Making Sense of the Current US Treasury Market

It’s a tumultuous time for US government bonds, as long-end yields remain elevated and foreign demand concerns loom large. We unpack the recent bear steepening in the US Treasury curve, outline what historical data shows about rapid drawdowns in Treasuries, and discuss some potential tailwinds for long-dated Treasuries as we look ahead.

Understanding the Treasury Market Selloff

The Importance of Technicals

The recent rise in longer-term Treasury yields was due to a mix of factors, but in general, tariff announcements caused concerns about a potential fall in foreign demand for US government bonds. Technicals—clogs in the “plumbing” of the bond market from levered investors quickly derisking—were a large driver of the volatility. Specifically:

• Swap Spread Widener Unwinds

The 30-year US Treasury yield jumped 46 basis points (bps) over the week ending April 11 – the largest week-over-week increase in nearly four decades. This occurred during a week in which tariff announcements spawned growth concerns and understandably rattled equity markets. But the bond market also declined along with equities. What happened?
One main culprit is that investors—especially “fast money”¹ levered type trading shops—had built up long positions in US Treasuries through swap spread “wideners.”²  In these trades, investors are long cash bonds, and short swaps, via a paid position in a pay fixed swap.³  Some of these paid positions were “stopped out,” or forced unwound, as rates spiked.

• Basis Trade Unwinds, Trend-Following CTAs, and Risk Parity Funds

There was another technical issue, largely stemming from the levered and systematic spaces. As real money managers have increasingly employed long Treasury futures positions,⁴  levered investors have been shorting futures to take the other side of this trade (Figure 1). These short futures positions are held alongside long positions in cash bonds (via repo⁵ trades) in so-called “basis trades.” These basis trades bet on the price convergence of the cash and futures positions by applying leverage—at times as high as 100x.
The sudden tariff-related spike in bond market volatility triggered a combination of Risk Parity Funds⁶ derisking; accelerated by trend-following CTAs;⁷  on top of the delevering and unwinding of basis trades—all  of which meant selling Treasury bonds to derisk or meet funding obligations. So a feedback loop was created, where rising yields led to even more selling.

For further evidence of these swap widener/futures stop-outs, Figure 2 shows that longer-maturity US Treasury rates rose more than swap rates or futures rates during the recent volatility. This may indicate that investors were selling cash bonds and receiving swaps or covering short futures positions in order to unwind these trades. This tariff-related wave of swap spread/basis trade unwinds is akin to the COVID-19 selloff of March 2020, and the repo crisis of September 2019.

Price differences between futures/swaps and bonds arise partly due to demand and supply imbalances that followed the introduction of stricter regulation on both banks’ and dealers’ securities holdings post GFC. Fast money investors are positioned to benefit or profit from the convergence of Treasury futures/swap prices and bond prices. However, the large and growing cash-futures basis, cash-swap spread trades driven by levered positions in Treasuries are risks when abrupt market disruption and liquidity issues occur—especially in the event of an exogenous shock.

Was There a Demand Strike from Japan/China?

There was chatter of stop-loss orders being implemented by large Japanese banks that were “dumping” US Treasuries as spikes in Treasury yields triggered risk limit budgets. But the likelihood of this is low. Most large Japanese banks’ common equity tier 1 (CET1) percent is relatively high, let alone that a US Treasury bond is considered a "no-risk asset" and assigned a zero percent risk weight under CET1% calculations.

In terms of China, there may have been some impact from sales out of China, but this is unlikely. According to official US Treasury holdings data, the duration of Chinese holdings is concentrated more in the shorter end. Also, China has already been reducing US Treasuries gradually in past years, in favor of gold and other assets.⁸

Sudden Risk, Sudden Unwind. Sound Familiar?

A sudden drawdown of US Treasuries is not something new to the market; we have seen the same phenomenon occur over the last decade (September 2019 and March 2020). When looking at these episodes, and taking an even longer-term view of historical data, we find that real money demand persists and usually comes back gradually after a spike in yield (Figure 3). This is because higher bond yields can attract especially price-sensitive investors by providing diversification, capital preservation and income (see: Volatility Positioning: How to Hold on for the Ride).

Looking Ahead: Potential Tailwinds for Long-Dated Treasuries

Regulatory Reforms

Market participants have been awaiting potential regulatory reforms that could ease tightness in supply/demand technicals for US Treasuries. These reforms could encourage more flows to Treasuries from large domestic US banks, and potentially, from the Fed. These possible reforms include:

• The exclusion of US Treasuries from the Fed’s supplementary leverage ratio (SLR) calculations.

This topic has picked up traction since late 2024, following the return of the Trump administration. The SLR requires the largest US banks to hold capital equal to at least 5% of their assets, regardless of those assets’ risk weightings. Exempting Treasuries from the equation would encourage banks to increase their Treasury securities holdings, potentially in the ballpark of $1 trillion or more. In past periods when Treasuries were temporarily excluded from the SLR (such as during the COVID-19 panic in 2020), Treasury market liquidity has materially improved.

• Accelerating the privatization of Fannie Mae and Freddie Mac.

In 2019, the Trump administration tried to wrest Fannie and Freddie from their government conservatorship. If privatization were to be pushed forward this time around, proceeds could be used to pay down federal debt. Privatization could also prompt the Federal Reserve to increase the speed at which it is running down its agency mortgage-backed securities (MBS) holdings, in favor of Treasuries (part of Quantitative Tightening, or QT). Converting these agency MBS holdings to US Treasuries would potentially lead to downward pressure on Treasury yields. On the flip side, this would also imply upward pressure on mortgage rates, which may further dent US household sentiment.

Given recent discussions within both the Treasury ⁹  and Fed ¹⁰  about speeding up regulatory relief for banks, the SLR rule amendment would be the easiest and most effective way to try to restore stability to the US Treasury market and to cap yields, in the immediate future. Banks could grow their balance sheets by taking advantage of the spread between the lower cost of interest on deposits, and the higher yields earned by holding longer-dated Treasuries.

International Demand Implications for US Bonds (Treasuries and Credit)

Since the recent selloff was concentrated in the longer end of the Treasury curve, the spread between short- and long-dated bond yields has widened (e.g. 2s10s from 25bps to 50bps, 5s30s from 60bps to 85bps).¹¹  This bear steepening is actually a positive factor when it comes to international demand for US bonds. International investors hedge their FX exposure using the front end of the curve, in exchange for locking in longer-term yields.

We continue to expect more rate cuts from the Fed this year (see: Fixed Income 2025: Return of the Sovereigns). We also believe that a more permanent trend of repricing of the term premium will keep the longer-end yield relatively elevated. As a result, there is potential for the US Treasury curve to continue a mild steepening trend. This, combined with another possible hike from the Bank of Japan in 2025 (see: Can the Bank of Japan Continue to Swim Against the Tide?), could translate into lower hedge costs for Japanese investors (as a proxy of international demand).

In general, “lower hedge costs plus a higher pickup in back-end spreads” is a formula that could lead to increased international demand for US bonds—especially in corporate bonds, which offer a spread pickup over Treasury rates.

Key Takeaways

• The recent sudden Treasury selloff was a combination of fast money trades being stopped out, accelerated by trend-following CTAs and Risk Parity Fund derisking. This irregular behavior in US Treasury yields usually occurs during crises in which large risk unwinds are triggered.
• Large investors and hedge funds typically have global trading desks with 24/7 coverage, so it is hard to pinpoint the “nationality” of Treasury sales by looking solely at time zones. However, TIC data and the fact that foreign investors tend to hold more shorter-dated paper versus longer make it unlikely that China and Japan were the main forces behind the recent volatility.
• Historical data shows that real money demand for US Treasuries has persisted through previous drawdowns, with large selloffs representing buying opportunities for long-term investors.
• Expected Fed cuts and potential regulatory reforms could act as additional tailwinds for long-end Treasuries over the long term. Further curve steepening could also help boost international demand for US bonds (both corporates and government bonds).

We look forward to continuing to provide investors with thoughtful perspective as markets shift.