“The big takeaway from this year, from the Trump presidency, from everything that’s happened, is that there’s a rotation out of the U.S. And obviously that’s become vicious now — with bond yields staying high and the dollar falling, it’s become the story. But that exodus started well before Liberation Day...US is the bubble. US All of it,” said Marco Papic, BCA Research strategist.
Is the entire world pivoting out of the US? Is that why the 10 Year Treasury yield surged last week? Marco wasn’t alone in his sentiment.
- “The market is re-assessing the structural attractiveness of the dollar as the world’s global reserve currency and is undergoing a process of rapid de-dollarization. Nowhere is this more evident than the continued and combined collapse in the currency and US bond market as this week comes to a close,” Deutsche Bank strategist George Saravelos said in a note to clients Friday.
- “Markets are very confidence-driven. Even the perception that foreign investors are trying to step away from Treasury markets can trigger pretty significant panic,” said Gennadiy Goldberg, head of US rates strategy at TD Securities.
- “Normally, when you see big tariff increases, I would have expected the dollar to go up. The fact that the dollar is going down at the same time I think lends some more credibility to the story of investor preferences changing,” Minneapolis Fed president Neel Kashkari said Friday.
Welp, guess that’s the end of it. The 10 Year Treasury is no longer the global benchmark. Let’s all pack up our bags and go home.
Sell America, right Marco?
Last Week This Morning
- 10T: 4.48%
- 2T: 3.97%
- SOFR: 4.37%
- Term SOFR: 4.32%
- CPI cooler than expected
- PPI inflation much cooler than expected (and even negative on some readings)
- U Mich. Consumer Sentiment: 50.8 actual vs 53.8 expected
- FOMC Meeting Minutes: Policymakers were nearly unanimously in agreement that the US economy is facing higher inflation and slower growth
- That darn Warren Buffet, man…he’s kinda good
- Speaking of good, does anyone have Scott Bessent’s address? I want to send him a fruit basket
- "Some of you may die, but it’s a sacrifice I am willing to make." –Lord Farquaad President Xi
Inflation
Before we dive into the incredible Treasury volatility, how about that CPI report? Lower than expected across the board, with some elements of PPI printing negative. I know it seems irrelevant considering the impact of tariffs hasn’t really hit yet, but I think Powell appreciates any head start he can get.
The market has a 40% chance of a rate cut at the May 7th meeting. What?!? The June meeting had been as high as 98%, but is now back down to 70%.
I disagree with cuts that soon. The Fed will wait too long to cut on artificially inflated (get it?) fears of inflation, but ultimately have to cut more as it plays catch up like it always does. Year end 2026 has a 75% probability that FF is below 3.5%.
WTF Happened?
I put last week right up there with the GFC and covid for craziest weeks of my career. I was staring at a Bloomberg terminal that couldn’t keep up with the swings. I saw it run up to 4.66% and then immediately revert to 4.51%. I could put a volatility graph here to drive the point home, but I think you already get it.
Let’s start with what it wasn’t.
I lost count of the number of people claiming the surge in yields was the result of deficit concerns.
Please.
These are the same people that cried about inflation for 20 years and then when it made an appearance came out of the woodwork to say, “I told you so.” The entire universe simultaneously decided our deficit was no longer sustainable? Come on. That sort of tectonic shift happens over a very long time, not in the course of 24-48 hours. Remember, I compared last week’s volatility to GFC and covid – life changing events. Rates don’t spike 60bps in a few days because, “Gee I wonder if the US has a spending problem?” Plus, why would the T10 stop at 4.5% if everyone was suddenly worried about getting repaid?
You still disagree, don’t you? OK…how come last week’s 10 Year Treasury auction had the strongest foreign demand on record? That’s not hyperbole - literally ever. “Indirect bidders” (foreign central banks) were 87.9% of T10 buying at the auction, pushing the yield 3bps inside the issued coupon. Does that sound like a world that is avoiding US debt? C’mon.
A close second is, “China is punishing us!”
I’ve spent a lot of time over the last few years disputing this fear. Since I can’t convince you otherwise, I’ll instead expend my energy this way…China’s official Treasury holdings are $800B (3rd largest after the Fed and Japan). The last round of QE was $4.5T – that’s 5.6x more than China’s total holdings. After covid, the Fed started buying $80B per month of Treasurys. At that pace, it would take just 10 months to totally offset China dumping 100% of its official holdings. The Fed has shrunk its balance sheet by $2.1T over the last couple of years during QT, so $800B is doable.
I’m not saying it’s healthy…I’m saying the Fed will intervene if it felt like China is dumping Treasurys to punish the US. China knows this, so even if they are selling Treasurys they aren’t going to dump all of them.
If you see anyone reference Chinese holdings in Europe (Belgium and Ireland), they are almost certainly referencing Brad Setser’s research1 and just refusing to credit him to make themselves seem smarter. He’s the GOAT of this stuff. You’ve seen a lot of his graphs in my previous newsletters. Basically, China got better at disguising its Treasury holdings though custodial accounts in Europe. Selling out of Europe is likely just China and other opaque actors. Unfortunately, that data is extremely stale and we won’t have much insight for a couple of months.
“But the USD plunged last week! The greenback is losing its status as the reserve currency!” Yeah, I mean technically it lost value…but the USD is still well above most levels over the last 20 years. If I lost 10lbs but was still 40lbs more than 20 years ago, I’m not sure how much credit The Real Boss™ would give me…
Remember when I said the market started pricing in a lot more cuts…all the chicken little CNBC guests forgot to talk about the correlation between the USD and rate cut expectations. Here’s the Dec ’26 Fed Funds futures contract overlaid on the USD Index.
I know it gets you invited onto CNBC to cry the sky is falling and the world is shorting the United States…but it’s not true. And certainly not over deficits.
If anything, I do think the Uncertainty Bends™ played a role. A big reason to invest in the US is the relative stability…which isn’t exactly our calling card right now. I think that’s why gold popped and I suspect we will see huge cash inflows when the data becomes available. Just stick your money into a money market account earning 4% and wait to see how things shake out.
But reducing exposure to the US isn’t the same as betting against the US.
“Maybe we should be less long the US” isn’t the same thing as “Sell and sell on!”
So What Did Happen?
I don’t know.
But since when has that stopped me?
Basis Trade Unwind
Last week’s movement felt like a technical movement, not a shift in fundamental expectations. Let me try to explain the mechanics of a typical basis trade.
A basis trade measures the change in a relationship between two things. Instead of buying Property A and selling Property B, you might bet on the cap rate relationships between them changing. Or expenses. Or maybe occupancy. “I want to go long Property A occupancy and short Property B occupancy.” That would be a basis trade. Hedge funds and banks do this to clip small returns that are supposed to be nearly risk free.
At times, there can be very minor dislocations between spot Treasury prices and Treasury futures, usually driven by large futures purchases made by pension funds and insurance companies, usually for quarter or year end reasons. This makes the futures price slightly higher than the spot price.
Before those can converge, hedge funds simultaneously buy actual Treasurys and short the futures contract, thereby locking in the spread. The profit is tiny, usually fractions of a penny per bond. Since that won’t pay for another Hampton’s house, the hedge funds lever up 20-30x.
They might buy $30B in Treasurys via a repo agreement where they only have to post $1B in cash. The Treasurys get used as collateral and the hedge fund collects the coupon. Over time, the trade generally sees the price of Treasurys and the futures contracts converge.
Extreme volatility can cause the spread (basis) to break down…and once that starts happening the hedge funds get pinched. Repo/margin calls require they liquidate their positions, which applies upward pressure on yields, increases volatility, and creates a vicious cycle. When everyone does this at the same time, the pain is exacerbated, and you see a 60bps move in a couple of days. And it doesn’t help if you have to do this at the exact same moment everyone is wondering about the stability of the US market. Fewer Treasury buyers means you have to discount your Treasurys even more to move them…higher yields.
As you might guess, this strategy is highly dependent on a liquid and functioning repo market. We’ll come back to that in a moment, but we had a very similar issue in March 2020 when everyone was selling everything to move to cash. If repo seizes up, it’s a domino effect.
Just three short weeks ago, a panel of experts recommended a sort of bailout fund in the event there was a massive unwind2. Probably just a coincidence…
Also, it doesn’t stop there. Hedge funds will also use swaps to execute a similar strategy.
Let’s say the T10 is yielding 4.5%. You are a hedge fund and borrow $1B at the overnight repo rate to buy T10s. Let’s say that’s 4.35%. That’s a free 0.15%, right? $1.5mm can buy a nice carriage house in the Hamptons so your dog has somewhere to relax. This is a classic carry trade.
But if the T10 yield climbs just 2bps to 4.52%, the loss on the Treasurys has moved against you by the same $1.5mm.
So you enter into a pay fixed swap to help manage the valuation risk. If rates move up or down, the swap MtM helps offset the gain/loss on the bonds and you focus on locking in the positive carry. Fido’s spec house is back on! He really does deserve only the best.
But margin calls on the repo line are different than the swap MtM, which is a paper valuation until you unwind it. The repo line demands more cash now, so you sell Treasurys to create liquidity. This pushes yields up, lowering the value of the rest of your Treasury portfolio. Rinse and repeat, enjoy that vicious cycle bath.
Now you’ve got this swap with an oscillating MtM risk to deal with. Having found God prudence, you unwind. When you unwind a pay fixed swap, you are effectively offsetting it with a received fixed position. This creates downward pressure on swap rates, in particular swap spreads (which measure the delta between Treasurys and swaps). A spread that was already -40bps gaps out to -65bps in a couple of days.
This type of insane movement is one of the main reasons I believe the volatility was more about basis/swap unwinds than the collective conviction that US deficits are bad.
There are other variations of this, most notably the yen carry trade. It’s just a different flavor with a similar reaction function – higher UST yields as traders sell Treasurys to create liquidity.
I Started Skimming…Oh, And I Still Don’t Believe You About China Selling
A big reason why China has such large US Treasury holdings is the natural result of the trade surplus. When the Chinese companies receive USD, they exchange them for CNY. The USDs end up as fx reserves, which in turn are used to buy Treasurys.
If China expects to export fewer goods to the US and therefore receive fewer USD, it makes sense to reduce its overall exposure to USDs.
I suspect some of China’s motivation is propping up its currency, or decreasing exposure to the US like any asset manager might, and they might even be poking the bear a little bit just to rattle the cage. They are probably the biggest media leaks of “selling out of China” rumors. But China selling Treasurys (either via its official holdings or the custodial accounts in Europe) is also just a natural next step of exporting fewer goods to the US.
You Mentioned Something About the Repo Market?
As of right now, repo traders seem to be ok. If that market seizes up, all bets are off.
I wrote this last week: “While inflation hovers over the Fed like a dark cloud, there are only two things that would lead to a cut in June.
- Financial system instability
- Job losses”
Welp.
On Friday morning, Boston Fed President Susan Collins said markets are “continuing to function well” and “liquidity has been maintained.” But then she added. “That’s something of course we’re watching very carefully, and we do have tools to intervene if there were concerns in terms of market function or in terms of liquidity, and we are absolutely prepared to do so.”
The wild ride experienced last week won’t be solved with rate cuts, but rather some version of QE. They might create a liquidity mechanism (a la Term Funding Program for banks) or stop all QT, but they will intervene aggressively if liquidity becomes an issue. And with a $1T basis trade unwind roiling markets, the odds of an intervention are going up each day.
So What Happens Next?
I don’t know, you tell me.
My money would be on rates settling down since I believe most of the unwind pain is in the rear view mirror.
If I am wrong and there really is a structural shift in the role of the US as the reserve currency, the T10 will surge.
I don’t think the Fed will need to intervene, but the odds aren’t 0%.
The Week Ahead
Retail Sales this week, but honestly who cares? Around a hundred Fed speeches this week, with the O/U on references to “financial stability” at 39,531x.
