Perspective on Risk - April 10, 2025 (The Equilibrium Is Shifting)

Tariffs, Volatility, Deleveraging, and the Return of the Basis Trade; Fed Is Prepared To Respond; Risks; Levine

Some of this will be basic for those in the risk management community. But since subscribers to the Substack have grown substantially from when I first started writing these things, it ought to help inform a portion of the audience.

Tariffs, Volatility, Deleveraging, and the Return of the Basis Trade

Let’s start with a simple run-down of market developments.

Trump’s poorly-designed introduction of tariffs has several effects. First, as we discussed here, it increased uncertainty, which increased asset volatility. But it’s the feedback loops that matter now.

Tariffs Are a Destructive Shock

Let’s be clear: tariffs destroy value. That’s not ideology—it’s economics.

(Graph courtesy of Marginal Revolution)

They unwind decades of gains from specialization and comparative advantage. And they don’t just disrupt trade—they inject uncertainty into corporate planning, cloud earnings visibility, and, as we're seeing now, they rattle markets.

For global firms, which depend on supply chains woven over decades, the tariff shock threatens core economics. Input prices are rising. Output prices are rising. Consumption is falling. CEOs are paralyzed. The playbook from Trump’s first term? We're ripping it up and writing something uglier.

“If [Trump’s plan] holds as unveiled... supply chains will be tangled, investment plans rewritten, prices for imports will spike…” – Bloomberg’s Big Take​

In the short term, tariffs will raise prices on imported and domestic goods, both intermediate inputs and final consumer products. Firms' cost-of-goods-sold rises, and consumer prices rise. This is the classic tariff tax, which falls primarily on domestic consumers contrary to Trump's "foreign scavengers" rhetoric.

Uncertainty reduces US consumption, which in turn further reduces US firm earnings prospects – creating a potential feedback loop. This is the dangerous dynamic that makes tariff policy so much more than a simple reallocation of trade flows.

Reallocation, Deleveraging & Collateral Calls

With equity and fixed income markets repricing, and faced with losses and heightened uncertainty, individual investors typically become more defensive and reallocate from equities to bonds.

The two most prevalent hedge fund trades before the Trump tariffs were leveraged long equity trades on high-growth companies, and long-short equity strategies that assumed tariff moderation. These were the first to unwind—hit by earnings downgrades, volatility spikes, and factor model recalibrations—triggering broader reallocation. As losses deepened, more structured and leveraged trades, including basis and swap spread positions, began to unravel.

Thursday was the worst day of performance for US-based long/short equity funds since it began tracking the data in 2016, with the average fund down 2.6 per cent, according to a new weekly report by Morgan Stanley’s prime brokerage division. — FT Hedge funds hit with steepest margin calls since 2020 Covid crisis

Hedge funds, which operate on varying degrees of leverage, either close their positions and deleverage or are forced by their prime brokers to post additional collateral.

"Multisector funds are trying to deleverage, which leads to a 'sell everything' trade," noted Gennadiy Goldberg at TD Securities.

This is classic deleveraging: margin calls, forced unwinds, indiscriminate selling. Liquidity vanishes where it’s needed most.

Treasury Market Dysfunction

We talked a lot about central banker’s concerns about “treasury market dysfunction.” Central banker economists care about wealth effects, central banker portfolio managers care about Treasury market liquidity, function and plumbing, and central bank examiners care about the effects on the institutions.

As we have discussed before, we have long-run structural issues. The Fed has an overly-large balance sheet, as the US government is issuing Treasury debt faster than industry (and bank) capital is growing. This is defacto macro leveraging.

And if the tariffs are effective in reducing the trade deficit, they will also by construct reduce the fiscal surplus from trade, reducing the demand for US assets (and in particular Treasury securities).

Initially, we saw a relatively normal flight-to-safety, with money flowing from equities to Treasuries, driving prices up and yields down. But then Treasury prices began falling (yields rising) even as equities sold off further.

This pattern suggests forced selling, and the finger points directly at the Treasury basis trade that’s been discussed for over a year now. This is a well-known and examined issue.

Thinly capitalized hedge funds’ growing role in the enormous and rapidly expanding market for U.S. Treasury securities poses a clear and present danger to financial stability that warrants a new approach from the Federal Reserve during times of extreme market stress, suggests a paper discussed at the Brookings Papers on Economic Activity (BPEA) conference on March 28. — Brookings

As we’ve discussed before, the basis trade was one of the factors that did in LTCM back in 1998. LTCM was long Treasury futures and short cash bonds expecting the basis to narrow. That version of the trade was premised on mean reversion, betting that market dislocations post-Russian default would resolve. When liquidity dried up, and Treasuries became the only asset anyone would buy, cash bonds rallied and futures underperformed. LTCM was short the bonds—they lost money as the cheapest-to-deliver rallied away from them.

The current basis trade is the opposite of the LTCM trade; hedge funds are long cash Treasuries (financed through repo) and short futures. This trade assumes that futures prices will converge down toward the cheaper cash Treasuries as delivery approaches.

The spike in volatility affects both legs of the trade. On the futures side, if prices rise or if vol simply spikes, the HFs must post more cash immediately—even if the cash Treasuries haven’t moved much. This is a liquidity demand. On the repo side, a number of things COULD happen: lenders could demand wider haircuts, reduce eligible collateral, and rolling the positions could become more uncertain.

The problem is that both Treasury futures and repo markets demand much more collateral when there is an unusual amount of volatility in the Treasury market. — FT Alphaville, April 8, 2025

An initial unwind drives a feedback loop here as well. As HFs seek to maintain liquidity they sell Treasuries and cover their futures trades. This activity drives the basis even wider, setting off a further collateral cycle.

Across several market observers, the evidence is compelling:

"Hedge funds have been liquidating US Treasury basis trades furiously," said one hedge fund manager quoted in the Financial Times.

As discussed previously. the Treasury basis trade has become enormous – with hedge funds' net short Treasury futures position standing beyond $800 billion, with asset managers the mirror image on the long side. With leverage ratios of 50-100x being common in this trade, just $10 million of capital can support as much as $1 billion in Treasury purchases.

Again, this is necessary as Treasury issuance outstanding has grown faster than industry (and bank) capital. And this is why SLR relief is being considered, and what there is urgency to reducing the fiscal deficit.

We’ve seen this before: March 2020.
It’s not 2020 now, but it rhymes.

Swap Spreads

Swap spreads represent the difference between swap rates and Treasury yields of equivalent maturity. In normal market conditions, swap rates trade at a premium to Treasury yields, reflecting the credit risk inherent in interbank lending compared to "risk-free" Treasury debt. This premium also incorporates liquidity factors, supply-demand dynamics, and regulatory constraints on bank balance sheets.

When swap spreads narrow, it typically means either that Treasury yields are rising relative to swap rates, or that banks and other market participants are increasing their demand for swaps exposure relative to cash Treasuries. When they turn negative, as they have in long tenors, it suggests severe balance sheet constraints or extraordinary Treasury supply pressures.

The benchmark 10-year Treasury yield jumped 19 basis points on Monday to 4.18 percent, while the 30-year yield rose 21 basis points. As reported by Bloomberg, this was "the biggest daily rise since September 2022" for the 10-year and the largest move in the long bond "since March 2020." Meanwhile, swap rates moved much less dramatically, leading to a collapse in spread levels.

As the Financial Times reported, the 30-year swap spread reached a record low, indicating that banks' balance sheet constraints were forcing them to reduce Treasury holdings while maintaining interest rate exposure through derivatives.

This is not just a technical unwind. It's a signal that balance sheet stress is back. And it puts the spotlight back on the microstructure of the Treasury market—a discussion long overdue.

Columbia Threadneedle's Ed Al-Hussainy described it bluntly:

"The most violent move in the last six weeks has been that swap-spread trade coming to a violent conclusion. This tells us that banks are now looking to raise and looking to preserve cash."

The immediate question is whether Powell and company will pre-emptively address market dysfunction or wait until more severe stress emerges. History suggests they'll wait, but the rate of deterioration may force their hand sooner.

Fed Is Able To Respond

The Federal Reserve has several tools available to address Treasury market dysfunction. The standing repo facility (SRF) provides a daily liquidity backstop to primary dealers. In more acute stress, the Fed could reactivate emergency tools like the Primary Dealer Credit Facility (PDCF) or even extend support to the basis trade itself, though this is unlikely in the near term. As we discussed in an earlier PoR, a recent Brookings proposal suggests the Fed could intermediate both legs of failing trades—holding the position to maturity and absorbing mark-to-market volatility that private funds cannot tolerate.

I suspect that the Fed will let stresses play out and expect that the existing mechanisms in place will be initially sufficient. Behind the scenes, they will be evaluating what, if anything additional, needs to be done should the need arise.

Too many commentators jump to calling every crisis a Lehman-moment. We are no where near a Lehman moment. If anything, the current situation reminds me more of the first six months of 2007, before Bear Stearns High-Grade Structured Credit Fund began experiencing distress. Both periods featured heightened uncertainty as well as the beginning of a shift in the equilibrium position of the market.

There is also endogeneity in both experiences.

In the GFC, the system collapsed not because of an exogenous shock, but because of vulnerabilities created and amplified within the financial system itself. Falling subprime MBS prices led to margin calls on hedge funds and SIVs that in turn led to more selling of MBS; cycle of liquidation. Additionally, super-senior positions were stable in normal times and hence highly leveraged, but needed to be deleveraged as their credit ratings deteriorated.

Now, the Treasury basis trade is stable and profitable in normal times, but being highly leveraged is fragile under stress and subject to the collateral call feedback loop. The Supplementary Leverage Ratio (SLR) caps how many Treasuries dealers can hold, which reduces the shock-absorbing capacity of the system at exactly the moment it’s most needed. The swap spread inversion and record-low 30-year spreads suggest banks are moving exposure off balance sheet to manage capital, not credit risk.

Risks

China Devaluation Risk

During President Trump's first term, when tariffs were initially imposed on Chinese imports, China did allow the yuan to depreciate modestly. This depreciation was seen as a mechanism to partially offset the tariff impacts on Chinese exports. Nonetheless, the Chinese government exercised caution to prevent excessive capital flight.

In the current scenario, the People's Bank of China (PBOC) has set the yuan's daily reference rate at its weakest level since September 2023, leading to the offshore yuan falling to its lowest point on record. This suggests that while China is allowing some degree of currency depreciation, it is doing so in a controlled manner to balance export competitiveness with financial stability.

We think the pace of depreciation will accelerate from here, and China is also hinting at greater flexibility” with its so-called fixing, said Aroop Chatterjee, managing director for macro strategy and emerging markets at Wells Fargo in New York.

This will be a managed and persistent depreciation” that could cause the offshore yuan to weaken to 7.50 per dollar or more, he said. — Bloomberg China’s Offshore Yuan Hits Record Low After PBOC Eases Grip

A growing, but non-consensus, cohort of analysts are predicting a sharper plunge in the yuan in the near future. — Bloomberg China’s Offshore Yuan Hits Record Low After PBOC Eases Grip

China, however, is currently emphasizing that it acts responsibly, in contrast with the Trump tariffs, so at least for now, the baseline assumption should be a gradual depreciation.

Unwind of Yen Carry Trade

A general description of the Yen carry trade is that investors borrow in yen (where interest rates have been near zero or even negative for decades), invest in higher-yielding assets abroad—U.S. Treasuries, emerging market debt, equities, crypto, etc and pocket the yield spread (the “carry”), often leveraged. Many carry trades are executed via FX swaps or basis trades using short-term repo. Unwinding could widen cross-currency basis spreads, signaling dollar funding strain—especially in Asia.

It doesn’t appear that this has happened with any size over the recent weeks. Yes, the Japanese yen has strengthened against the U.S. dollar. This appreciation is a typical sign of carry trade reversals, where borrowed yen are bought back, driving up its value. ​But the magnitude does not seem sufficiently large to indicate an issue here, at least yet.

Bottom Line

This isn’t a crisis—yet. But it’s the kind of nonlinear shift in market structure that bears watching. Tariffs are a visible catalyst, but they’re revealing deeper fragilities already embedded in the system: leverage, liquidity mismatches, and regulatory constraints. The Treasury basis trade is a symptom of broader structural tension, not the cause. Swap spreads inverting, forced selling in Treasuries, and the narrowing of the system’s shock absorbers all point in the same direction.

The risk here is endogenous. We’re not seeing a single breaking point, but a series of self-reinforcing adjustments—tighter margins, weaker liquidity, and a growing premium on optionality. The Fed has tools to respond; the market will want a response sooner than officials would like, but in general the Fed will provide liquidity and let things play out.

This isn’t 2008. It’s more like 2007—when the plumbing started to groan before the roof gave way. The data is still noisy, the narrative still unsettled—but the equilibrium is shifting.

Late Addendum

OK. Rather than rewrite the above, which was first penned Tuesday evening, let’s just add an update. Things are moving too fast.

Trump/Bessent partially caved on tariffs.

It sounds like it was worse in the bond market than I may have anticipated when I first wrote the post.

MOVE is the Merrill Option Volatility Estimate Index. It's essentially the bond market’s version of the stock market’s VIX.

This sounds now more like the time after the failure of BSHGIF, but before BNP froze redemptions. The equivalent time during the GFC had Kramer yelling the Fed knew nothing and industry participants privately calling the Fed hoping for action.

When the bond market collapsed, their whole narrative collapsed,” Kolanovic told MarketWatch during a follow-up interview on Wednesday. “Their first excuse was, ‘Oh well, it worked for bonds.’ … The bond market probably forced their hand. — Kolanovic in MarketWatch

The Bessent/Trump put appears to be 4.50% on the 10-year.

Still early innings folks.

Addendum: Levine Is The Best