Sell-off of US debt continues, "basis trading" may be the hidden hand behind it

The US Treasury market has experienced intense volatility this week, with both the 10-year and 30-year Treasury yields soaring, triggering concerns among investors and analysts that "basis trades" may be facing massive unwinding. On Tuesday, the yield on the 10-year Treasury rose by 9.6 basis points to 4.259%, while the 30-year yield jumped by 12.3 basis points to 4.714%, marking one of the largest two-day increases since the pandemic. The rise in yields directly led to a 1.6% drop in the iShares 20+ Year Treasury Bond ETF (TLT.US), which tracks long-term Treasuries. At the same time, the S&P 500 index also fell by 1.6%, indicating a visibly tense market sentiment. The market movements of the past two days have been described as "extremely unusual." On Monday, the 10-year Treasury yield dropped by 14.4 basis points at one point, only to rebound by 16.8 basis points. Such a drastic V-shaped reversal has only occurred once since 2006 - the day after Donald Trump was elected president in 2016. The MOVE index, which measures implied volatility in the US Treasury market, also surged to its highest level since October 2023. Jim Bianco, President of Bianco Research, wrote on LinkedIn, "This is a trading day worth telling your grandchildren about." What is confusing is that this volatility did not stem from the release of significant economic data, but rather occurred against a backdrop of widespread concerns about tariffs and economic recession. Normally, these risks should prompt funds to flow into safe-haven assets like US Treasuries, not out of them. There are rumors that foreign investors may be selling US Treasuries to acquire US dollars, but the results of a three-year Treasury auction did not show any sign of a significant pullback by foreign central banks. What truly sparked market panic was the lackluster three-year Treasury auction held on Tuesday. Domestic institutions such as pension funds and insurance companies subscribed to only 6.2% of the supply, far below the average level of 19%, casting a shadow over the upcoming 10-year auction on Wednesday and 30-year auction on Thursday. More and more market voices are now focusing on the unwinding of "basis trades." This is a common strategy used by hedge funds, which involves exploiting the price difference between Treasury spot prices and their futures contract prices. The process involves buying cheap Treasuries, selling expensive futures contracts, and closing both positions when the prices converge, to profit from the difference. The risk of this strategy lies in its extremely high leverage ratio, sometimes reaching 50 to 100 times. Once the market experiences violent fluctuations, especially when some institutions suddenly exit the market or their funding chains break, it is easy to trigger a stampede effect, leading to even larger-scale market turmoil. Research has indicated that this strategy intensified the chaos in the US Treasury market at the onset of the COVID-19 pandemic in March 2020. While supporters argue that "basis trades" help increase market liquidity, critics view it as a high-risk, low-transparency gamble. According to Torsten Slk, Chief Economist at Apollo Global, the size of basis trades in the market is currently estimated at around $800 billion and is expected to continue expanding, especially against the backdrop of the persistent increase in the US fiscal deficit and Treasury supply. Although there is currently no concrete evidence to suggest that basis trades are being unwound on a large scale, the high leverage nature of these trades, coupled with the current market volatility, is enough to draw heightened attention from regulators and market participants. Ian Lyngen, Head of Interest Rate Strategy at BMO Capital Markets, pointed out that this recent intense volatility may also be related to Trump's renewed proposal to impose tariffs, which has raised inflation expectations. Higher inflation would prompt investors to demand higher bond yields. However, traditional explanations such as inflation, fiscal deficits, and foreign selling still struggle to fully explain such extreme selling behavior. The more uncertain the market becomes, the more likely that basis trades, this "leveraged time bomb," could become a core factor exacerbating the situation. In the upcoming auctions of 10-year and 30-year Treasuries, investors will closely monitor subscription levels and price reactions. If the situation does not improve, the US Treasury market may face even more drastic adjustments.