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Stocks are giving back some of their gains from yesterday and are down sharply, while Bonds are also slightly lower. The 10-year Treasury yield is up 4bp to around 4.33%.

The markets have been extremely volatile. Yesterday, President Trump dropped tariffs on all countries but China to 10%, at least for the next 90 days. This caused a huge rally in the Stock market, but there have been a lot of rumors as to why the Bond market has not been performing as you would normally expect, especially with the recent decline in the Stock market.

One reason is that sharp declines in the Stock market caused margin calls, and when that occurs, investors must sell what’s liquid. Oftentimes they have to sell their Treasuries as they are highly liquid.

Another reason is the unwinding of the Basis Trade – more on that in just a bit.

Many on social media are saying that Bonds are selling off because China is selling their US Bonds. We completely disagree with this. First off, China is no longer even close to the largest holder of US Treasuries:

Fed       $4.7T

Japan   $1.1T

China  $0.76T

UK         $0.74T

Additionally, if China sold Treasuries, it would be at a huge loss, because they purchased most of them at much lower yields. If they were selling, their currency would strengthen, but it has been weakening. This would occur because they would sell US Treasuries and convert those dollars into the Yuan, causing it to rise comparatively.

Here is what China has done in the past to keep their currency weak vs the Dollar. When the US buys goods from China, China gets US dollars, which would normally strengthen their currency when exchanged for the Yuan…especially because they export much more to us than they import. They don’t want this because it would make their exports more expensive. China then repatriates their Yuan into dollars by purchasing US Equities and Treasuries, keeping their currency from rising. For a very long time, China has pegged their currency to the dollar and prevented it from rising.

Again, if they sold our Treasuries, their currency would rise, but it has not. And even if they were to sell, at a loss, where would they go? The US has a better yield, better quality, and more liquidity. Over the last several years, China’s holdings of our Treasuries have fallen, but not from selling, from Treasuries maturing and them buying much less than is maturing.

The most important concept for today is the Basis Trade. Investors and Hedge Funds are always looking for arbitrage or inefficiencies in the market, which is essentially a mispricing between two assets and almost guaranteed profit.

In this case, it involves buying a Treasury in the spot market (cash market) and then selling the futures contract of that Treasury if there is an arbitrage opportunity.

The inefficiency or mispricing in the market is normally small, but can be made much bigger by using leverage. And many hedge funds are using 50x or even 100x leverage, which makes the gain or loss much larger. When using leverage, you are borrowing a large amount of the money, so there is not a lot of cushion if the trade goes in the wrong direction. Once you are liquidated, you have to sell the underlying asset or Treasury.

Example: If an investor used 100x leverage on a $100,000 investment, they would be getting the purchasing power of $10,000,000. That means a very small move in the market in the right direction can cause big profits, but a move in the wrong way can cause big losses and liquidations very fast.

This Basis Trade is not small – It makes up almost $1T or roughly 3% of the entire $29T US Treasury market.

Let’s look at an example with the 10-year Treasury:

A 10-year Treasury Basis Trade involves buying a 10-year Treasury and simultaneously selling a 10-year Treasury futures contract (going short).

Assume the 10-year Treasury bond is trading at $98, and the 10-year Treasury futures contract is trading at $99. There is clearly an arbitrage opportunity as the futures contract, once it nears expiration, should converge with the price of the Treasury…it appears to be priced too high.

The investor would buy the Treasury at $98 and sell the futures contract at $99. As the futures contract nears expiration, the prices should converge, and the futures contract price falls to $98. The investor can then buy back the futures contract that they sold short at $98, locking in a profit of $1 per contract.

But if the Bond market moves too quickly, instead of the price of the Treasury and futures contract converging, they can go in the opposite direction, causing big losses and liquidations.

Last week Stocks fell sharply on news of reciprocal tariffs. As you would expect, Treasury yields moved much lower and FAST: 10-yr yields moved sharply lower from 4.30% to 3.86%, but futures contracts that they are holding short of equal value did not move as fast. Instead of the price of the Treasury and Futures contract converging, where they make money, they widened and were put in big losses or liquidated.

This forced them to sell the borrowed Treasuries at up to 100x leverage, and that’s why as Stocks continued to move lower, you did not see the benefit in the Bond market. Yields moved higher as a lot of this trade was unwound and Treasuries were sold, causing yields to move sharply higher.

Consumer Price Index

The March Consumer Price Index (CPI) report showed that overall inflation fell 0.1% for the month, which was lower than the 0.1% expected. Year over year, inflation slowed from 2.8% to 2.4%, one tenth lower than anticipated.

Helping the headline was a big decline in gasoline prices, which fell 6.3%.

The Core rate, which strips out food and energy prices, increased by 0.1%, one tenth lighter than market estimates. Taken out to the second decimal, Core CPI only rose 0.06%. Year over year, Core CPI moved from 3.1% to 2.8%, and the market was only expecting it to drop to 3%.

Airline fares fell a sharp 5.3%, due to a combination of lower fuel prices and less demand.

Shelter is always the most important component, as it makes up 44% of the entire Core index. It came in favorable at 0.22%, but not exactly for the right reasons.

Rents rose at 0.33%, while Owners Equivalent Rent rose at 0.4%...but the volatile Lodging Away from Home fell 3.5% and dragged down the overall shelter component.

Used Cars and Trucks fell 0.7% and Motor Vehicle Insurance fell 0.8%. Shelter really made up the majority of the inflation, when subtracting out the other items we went over, everything else went up by 0.07%.

Bottom line – this would normally have been a very good report for the Bond market, but it was for March, ahead of the tariffs.

Technical Analysis

Mortgage Bonds are being rejected from their 100-day Moving Average, and there is a lot of room to the downside before reaching support at the 100.43 level.

The 10-year has broken above its 50-day Moving Average, with the next stop at 4.41%.