When U.S. stocks fall, U.S. Treasuries plummet instead. Is the market telling the "ghost story" of 2020?

The S&P 500 index rose 4.1% at one point on Tuesday but ultimately closed down 1.6%. However, what is even more concerning for the market is the significant sell-off in the U.S. Treasury market, leading to a sharp rise in yields.

The yield on the 10-year U.S. Treasury bond surged by 30 basis points over two days.

It is very rare for U.S. stocks to decline while U.S. Treasuries plummet; does this indicate that the market is replaying the "ghost story" from five years ago? Hedge funds are massively unwinding basis trades, reminiscent of the scenario during the crisis in March 2020.

The Financial Times analysis suggests that the current unwinding of basis trades has not yet caused significant disruption to the U.S. Treasury market. However, will this latent vulnerability ultimately evolve into a systemic crisis? This time, will it also depend on the Federal Reserve to intervene?

Rare Anomalous Volatility in the U.S. Treasury Market

On Monday, there was a significant sell-off of U.S. government bonds, with the benchmark 10-year Treasury yield jumping 19 basis points to 4.18%, marking the largest single-day increase since September 2022. The yield on the 30-year Treasury bond soared by 21 basis points, the largest increase since March 2020. Even more concerning, the sell-off in U.S. Treasuries continued on Tuesday, with the 10-year Treasury yield climbing to 4.29%, a daily increase of 13 basis points, and a cumulative rise of 42 basis points since the low on April 4.

George Pearkes of Bespoke Investment Group noted in a report that it is rare for U.S. Treasury yields to surge significantly while the stock market is declining:

“Although today’s historic reversal in the stock market is concerning—where the market rose over 4% at one point but ultimately fell more than 1.5%—the turbulence in the fixed income market seems even more unsettling.

Over the past two days, the yield on the 30-year U.S. Treasury bond has risen an astonishing 35 basis points. While this is not the largest increase in history, it ranks in the top 0.4% of all two-day changes, which is extremely rare.

Even more unusual is the significant rise in long-term bond yields while the stock market is declining. In fact, this is the first time since 1982 that the 30-year Treasury yield has risen this much while the stock market has fallen at least 1.5% over two days.

Basis Trading: The Invisible Time Bomb of the U.S. Treasury Market

The Financial Times analysis suggests that while there may be various factors leading to the sell-off of U.S. Treasuries, such as weak demand at the three-year Treasury auction and the unwinding of Treasury swap spreads, the large-scale unwinding of "basis trades" seems to be a significant factor behind the cracks in the U.S. government bond market.

What is basis trading? In simple terms, it is a highly leveraged hedge fund strategy that profits by capturing small price differences between Treasury spot and futures. Treasury futures contracts are typically traded at a premium, above the government bonds available for fulfilling derivative contract deliveries. This is mainly because futures provide a convenient way for investors to gain leveraged exposure to Treasuries (requiring only the initial margin for nominal exposure) Therefore, asset management companies are usually net long in Treasury futures.

However, this premium creates an opportunity for hedge funds to profit from the other side. They short Treasury futures and buy Treasuries for hedging, obtaining a nearly risk-free spread of a few basis points. Typically, hedge fund managers would not go to great lengths for a few insignificant basis points, but due to the extreme stability of Treasuries, you can leverage this trade multiple times.

The typical leverage level for hedge fund basis trading is difficult to determine, but according to the Financial Times, 50 times leverage is normal, and up to 100 times is not uncommon. In other words, just $10 million in capital could support up to $1 billion in Treasury purchases.

How large is the overall scale of such trades? While it is difficult to measure precisely, the most reliable approximate indicator currently is: Hedge funds' net short positions in the U.S. Treasury futures market have exceeded $800 billion. Correspondingly, asset management companies hold the corresponding long positions.

The problem is that when the Treasury market experiences unusual volatility, both Treasury futures and the repo market will require more collateral. If hedge funds cannot provide sufficient collateral, lenders may seize the collateral (Treasury bonds) and sell it in the market, further exacerbating market volatility.

Lessons from 2020

Torsten Sløk, chief economist at Apollo Global Management, emphasized the dangers of this trading strategy:

Why is this a problem? Because 'spot-futures basis trading' is a potential source of instability.

Once an external shock occurs, these highly leveraged cash positions will be rapidly liquidated, and this must be temporarily absorbed by capital-constrained brokers. This could severely disrupt brokers' ability to provide liquidity in the secondary market and facilitate borrowing in the repo market.

In March 2020, this latent vulnerability suddenly erupted, evolving into a systemic risk.

At that time, foreign central banks and bond funds facing a wave of investor redemptions fell into a "cash grab" mode, forced to sell the most liquid assets—U.S. Treasuries—resulting in a blow to hedge funds holding large leveraged basis trading positions, and the entire Treasury market came close to losing control. It was the Federal Reserve's "massive intervention" that prevented the situation from worsening—its balance sheet surged by $1.6 trillion that month.

Major Concerns Not Yet Apparent, But Watch for "Abnormal Rise" in U.S. Treasury Yields

Since then, many regulators and policymakers have been concerned about Treasury basis trading, especially because the Federal Reserve's intervention that year amounted to a "de facto rescue" of this trading strategy. Now, the scale of basis trading has far exceeded that of March 2020, raising further concerns.

Unfortunately, it is not easy to intervene forcefully in such trades, precisely because it has become an important pillar supporting the U.S. Treasury market—at a time when the U.S. government's borrowing costs have already risen sharply.

As Ken Griffin of Citadel pointed out in 2023—when SEC Chairman Gary Gensler had already set his sights on this strategy—if basis trading were to be uniformly targeted, it would "significantly increase the cost for the U.S. government to issue new debt, borne by taxpayers, potentially adding billions or even tens of billions of dollars in expenses each year." Currently, the clearing of basis trading has not caused significant disruption to the government bond market. What was most frightening in 2020 was that, during a surge in "risk aversion" sentiment, government bond yields rose abnormally, and trading completely stalled, which is unimaginable in an asset class that now often trades about $1 trillion daily.

Although a similar scenario does not seem to have reoccurred yet, the rising government bond yields against the trend during "risk aversion days" have begun to raise market concerns, and Bloomberg's government bond market liquidity index (though controversial) has also shown some abnormal fluctuations recently—this is a risk point worth continuing to monitor