How to view the current adjustment of U.S. Treasury bonds and the risk of U.S. dollar liquidity

Starting this week, the U.S. Treasury market shifted from rising to falling, with a significant bear steepening of the curve. The 10-year and 30-year U.S. Treasury yields briefly rose to around 4.5% and 5.0%, respectively, increasing by about 50 basis points or even more during the week. The rise in short-term yields was relatively small, with the 2-year yield increasing by less than 20 basis points, and expectations for interest rate cuts also changed little. While the U.S. Treasury market underwent significant adjustments, macroeconomic data did not seem to change dramatically, and other major asset classes did not exhibit similar trends, leading to investor skepticism.

We believe that the main factors driving the U.S. Treasury market this week are investor behavior and other factors, which are precisely areas that are difficult to prove and where conspiracy theories thrive. Recently, potential factors affecting U.S. Treasury volatility that the market has been paying attention to include:

① Hedge fund basis trade liquidation triggering sell-offs. U.S. Treasury basis trading refers to a trading strategy in the U.S. Treasury market that utilizes the basis (the difference between the spot price of Treasury bonds and the futures price) for trading. The main form currently is that hedge funds hold long positions in the Treasury spot market and short positions in the Treasury futures market. Generally, this operation requires high leverage, possibly dozens or even hundreds of times. If there is a significant short-term rise in U.S. Treasury yields, the long positions in the basis trade may face liquidation, requiring margin calls, which may necessitate further selling of positions, ultimately leading to a spiral decline.

② Some institutions may sell U.S. Treasuries due to liquidity pressure. For example, in June 2024, Japan's Norinchukin Bank reported significant losses in overseas bond investments and stated plans to sell $63 billion in related bonds to alleviate liquidity pressure. In February of this year, Norinchukin confirmed that total losses for 2024 reached $12.66 billion.

③ Potential "tax increase" hints on U.S. Treasuries triggering panic among foreign investors. On April 7, Stephen Miller, chairman of the White House Council of Economic Advisers, stated in an interview that to achieve global trade fairness, other countries could directly pay the U.S. Treasury to help the U.S. provide global public goods, implying that interest taxes might be levied on foreign investors in U.S. Treasuries.

④ Foreign central banks selling U.S. Treasuries.

From a cross-asset price perspective, some clues can also be found:

① As U.S. Treasury yields rise, the U.S. dollar exchange rate declines, and U.S. stocks perform poorly, possibly due to some funds fleeing dollar assets.

② If foreign central banks are selling U.S. Treasuries, it is often for currency intervention purposes. Recently, some Asian currencies have come under pressure, which may be one of the motivations for central banks to sell bonds.

③ The large-scale sell-off of U.S. Treasuries likely has certain passive factors behind it. We believe that the liquidation of some institutions and central bank sell-offs may partially align with this characteristic.

Regarding the recent surge in U.S. Treasury yields and subsequent concerns about dollar liquidity, we believe it can be considered from the following five perspectives.

First, can we identify which factor is driving the rise in U.S. Treasury yields? In the short term, we can use U.S. Treasury futures positions to confirm the situation of basis trading, while other reasons may need to be corroborated with news reports. For basis trading, we can observe the short positions of leveraged funds published weekly by the Commodity Futures Trading Commission (CFTC) Although not all short positions are used for basis trading, meaning the scale of short positions may exceed the actual scale of basis trading, the overall direction is generally consistent with basis trading. If we see a significant decrease in leveraged fund short positions this week, it can be considered that the liquidation of basis trading may be one of the important reasons for the rise in U.S. Treasury yields.

Second, will the rise in U.S. Treasury yields trigger a dollar liquidity crisis? The essence of a liquidity crisis is a sudden and significant reduction in the availability (liquidity) of dollars in the market, leading to rising borrowing costs, blocked financing channels, and financial market participants being unable to obtain enough dollars in a timely manner to meet their trading, debt repayment, or daily operational needs. Therefore, we mainly consider onshore and offshore dollar liquidity indicators and refer to the dynamics of interest rates and credit markets to assess the current position of dollar liquidity. Overall, we believe that there are indeed signs of some weakening in dollar liquidity, but it can still barely be considered robust, and there is still a considerable distance from the level of a liquidity crisis.

Third, what indicators can we look for to determine if a dollar liquidity crisis is occurring? Although a dollar liquidity crisis currently appears to be a low-probability event, there is some uncertainty in future developments, and it is necessary to closely monitor relevant indicators. If we see a significant rise in SOFR rates, a noticeable widening of the SOFR-EFFR spread, and an increase in the usage of liquidity tools such as reverse repos or discount windows, we can preliminarily determine that dollar liquidity is on the brink of crisis, and markets such as U.S. Treasuries and even U.S. stocks are expected to come under pressure.

Fourth, how to respond to a liquidity crisis? To untie the knot, one must tie it. The Federal Reserve is expected to stop QT immediately and may reopen QE at its discretion, and it is anticipated that the dollar liquidity crisis will ease in a relatively short period. Referring to the dollar liquidity crisis (cash crunch) in 2019, U.S. stocks and Treasuries returned to pre-crisis levels within 1 to 2 months. However, in March 2020, due to the impact of the pandemic, U.S. stocks adjusted more deeply and for a longer time, while U.S. Treasury yields still recovered in about a month.

Fifth, how to assess the long-term investment value of U.S. Treasuries? From the perspective of the economic cycle, the U.S. fundamentals remain under pressure, and a significant improvement is unlikely before the shift in Trump’s policies, which is somewhat favorable for U.S. Treasuries. However, subsequent inflation risks will also constrain the downward space for nominal interest rates, and the reshaping of the global trade and financial landscape may lead to a decline in demand for U.S. Treasuries from other countries, resulting in significant long-term uncertainty. In the short term, it is recommended to closely monitor dollar liquidity; if it does not deteriorate comprehensively, one can engage in speculation with small positions based on odds.

Risk warning: High uncertainty regarding tariff policies, U.S. inflation exceeding expectations, and tightening of Federal Reserve monetary policy.

This article is authored by Zhang Jiqiang, Tao Ye, et al., sourced from Huatai Securities Fixed Income Research, original title: "How to View the Current Adjustment of US Treasuries and Dollar Liquidity Risks"

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