On Monday, the U.S. Treasury market experienced a sharp sell-off, with the benchmark 10-year yield surging 19 basis points to 4.18%, marking the largest single-day increase since September 2022. Meanwhile, the 30-year yield jumped 21 basis points, the biggest rise since March 2020. More concerningly, the selling pressure continued into Tuesday, pushing the 10-year yield further up to 4.29%, with a single-day gain of 13 basis points and a total increase of 42 basis points since the low on April 4.

The immediate catalyst for this wave of selling was a lackluster $58 billion auction of 3-year Treasuries by the U.S. Treasury Department. The auction attracted the lowest demand since 2023, with primary dealers taking up 20.7% of the offering—the highest since December 2023—indicating significantly reduced interest from institutional and foreign investors. This weak demand has only fueled concerns that overseas investors may be pulling back from the U.S. Treasury market.

While multiple factors may have contributed to the bond sell-off—such as soft demand for the 3-year auction and the unwinding of positions related to Treasury swap spread trades—a deeper, more critical trigger appears to be the large-scale unwinding of “basis trades,” exposing underlying fragilities within the U.S. government bond market.

What is a Basis Trade?

In simple terms, a basis trade is a highly leveraged hedge fund strategy that aims to profit from small price differences between Treasury cash bonds and futures. Treasury futures typically trade at a premium to the underlying cash bonds eligible for delivery into the futures contract, creating an arbitrage opportunity. Hedge funds take advantage of this by shorting Treasury futures while simultaneously buying the corresponding cash bonds, establishing a hedged position to earn a nearly risk-free spread of a few basis points.

Although such small profit margins might not justify large-scale investment in other markets, the safety and liquidity of U.S. Treasuries allow funds to repeatedly leverage this trade, amplifying potential returns. Notably, basis trades often involve significant leverage, though the exact levels are typically opaque.

The issue arises when the Treasury market experiences sharp volatility. Futures and repo markets may demand additional margin or collateral. If hedge funds are unable to meet these margin calls in time, lenders may seize the collateral—namely, the Treasuries—and sell them on the open market. This can further depress prices and intensify market turbulence, potentially triggering a vicious cycle.