.png)
When safe havens become vulnerable
In turbulent times, US Treasuries are typically the ultimate fallback: liquid, stable, and backed by the US government. During this week of turmoil, the playbook flipped. Investors didn’t flee to Treasuries—they fled from them.
Even as equity markets trembled and volatility spiked, government bonds were sold off aggressively. Capital poured instead into traditional crisis hedges such as gold, the Swiss franc, and the Japanese yen. The US dollar itself took a beating, hitting a 10-year low against the franc. The message from global markets was unmistakable: trust in US policy direction and economic resilience was faltering.
10-year US Treasuries yield weekly change: +50bps last week!
Source: Bloomberg
The basis trade blow-up: when tiny margins turn into massive risks
Beneath the surface, the collapse was intensified by a mechanical but dangerous force: the sudden unwinding of massive basis trades, a common but risky arbitrage strategy favoured by hedge funds. Here’s how it works: funds borrow heavily—often via short-term repo markets—to purchase physical Treasury bonds while simultaneously selling interest rate futures or entering into interest rate swaps. The idea is to profit from the small difference—or basis—between the cash price of a bond and the price of its synthetic equivalent.
Basis trade: how does it work?
How does the basis trade work, concretely?
- The fund borrows money
- With that money, it buys real US government bonds (for example, 10-year Treasury bonds)
- At the same time, it sells a derivative contract (like a fixed-for-floating interest rate swap or a futures contract on the same 10-year Treasury)
- The fund pockets the small difference in price or yield between the bond and the derivative
If everything goes smoothly: the price gap (the “basis”) narrows over time, and the fund makes a small, steady profit.
But if the market turns...If bond prices move sharply (for example, due to a sudden rise in interest rates):
- The value of the bonds drops
- The fund must repay its loan or provide more collateral (margin calls)
- It’s forced to sell the bonds quickly, which pushes prices even lower
This vicious cycle is exactly what helped trigger the spike in yields in April 2025.
In theory, these price gaps should converge over time. In practice, the strategy only works in stable conditions. When bond prices fell sharply, that convergence broke down. The spread widened instead of narrowing. Funds with highly leveraged positions—sometimes 30:1 or more—were hit with margin calls and forced to sell Treasuries to cover losses. These sales pushed yields even higher, triggering more margin calls and more selling. It was a textbook feedback loop. By the height of the dislocation, the spread between 10-year Treasury yields and their swap equivalents exploded to 64 basis points—a level never seen before. Even in the world’s most liquid bond market, liquidity vanished. This wasn’t just a selloff. It was a structural tremor.
The 10y swap-Treasury spread can be viewed as a gauge of market risk sentiment, liquidity conditions, and structural pressures in the financial system. This spread can be seen as a measure of several things:
- Credit and counterparty risk: swap contracts are between private entities and carry some credit risk, whereas Treasuries are backed by the US government and considered risk-free. The spread often captures this difference in perceived risk.
- Liquidity conditions: US Treasuries are among the most liquid instruments in the world. Swaps are less liquid, especially in times of market stress. A wider spread may indicate tighter liquidity in the swap market or strong demand for Treasuries.
- Supply and demand imbalances: when there's unusually strong demand for Treasuries (e.g., during a flight to safety), yields can be artificially depressed, widening the spread versus swaps.
- Funding costs and balance sheet constraints: swap rates are influenced by interbank funding rates and the cost of collateral. Regulatory changes or balance sheet pressures can cause the swap rate to diverge structurally from Treasury yields.
Difference between the 10-year US Interest Rate Swap and US Treasury yield
Source: Bloomberg
While leveraged selling magnified the panic, macroeconomic developments lit the match. The week began with a surprisingly strong US jobs report, showing over 220,000 jobs added in March. Instead of boosting sentiment, attention quickly shifted to a far more destabilising force: a full-blown trade war. The Trump administration announced sweeping tariffs on a wide range of imports, including from long-standing allies. China responded with equally aggressive countermeasures. This tit-for-tat escalation ignited fears of a global trade freeze. For the bond market, the implications were immediate. Tariffs raise the cost of imported goods, putting upward pressure on inflation even as they dampen growth. That mix—rising prices and slowing output—evokes the dreaded word: stagflation. Within days, consumer inflation expectations, as measured by the University of Michigan, jumped to their highest level since 1981. When inflation expectations rise, bondholders demand higher yields to preserve real returns. The result was another brutal leg higher in long-end rates.
In normal times, a bond market dislocation of this magnitude would draw a swift policy response, but the Federal Reserve was caught in a bind. Just weeks earlier, markets had priced in rate cuts by Summer 2025. But now, with inflation expectations soaring and financial markets destabilised, the Fed couldn’t move without risking further credibility loss. Officials chose a cautious path—no emergency cuts or new asset purchases. Instead, they deployed forward guidance, signalling their readiness to intervene if market functioning broke down. Boston Fed President Susan Collins was among those seeking to reassure investors, while Chair Jerome Powell acknowledged the inflationary impact of tariffs without committing to immediate action. It was a balancing act: too much support could anchor inflation fears; too little risked deepening market instability. Beneath it all was a deeper rupture—the erosion of confidence in the US as the default safe-haven. The dollar weakened rapidly, not just due to macro forces, but also amid speculation that China might offload a portion of its vast Treasury holdings in retaliation. Whether or not these rumours were founded, they were enough to move markets. Investors began rotating out of US assets altogether, reallocating capital toward Europe, Japan, and commodities. The dollar was no longer the automatic hedge. This flight from US assets wasn’t just a reaction—it was a reallocation of risk in real time.
10-year US Treasury yield and US dollar index
