The US financial system typically sees a rush into long-dated Treasuries during crises, resulting in lower borrowing costs. This pattern was evident during the last financial crisis and has changed recently, as seen during the Covid pandemic, where the Fed had to buy trillions of bonds.
The shift stems from factors in the derivatives market, with highly-leveraged trades leading to bond selling due to deleveraging. This emerging trend is concerning for US policymakers since it discourages investment in Treasuries during crises, potentially diminishing liquidity and increasing yields.
Intervention And Challenges
Efforts have been made to establish a bailout fund for the basis trade, but the window for effective intervention may have closed, leading to higher costs. Without action, the Fed might need to engage in inflationary measures again in response to future crises.
In the past, when markets were under strain, there was a tendency for investors to rush into long-term US government bonds — popularly known as Treasuries — which drove up their prices and brought yields down. It acted as something of a pressure valve, allowing funding costs to compress while giving financial players somewhere to park capital safely. We saw this during the last financial crisis, where investors fled risky assets and piled into Treasuries. Lower yields helped cool fears and allowed borrowing to continue at manageable levels.
However, things didn’t follow that path during the Covid shock. Rather than seeing a straightforward flight to safety, the Federal Reserve stepped in and bought immense quantities of bonds to keep the machine humming. That was unusual and marked a shift in how deep stress plays out in the system. At the heart of it is a complex trade involving interest rate futures and cash bonds — what some call the “basis trade” — using borrowed money, or leverage, to capture thin differences in pricing.
The challenge arises when those leveraged trades begin to unravel. When prices move unfavourably, margin calls kick in, and traders are forced to sell bonds to cover losses. The result? Treasury prices fall even when you’d expect them to rise, and yields — which move in the opposite direction — climb. It’s the sort of dislocation that throws traditional defensive thinking into doubt.
Yellen and others have raised eyebrows over the consequences, particularly as higher yields during times of panic make borrowing more costly for everyone — not just traders. The difficulty isn’t just the trades themselves, but their size and the rapid pace at which losses can mount. This isn’t a standard portfolio unwind. It’s more like dominoes falling over one another when leverage reaches excess.
Risk Management And Market Stability
Attempts have been made to backstop this risk, including talks around setting up a rescue mechanism specifically for these trades. That would provide balance without the Fed having to leap straight into large-scale purchases. But support of that kind needs timing and commitment. The fear now is that window may have already shut. Bond markets have adjusted, liquidity isn’t what it used to be, and without intervention, wider consequences may follow.
Traders should take this at face value. The old assumption — that bonds automatically provide a cushion in crisis — no longer holds with confidence. Forward rates have started baking in greater risk premiums, and the cost for holding long positions is higher than it was a year ago. That’s not temporary distortion; it’s the result of structural forces.
Volatility in long-dated rates is no longer just about inflation expectations or central bank guidance. It’s about positioning, balance sheet strain, and the mechanics of who is forced to buy or sell under pressure. It’s about reflexivity — where price moves create the very conditions that worsen them.
Powell may find himself in an uncomfortable spot if another shock hits. Without natural buyers stepping in, the only force able to stabilise the market would be the Fed. But purchases of that kind would fuel inflation if they happen when price stability already hangs in the balance.
We need to adjust accordingly. Funding sensitivity matters more now. Use of leverage must reflect not only asset risk but also systemic reaction to stress. Models might underestimate tail events if they fail to account for flows driven by margin and collateral behaviour.
In this context, risk models based purely on volatility and correlation are insufficient. We are beginning to operate in an environment where feedback loops from leveraged trades can overpower macro fundamentals, even in assets as historically steady as Treasuries.
The path ahead calls for sharper attention to positioning data, particularly in futures markets, and for tighter controls on margin exposure. Not because this is theoretical, but because we’ve already seen how unlocking a crowded basis trade led to liquidity evaporation and price disorder. What was once considered a technical corner of finance holds outsized influence when markets strain.
It’s not just about being smart — it’s about being early.
