Trade war hits Treasurys – Blockworks

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This is a segment from the Forward Guidance newsletter. To read full editions, subscribe. As equities posted a modest rebound, it was US Treasury markets that had Wall Street worried this morning.  The 10-year yield climbed above 4.51% around midnight, just as President Trump’s 104% tariff against Chinese imports went into effect. The question on everyone’s mind now is why.  I know I wrote yesterday that foreign bond holders could be selling, and this is still a possibility. But the overnight moves point to a perhaps more frightening reality: The basis trade is unwinding.  Hedge funds frequently employ a Treasury basis trade strategy. It’s an arbitrage trade that looks to exploit the tiny price differences between Treasurys and futures. It’s low-risk and low-reward, but huge when leveraged — so funds typically borrow to fund these trades and multiply their bets. Mass selling causes Treasury yields to spike, like we saw last night. The lower the price falls (remember Treasury prices and yields are inversely correlated), the more margin calls we see, and the more selling we see to meet those calls. Plus, liquidity evaporates when the number of sellers is vastly greater than buyers.  “If it’s not a case of selling winners to pay up margin elsewhere, then maybe it’s a market bracing for a deep recession that would start with a 7% deficit that will then only get worse,” Pepperstone research strategist Michael Brown said. “I’m honestly not sure which of those scenarios is worse.” So either way — bad. As Joseph Wang said: “This might become a legitimate market functioning issue.”  We saw an unwinding in 2020. Yield on the 10-year went from a record low of 0.3% to 1.2% in a matter of days in March 2020. The Fed intervened with quantitative easing on March 23, 2020,…