Nothing makes sense. We began our 2Q25 outlook lamenting about how tough it was to be a bond strategist these days. It just got a lot tougher. President Trump’s tariffs have been unmistakably negative for risk assets, judging by the sea of blood that is the global markets this year. Despite the fears however, bond yields spiked overnight – a phenomenon that no one would anticipate in a risk-off event – in pure defiance of any conventional logic in investment theory. Put in context, the US 10Y treasury yield has risen close to 50 bps over just three days, a nearly five-sigma move in the last five years.

All common threads of rationality have been thrown out the window. Did the markets expect tariff-driven inflation and price out rate cuts? Nope, breakeven inflation hardly budged while Fed funds futures still anticipated four cuts by end-2025. Are markets abandoning all assets in a dash for cash à la Covid-crisis? No, the dollar is on the contrary weakening as we speak. When all avenues of rationality have been exhausted, the only explanation for the bond selloff – by process of elimination – begins to stare at us in the face.

Irrationality.

Indiscriminate selling from a basis trade unwind. In an obscure corner of the Hedge Funds universe lies a profitable but highly leveraged trade known as the treasury basis trade, where managers arbitrage on the price differential between a treasury cash security and a treasury futures contract with similar characteristics (known as the “basis”) to make an apparent riskless profit. As such differentials are minute, the bet must be extremely leveraged – sometimes up to 100x – to make any meaningful gains. Profits are made when prices converge as the futures contract approaches expiry. As inconspicuous as this sounds, this basis trade is estimated to be between USD500bn-1tn today.

Why is there even a basis to exploit? The opportunity only arises because treasury futures have a persistent premium over cash bonds due to demand. This demand for futures contracts is fuelled by institutional asset managers who manage credit funds but are benchmarked against global aggregate funds that include large weights in long duration government bonds, due to the bigger sizes of sovereign issuances. As these fund managers are often overweight on credit (which have lower durations than the benchmark), they would cover the duration shorts with futures contracts as this requires a much lower cash outlay than cash bonds.

Hedge funds, recognising this demand, take the opposite short position on the futures contract, but take a long position on the cash treasuries (on leverage) to exploit the difference. The risk is that the cash treasury markets are increasingly teetering off a demand-supply imbalance given the ever-growing US deficit meeting ever-diminishing demand (foreign central banks not buying, US credit downgrade). Therefore, anything that triggers fears in cash bonds (poor auctions, inflationary fears, central bank hikes) results in a disorderly unwind by hedge funds selling the cash bonds to cover the margins on their futures short. Bonds get marked down, widening the basis, which triggers a series of indiscriminate liquidations – moves that could have contributed to the outsized bond selloff over the last few trading sessions.

Searching for other clues. Other narratives include perhaps the shift away from USD assets from China/Japan – some of the larger holders of cash treasuries – as a result from the trade tensions, as well as other treasury long positions being unwound similar to the UK budget crisis in 2022. As with all tumultuous markets, clues to the madness often lies in the outlier performers. Amid the carnage, gold markets were up, perhaps pricing in odds of Fed intervention to ease the dysfunction seen in the treasury markets with quantitative easing, as they had done most recently with the Covid crisis in 2020 and the US banking crisis in 2023. As such, we think that there is a limit to how much yields can spike before the authorities step in to ease financial conditions.

The only thing to fear is fear itself. From a fixed income standpoint, we view indiscriminate selling not as an opportunity to join the madness, but one to continue to build high quality income with A/BBB credit in the 2-3Y and 7-10Y buckets. We continue to see TIPS as a beneficiary of an environment of declining economic confidence but rising inflation expectations from tariffs. With much uncertainty still on the horizon, assets like fixed income that provide contractual coupons remain an investor’s good hope for stable returns for the rest of 2025.