A sharp rise in long-term US Treasury yields is placing renewed pressure on a widely held hedge fund strategy predicated on the relative outperformance of government bonds versus interest rate swaps, according to a report by Bloomberg.
The popular basis trade – betting that Treasury securities would outperform SOFR-linked swaps – has come under renewed scrutiny amid concerns over escalating sovereign debt levels and the broader macro backdrop. As long-dated yields push higher, the relative value of the trade has deteriorated, challenging recent positions established by macro funds and relative value specialists alike.
Driving the dislocation is a growing unease around fiscal sustainability in the US and other major economies. Widening budget deficits and increasing debt issuance have pushed long-end yields to levels not seen since before the global financial crisis – with 30-year Treasury yields briefly topping 5%, the highest in nearly two decades.
This has pushed swap spreads significantly tighter, with the 30-year spread compressing to as narrow as -94 basis points – its tightest in over a year – while the 10-year spread reached -59 basis points, triggering stop-loss levels for several banks. Societe Generale has since exited its recommendation on the trade, underscoring the magnitude of the move.
The squeeze comes at a particularly delicate time for funds who re-engaged with the trade in anticipation of regulatory changes. Market chatter around a possible revision to the supplementary leverage ratio (SLR) had fuelled optimism that banks would be granted greater flexibility to hold Treasuries without incurring leverage constraints. Strategists at Deutsche Bank had flagged potential updates as early as June, though official details remain scarce.
Despite the lack of clarity, a number of global investment banks – including Barclays, Goldman Sachs and Societe Generale – had recently advocated for the position, citing regulatory tailwinds and valuation dislocations.
Thursday’s market action delivered a sharp reversal, challenging conviction in the trade for the second time in recent months. A similar blowout in spreads occurred in April following the announcement of aggressive trade tariffs by former President Donald Trump, which spurred a flight from the trade and significant P&L drawdowns across the basis community.
