US Treasury bonds hit by "nuclear explosion" of tariffs: Nearly a trillion basis point trades fluctuate, Federal Reserve's market rescue ammunition reserves in urgent need.

Recently, there has been dramatic volatility in the US Treasury bond market, causing concerns about the vulnerability of the world's largest bond market. Driven by risk aversion sparked by tariffs, investors have been selling stocks and shifting to safe government bonds, leading to a significant increase in the $29 trillion US Treasury bond market. However, on Monday, US Treasury bonds experienced a wave of selling, causing the benchmark yield to rise by 17 basis points that day, with the yield fluctuation range currently around 35 basis points, making it one of the largest volatility swings in the 10-year bond yield in 20 years. This storm not only brought Wall Street traders back to the "money grab" frenzy of the early days of the COVID-19 pandemic in 2020, but also exposed the vulnerability hidden in the world's largest bond market. The story began with a chain reaction triggered by tariffs. The Trump administration suddenly imposed tariffs on over 60 countries with trade surpluses, with the highest tariff rate on Chinese goods reaching 104%, rapidly escalating global trade wars. Risk aversion has driven up US bond prices, but strangely, while the stock market continues to be under pressure, US bonds experienced heavy selling on Monday: the 10-year yield broke the 4% mark, while the 30-year bond surged 25 basis points in a single day, reaching a new high since November 2023. Some market participants have indicated that the sharp volatility in the US Treasury bond market and the significant narrowing of the swap spreads suggest that investors, including hedge funds, have been selling liquid assets like US Treasury bonds to meet margin requirements due to losses in various asset classes. Market players have opened the "Pandora's box" of this storm. Hedge funds have built positions of up to $800 billion through "basis trading" (arbitrage using the price difference between spot and futures). When US bond prices plummet and the value of collateral shrinks, these highly leveraged players are forced to sell assets to cover margins, creating a vicious cycle. Jay Neffluez, US rate strategist at Bank of America, said, "The significant volatility across asset classes has led to market liquidation." This situation recalls the panic buying frenzy at the onset of the COVID-19 pandemic in March 2020, when concerns about the coronavirus intensified, causing the market to stagnate and prompting the Federal Reserve to purchase $1.6 trillion in government bonds. Similar to that event, Monday also saw a reduction in so-called basis trading. Regulatory authorities have been closely monitoring basis trading in recent years, as rapid unwinding of highly leveraged hedge fund positions could be a source of market instability. Thorstern Strock, Chief Economist at Apollo Global Management, estimated in a report on Tuesday that basis trading is currently valued at around $800 billion. Hedge funds typically borrow from the repo market to purchase US Treasury bonds, using them as collateral. As selling leads to lower US bond prices, the value of the collateral for the borrowed funds decreases, resulting in additional margin calls. Some analysts also point out that in addition to significant yield increases, the changes in the spread between US Treasury bonds and interest rate swaps indicate specific selling of the bonds, rather than a more widespread trend. The swap spread reflects the difference between the fixed rate of interest rate swaps and the yield on comparable government bonds, which has significantly narrowed, especially for longer-term bonds. Since April 3rd, when Trump announced comprehensive tariffs on imported products, the spread between 10-year and 30-year swaps has significantly decreased or narrowed. The latest data shows these two spreads at -58 basis points and -94.5 basis points, respectively. Jonathan Cohen, head of the US rate division at Nomura Securities International, stated that US Treasury bonds have performed worse than swaps, indicating "a large amount of foreign entity money selling off." With expectations of further relaxation in bank regulations, consensus trades among hedge funds have been to increase positions in widening swap spreads. These positions are likely to be unwound, further exacerbating the selling of US Treasury bonds. Finally, a Citi report also indicates that tariffs will restrict the growth of global dollar reserves, directly impacting the demand for US bonds. China has been continuously reducing its holdings of US bonds, and Japanese investors are also accelerating their exit. In a report on Tuesday, Citi analysts stated that the selling spree peaked on Monday, with "small cash purchases showing signs of potential disruption to US bond demand." They suggest that while factors normally driving down swap spreads are a sign of concerns about fiscal trajectories, tariffs have also added pressure. The market turmoil of 2020 is still fresh in memory: the COVID-19 pandemic caused the market to come to a halt, forcing the Federal Reserve to intervene on a large scale by purchasing $1.6 trillion in US bonds to stabilize the market. Now, a similar scenario is unfolding, with unwinding of basis trades, sudden liquidity shortages, inverted yield curves, and other phenomena occurring in succession. However, unlike before, the Federal Reserve is now facing inflation pressures, making it difficult to play the role of "firefighter" once again. US bond storm sweeps the globe, chain reactions emerge In terms of global measures, Japanese government bonds have plummeted, with selling focused on longer-term bonds as market volatility has prompted investors to reduce exposure to volatile yields. Amid escalating trade wars and uncertainty surrounding their impact on Bank of Japan policy, signs of disorder have begun to appear in the Japanese bond market, leading investors to cautiously withdraw. Meanwhile, the US dollar has shown an unusual trend, despite rising yields. This has driven the rise of other safe-haven currencies such as the Japanese yen and Swiss franc, both of which surged by more than 1% at one point. However, other bond markets have performed better - German government bond futures inched higher on Wednesday. Rajiv DeMello, Global Macro Investment Portfolio Manager at Gama Asset Management, said, "Imposing tariffs of over 100% on China could cause great concern for reserve managers. European bonds have been affected by this, with significant fluctuations in spreads between the US and Germany over the past week." Not everyone believes that US Treasury bonds have lost their safe-haven appeal. Lia Traub, a fund manager at Lord Abbett & Co. managing $217 billion in assets, still recalls the negative correlation between US bonds and stocks when the market reacted to concerns about slowing US economic growth in March. She said, "As we saw in March, when markets reacted to concerns about a slowdown in US economic growth, US bonds were negatively correlated with stocks."If the United States or the global economy enters into a recession, we still believe that investors will flock back to U.S. Treasury bonds.But more traders have sensed the crisis, and hedge funds remain at the core, because when the market begins to fluctuate due to the impact of tariff news, lenders to hedge funds can no longer tolerate "basis trading" - a large amount of betting on the tiny differences between spot government bonds and futures prices. In response, JPMorgan strategist Craig pointed out that the movement of the US 10-year Treasury yield in the past day may also indicate that the market is paying more attention to inflation rather than economic growth. There may also be operational reasons in the market, and hedge funds may be reducing their use of basis trading. US Bank trading chief Elworthy likened the current volatility to the "epic shocks" of the 2008 financial crisis and the COVID-19 plunge. He warned: "If this chaos continues, global central banks will be forced to intervene within 48 hours." It is worth mentioning that the market has sensed a change in policy direction: expectations of a rate cut by the Federal Reserve have suddenly increased, with traders betting on consecutive rate cuts in June and July, totaling four rate cuts for the year. Dave, chief of Singapore's ARAVALI Asset Management, revealed a more frightening chain reaction: "When the US bond market loses buyers and even foreign central banks stand by, the entire cash market will face a liquidity crisis." French BNP Paribas analyst Tan Man pointed out that China may counteract by selling US bonds, leading to a further steepening of the global bond yield curve, "Japanese government bond sales have seen a rare huge decline, and eurozone long-term bond yields are under pressure." The current scenario bears a striking resemblance to the liquidity crisis in March 2020. At that time, highly leveraged funds collectively blew up in basis trading, leading to a depletion of liquidity in the US bond market. ANZ Bank's Qianbos warned: "The basis market is experiencing chaotic plunges, which have gone beyond the fundamentals and are purely due to liquidity stampedes." Tariff policies are shaking the foundation of international market demand for US bonds. May Leng, a strategist at OCBC Bank, said: "Tariffs will lead to inflation, which may provide a basis for the inflation impact, and the steepening yield curve is impacting US bonds, causing long-term bond yields to rise sharply. In recent months, US bond yields have dropped significantly, and we have seen global fund managers closing profits to offset the significant losses in the stock market." Meanwhile, Daniel, portfolio manager at Singapore's Grasshopper Asset Management, said that the significant volatility in US bonds coincides with the full implementation of Trump's comprehensive tariffs, including a 104% tariff on China. In order to force Trump to compromise, China may take the following measures: 1) impose a 34% new tariff on US exports; 2) restrict the export of Rare Earth Resources and Technology from China; 3) as during the 2018 trade war, depress the Renminbi exchange rate; 4) sell about $760 billion worth of US bonds. Summary As the trade war escalates, global demand for the US dollar faces structural shocks. If China and other major holders of US bonds start a "financial nuclear weapon," the myth of the "risk-free asset" that has supported the global economy for 70 years may face its ultimate test. How many "rescue bullets" does the Federal Reserve have left in its arsenal? When tariff bullets penetrate the global economy, even the most solid "US bond fortress" shows cracks. The ultimate outcome of this storm depends not only on the Federal Reserve's policy maneuvers but also on testing the resilience of the global financial system - after all, when the "ultimate safe asset" starts seeking refuge, the real storm is just beginning. The direction of this storm depends on two key variables: China's retaliatory strength and the speed of the Federal Reserve's market intervention. If China suddenly announces restrictions on rare earth exports, or if the Federal Reserve unexpectedly adjusts its inflation target statement, it could become a turning point in market sentiment. But traders generally expect that under the shadow of tariffs, US bond volatility will remain high for the long term, "until a true shoe drops."