What’s Going On With Bonds?

The stock market rebounded impressively yesterday as shorts covered and dip buyers surged back into the market.

Treasury yields had spiked on the threat of tariffs and retested the 4.5% before the announcement of a 90-day delay on the imposition of many tariffs on smaller trading partners.

Even though the stock market, cryptocurrencies, gold, and other commodities rebounded, the impact on the bond market was much more muted.

Today, the yield curve spread continued its march higher, with the yield on the 2-year declining while that of the 10-year increased.

So what is going on?

There are several potential reasons for this anomaly. None are particularly encouraging.

The first and most obvious is the bond market is not happy with political volatility. When officials talk loudly about potentially defaulting or withholding payments to economic competitors it is not great for confidence.

The second is that with the tariffs are likely to be inflationary. That makes sense since most importers do not have sufficient margins to absorb the full tariff.

The third is traders are probably coming around to the idea that tariffs are not going to cover the cost of tax cuts and progress in the Department of Government Efficiency is haphazard at best.

The fourth is there was a massive sell-off in Treasuries because the basis trade was being unwound.

This kind of trade tends to be heavily leveraged. 50 to 100 times appears to be the norm. It functions by buying Treasuries and shorting an equal number of Treasury futures. In return you pick up a tiny spread that relies on the leverage to amplify the profit.

The basis trade has been very popular over the last several years because there was not much movement in the spread. The imposition of volatility at the long-end of the curve has forced an unwind which pushed yields up.