Breaking down the sharp rise in U.S. Treasury yields

Key Takeaways

• The sharp rise in intermediate and longer-dated U.S. Treasury yields is likely the result of a confluence of factors – thin market liquidity, foreign selling pressure, inflation and trade uncertainty, hawkish monetary policy, and a powerful hedge fund de-risking trade.
• Though we expect some of these factors to prove temporary, others may have more staying power as the Federal Reserve (Fed) remains on hold and some foreign entities look to other developed countries for a portion of their safe-haven investments.
• We continue to recommend a neutral duration posture; however, more extreme moves above IAG’s fair value assessments may encourage an upgraded view of duration against the backdrop of probable Fed easing this year and decelerating global growth.

What’s driving yields higher

Over the past week, 0- to 2- year yields held relatively steady based on stable Fed rate expectations. The market is still discounting 0.75-1.00% in Federal Funds rate reductions by year end. However, 3- to 30-year U.S. Treasury yields endured one of their sharpest spikes (i.e., bond prices lower) since 2019. The Bloomberg U.S. Treasury Index declined -2.4% and interest rate volatility is at its highest point in roughly two years.

We believe the sharp rise in intermediate and longer-dated U.S. Treasury yields is likely the result of a confluence of factors:

Low liquidity

The minute-to-minute pivots in U.S. trade policy is reducing the pool of willing buyers in the U.S. Treasury market. There is greater hesitancy among dealers given the uncertainty and balance sheets are currently heavy following last week’s 3-year, 10-year, and 30-year U.S. Treasury debt auctions. This is contributing to higher intraday swings in interest rates and is important to assessing the current trading environment.

Foreign selling

There is growing speculation of broad-based selling of U.S. assets, including U.S. Treasuries. With respect to the U.S. government debt market, there are reports that China may be selling securities through European intermediaries in response to the recent tariff escalations, presumably to raise borrowing costs in the U.S., complicate U.S. Treasuries’ “haven asset” status, and display China’s influence on global markets. From Wall Street, there have been little-to-no signs thus far of broad-based dumping of U.S. Treasuries. However, the recent decline in the value of the U.S. dollar – despite rising U.S. yields – is a sign that there is at least some aversion to U.S. assets at the moment. Some thawing of trade tensions would likely help U.S. yields and the U.S. dollar stabilize; however, global trade policy remains extremely fluid. Thus, any reduction in foreign demand could keep U.S. Treasury yields more elevated. It is notable (and positive) that the foreign demand at Wednesday’s 10-year U.S. Treasury auction was the highest on record.

Inflation uncertainty

If the Fed must step in and cut policy rates more than expected due to economic deterioration (particularly in the labor market), there are some investors questioning whether this will complicate the Fed’s mission to tame inflation towards the central bank’s 2% target, particularly if there is an inflationary impulse from tariffs. Perhaps, but we suspect the Fed is going to prioritize as gradual an approach as possible with respect to rate cuts – unless the “hard” economic data undeniably deteriorates in the months ahead. Additionally, slower U.S. growth and the recent decline in oil prices should provide some partial offsets to inflationary pressures. It is a big positive to see market-based long-term inflation expectations coming down since late-March, a welcome development for Fed policymakers. However, they will also keep an eye on the recent rise in survey-based measures, too.

No Fed “put” – yet

Since the Great Financial Crisis, the market has increasingly operated under the assumption that the Fed would step in and add liquidity at the first sign of market stress. In recent weeks, Fed Chair Powell and other officials have thrown some cold water on this notion. We do believe that the Fed would step in and support liquidity/market function at some point, but there would need to be larger, more persistent stress in funding markets than what we have seen thus far.

Global trade

If there is a permanent realignment of global trading partners that relies less on the U.S., that could create less structural demand for U.S. Treasuries. Foreign entities shipping into the U.S. get paid in U.S. dollars and often invest it in U.S. assets, even if only for a brief period of time. U.S. Treasuries are often selected as a “safe haven” asset to manage risk. This dynamic is likely contributing to some of the upward yield swings we have seen this week – as U.S.-China trade retaliations escalated daily and traders hedged.

Hedge fund de-risking/basis trade

There does appear to be some very large trading volumes (especially early last week) from hedge funds and active managers that are liquidating outstanding basis trades. The short version of basis trades: hedge funds and active managers establish long positions in traditional cash bonds and short their synthetic futures contracts to capture their small yield differential. To enhance returns, these managers typically use high amounts of leverage to boost return. When markets become volatile or demand for liquidations spike, a resultant unwind of these trades can happen rapidly. Last week, we saw this activity ramp up, all while fighting against the lower liquidity conditions previously mentioned. This is probably not a sustainable driver of upward yield moves. Eventually, enough of these trades will be closed out and risk acceptably lowered. In the meantime, they can effectively create powerful jolts of forced selling.

Bottom line

We continue to recommend a neutral duration posture. More extreme moves above IAG’s fair value assessments may encourage an upgraded view of duration against the backdrop of probable Fed easing this year and decelerating global growth. For instance, we would likely consider the 10-year rapidly rising towards 5% as an opportunity to extend duration, barring a dramatic shift in the economic landscape. If market conditions continue to deteriorate, the likelihood of policy intervention rises which would likely add a market-friendly layer of support. On the flip side, we continue to believe the 10-year U.S. Treasury yield will struggle to fall below the 3.50-3.75% range in the very near-term.