In a similar way to what we saw during the worst days of the tariff tantrum in April 2025, heavily leveraged bond trades are getting unwound again.
And when you start attacking the very foundation of financial markets – the bond market – things can get nasty very quickly.
There are two very popular, heavily leveraged trades in bond markets: swap spreads and basis trades.
Both involve going long the cash Treasury bond, and going short something against it: the basis trades uses the Treasury future as short leg, and the swap spread uses interest rate swaps.
In both cases, the trades involve a large use of leverage because the purchase of the cash Treasury bond is financed using the repo market: for a $100M trade in basis or swap spreads, due to repo market funding hedge funds must only use a tiny portion (~2-5%) of the needed capital to enter the transaction.
Let’s focus on the swap spread trade for a second.
Look at the chart below.
As long as repo markets remain orderly, investors can use it to fund purchases of , pay a fixed 30-year interest rate swap against it and earn a whopping 80-90 (!) bps per year in ‘’swap spreads’’.
But why on earth would investors be able to earn such a premium on US government bonds?
It’s because of regulation and the growing supply/demand imbalance problem in US Treasury markets.
Bank regulation has crippled the ability of market makers to warehouse risks, which means their ability to absorb large issuance of Treasuries on their balance sheet has diminished.
On top of it, Treasury departments of US banks are penalized for owning large amount of Treasuries from regulations like the Supplementary Leverage Ratio (SLR) which don’t exempt USTs from its calculations.
All of this is happening at a time when the supply of US Treasuries has dramatically grown because of persistent budget deficits, forcing dealers to swallow bonds at auctions and testing their limits.
Given the supply/demand imbalance, the marginal buyer of US Treasuries tends to be the leveraged hedge fund which gets involved in basis or swap spread trades and demands a hefty premium as compensation.
And this fragile system holds until it doesn’t.
In the last few days, many investors were hit by margin calls given turbulent markets. To meet these margin calls, they had to de-risk their portfolios and sell every asset they could – including Treasuries. As Treasuries got caught in the deleveraging mania, basis trades and swap spreads suffered.
The first stop losses in these highly leveraged trades were hit, and then a self-fulfilling VaR shock occurred.
As energy prices rapidly increase, governments are discussing price subsidies – but that’s just a fancy way of saying more fiscal stimulus, and more bond issuance.
The bond market is getting disorderly under the hood.
Thanks for reading and have a beautiful day
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