It was early morning. Two friends were having coffee and discussing markets. Anbarasu was on FinTwit looking at numerous posts on the US bond market meltdown.

Anbarasu: Hey Nalla, what exactly is this meltdown in US bond markets?

Nallasivam: Oh, last week was a mess in the US bond markets. The US 10-year bonds, considered a global safe haven asset, saw its yield spike by 50 basis points in just one week. Such a move was last seen only in 2001. Experts say it was likely exacerbated by what is called basis trade unwinding.

Anbarasu: What’s this basis trade unwinding and why is it causing US treasury yields to go up?

Nallasivam: Let me first explain what a basis trade is and then I’ll come to unwinding. Basis trade is basically Wall Street’s version of denoting an arbitrage. You know what an arbitrage is?

Anbarasu: Taking advantage of price difference between two markets for the same asset. You know, buy cheap in one market, sell high in the other and pocket the difference?

Nallasivam: Bingo. Now what traders such as large hedge funds do is – scout for arbitrage opportunities between the cash market and the futures market for US treasuries. They buy bonds in the less expensive market and sell them in the expensive market.

In a typical basis trade, the futures price of US bonds will be higher than that of the cash market price. Bond futures tend to trade at a premium to spot price because, insurance companies and pension funds buy large amounts of bond futures instead of the bonds themselves because, futures require less cash up front. Once the hedge funds spot a basis trade opportunity, they buy US bonds in the spot market and simultaneously go short on the same bonds in the futures market for the same amount as the spot market. On expiry, the futures price will converge with the spot price.

Anbarasu: Okay, see if I’ve got it. Say, US 10-year bond is selling at $100, and its futures price is $105, traders buy the bond at $100 and short the futures. The futures contract locks-in their selling price at $105 and they can pocket the $5 difference, come expiry day, right?

Nallasivam: Exactly. Except that in the real world, the spread or the difference will be just a few cents.

Anbarasu: Now tell me what basis trade unwinding has got to do with yields moving up.

Nallasivam: You see, the arbitrage window doesn’t remain open for long. Once an opportunity is spotted, traders will flock to buy bonds in the spot market, pushing spot prices up. Eventually the $5 spread you mentioned, will shrink and disappear. So, traders generally lever their trades to maximise returns. Meaning, they borrow funds to buy more bonds in the spot market and short in the futures market. In the same example, if interest cost is assumed as $3, traders can make a net profit of $2.

Now why did traders unwind their trades? With Trump imposing a tariff of 145 per cent on China, China was pushed into a corner. The market started speculating that China will retaliate by selling its large US treasury holdings to push yields up and hurt the US. This will go against the Trump administration’s objective of bringing down long-term yields. As China flushes the market with US bonds, the supply goes up and price goes down. Bond prices and yields have an inverse relationship and thus, yields went up. Also, with tariffs induced volatility, the safe haven perception of US treasuries diminishes, prompting yields to move up.

As yields rise, interest rates on every kind of loan increase, including the short-term loans that traders borrow to enter the basis trade. Additionally, brokers would also tend to increase margin requirements amid increased volatility. If the rates and margin requirements rise to such an extent that will make the trade less attractive or unviable, traders will be forced to sell the bonds and exit. Thus, the unwinding, which further exacerbated the yields shooting up.

Anbarasu: Right. Now I have a clear idea.

Nallasivam: Something similar happened at the onset of the pandemic in 2020, global central banks were selling US treasuries to prop up their currencies. That caused bond prices to fall in the spot market, taking yields higher and triggering a massive basis trade unwinding. Eventually the US Federal Reserve stepped in to buy bonds worth trillions of dollars to keep treasury market running smoothly. Only if treasury markets run smoothly can other markets like equities function smoothly.

Anbarasu: Hmm..ok. So what does this have to do with equity markets anyways?

Nallasivam: Treasury bonds given their safe haven status determine the pricing of all other assets. Bond yields form the fulcrum based on which risk premium and expected returns on equities and other classes are determined. Now if bond yield itself is so volatile, it adds to confusion on pricing of other assets also.

Anbarasu: How so?

Nallasivam: Think of it this way. A week back US 10-year bond yields were at 3.99 per cent. Let us say you were looking to invest in the Dow Jones or S&P 500 or Nasdaq Composite ETFs. You would be expecting higher returns since investing in equities entails higher risks unlike buying the treasury bond which is deemed risk-free. So last week if you were investing, you would have for example added an equity risk-premium of say 3 per cent to 3.99 per cent and expected annual return of at least 6.99 per cent on your ETF investment. But if you had postponed it by a week, since now the US 10-year bond yields are trading at 4.49 per cent after the bond market meltdown, you would now be expecting 7.49 per cent returns from your ETF investment. Such significant movements and disparities in return expectations in just a week can be unsettling for investors. Further Warren Buffet has said how interest rates act like gravity on stocks. If bond markets remain in stress and yields increase, cost of borrowings for companies will increase and their profits will be impacted. This higher expected return and impact to corporate profits can be a double whammy for stocks.

Anbarasu: So, for US equity markets to stabilise, the bond markets should stabilise first?

Nallasivam: You bet! The importance of bond market is best exemplified by a quote by James Carville who was Bill Clinton’s political advisor. He said “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a . 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

Anbarasu: Wow! No wonder Trump blinked last week and paused the reciprocal tariffs on all countries except China! He must have been intimidated by the bond market!

Nallasivam: Yes, so it is important to see whether the US treasury markets stabilise this week or not. Before you invest in US equities you need to be clear what the risk-free rate is.

Published on April 12, 2025