Executive Summary:
Equity market volatility has increased in recent weeks, a development typically corresponding to falling Treasury yields. Instead, yields rose last week and are higher than before the tariff announcement. While the precise cause remains unclear, one potential factor is a little-known arbitrage strategy known as the basis trade. Though generally considered low risk, this strategy can amplify instability during equity selloffs, particularly when liquidity dries up in the Treasury market. Despite this, bonds continue to serve as a reliable portfolio diversifier and in our view, there is little evidence that the basis trade poses a broader risk to capital markets.
The U.S. Treasury market delivered a surprise last week. As stock market volatility climbed following President Trump’s “Liberation Day” tariffs, Treasury yields first fell 19 basis points, then abruptly reversed course, rising 47 basis points to levels not seen since February.
That pattern defied conventional expectations. Treasury securities are typically viewed as a safe haven during periods of market stress, thanks to their depth, liquidity and explicit backing by the U.S. government. Rising yields during a risk-off environment challenge that long-standing view.
The specific driver of the yield spike remains uncertain. Some observers point to foreign investors reducing their Treasury holdings, citing a falling U.S. dollar as potential evidence. Others suggest shifting investor sentiment toward Treasurys more broadly. This article will focus on a different potential driver, the unwinding of the Treasury basis trade, an arbitrage strategy that, while well-established, is not widely understood.
At its core, the basis trade exploits price discrepancies between Treasury bonds and their corresponding futures contracts. Hedge funds buy the underlying bond and sell the futures contract, betting the two prices will converge as the futures contract nears delivery. The “basis” is the price difference between the cash bond and the future.
Under normal market conditions, the basis trade produces relatively steady profits. However, it relies on seamless market functioning. When liquidity breaks down—on either side of the trade—hedge funds may be forced to unwind positions, often rapidly, pushing Treasury yields higher.
These risks are magnified by leverage. Some hedge funds employ leverage ratios as high as 100-to-1. In such cases, even small disruptions can lead to margin calls, triggering rapid sales of Treasury holdings. With the strategy estimated at $800 billion to $1 trillion in aggregate size, widespread unwinding can have a meaningful impact on yields during periods of stress.
A key funding mechanism for basis trades is the repurchase (“repo”) market, where firms borrow short-term cash using Treasury securities as collateral. When repo market liquidity tightens—often when cash demand spikes—hedge funds may struggle to maintain their positions. That, in turn, can force additional unwinding, further pressuring bond prices and driving up yields.
Regulatory constraints can exacerbate the problem. Rules such as the Supplementary Leverage Ratio (SLR) limit the amount of Treasurys broker-dealers can hold. In prior years, large banks could absorb excess supply during market turmoil. Today, those limits hinder that capacity, shifting the burden to the broader market.
Although basis trades appear relatively low risk in stable environments, they are vulnerable when market liquidity dries up or price convergence is delayed. During the Covid-19 bear market, the Federal Reserve had to intervene after a rapid unwinding of basis trades and a broader flight to cash pushed Treasury yields higher. The Fed purchased up to $75 billion of Treasury securities per day, temporarily eased SLR restrictions, and expanded repo operations to inject liquidity, moves that stabilized yields and restored market functioning.
For now, it’s difficult to determine how much of the recent rise in rates stems from basis trade unwinding, foreign selling, or broader investor sentiment. Encouragingly, yields have since moderated, and past episodes suggest the Fed retains sufficient tools to support Treasury markets if needed.
Most important, bonds continue to fulfill their portfolio role—delivering income and reducing volatility—even amid unusual market behavior.
[1] https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20200401a1.pdf[1] Statement Regarding Repurchase Operations – FEDERAL RESERVE BANK of NEW YORK
[1] Statement Regarding Treasury Securities and Agency Mortgage-Backed Securities Operations – FEDERAL RESERVE BANK of NEW YORK
