Follow the leverage
- sebastienpautrot
- Apr 11
- 3 min read
11 April 2025
As we indicated earlier this week, our sense is that the stress in bond and funding market liquidity probably motivated the (partial) pivot by the US administration. Some have argued that the bond market stress (rise in yields) has been triggered by selling from China. However, it is not clear that China’s official holdings have fallen. To gain a complete picture it is necessary to include their holdings via Euroclear and other entities. More likely, the rise in Japanese yields is causing domestic Japanese participants to unwind carry positions. That has probably contributed to downward pressure on US equities, bond prices and the dollar. Similarly, we also note the weakness in USDCHF. The Swiss National Bank is also a large holder of US assets.
Chart 1
Historically, the carry trade tends to be unwound in waves over months. Levered participants have non-trivial (roughly $1 trillion) in basis trades between bond futures and physical bonds (short futures, long US Treasuries). Given the impulsive USDJPY weakness, market participants are likely unwinding their basis trade given the self-reinforcing unwind of the yen carry trade. The USDJPY is currently trading at 143 at the time of writing, still a few big figures above the August 2024 carry unwind episode, but down materially from 158 at the start of the year.
As we have noted, there is also a rapid and impulsive rise in Treasury yields (fall in bond prices). The big picture question is whether this develops into a disorderly unwind. From our vantage point, the signals for a disorderly episode would be when liquidity breaks, the repo market locks up and Treasuries stop behaving like Treasuries (the haven or diversifying asset). The key indicators to monitor are repo strikes and failed bond auctions. The 10 Year Treasury yield is still trading below 4.5% and below the January high. However, over the past week Treasury bonds have been correlated to equities and have not provided diversification on large drawdown days.
We noted earlier this week that if credit and funding spreads widen further from here that might contribute to a reflexive and non-trivial liquidity stress where the episode moves from aggressive re-pricing of risk to a proper disorderly breakdown. Several market participants have also noted the widening in the spread between the 30 Year SOFR Swap Spread and the Treasury. There has also been a widening in cross currency basis as well and “basis” in Treasuries. This is arguably a reflection of confidence in US Treasuries and symptomatic of de-leveraging. All this also leads to a correlated tightening in broad financial conditions.
Chart 2
The good news is that the SOFR rate is calm at around 4.3%, Repo is relatively stable (no signs of cash panic) bond auctions are clearing, and corporate credit spreads remain below average. What is disturbing is dollar weakness against the Swiss Franc and the Japanese Yen. Our understand is that bank spreads on currency forward rates are two to three times normal levels. In a typical disorderly panic, the US dollar index would spike.
On the negative side, the credit, equity risk premium and implied currency volatility remain below average if the episode leads to a genuine panic and a fundamental shock to global growth, trade, and corporate profits. Confidence is clearly already fragile. On the positive side, these risks would be fully appreciated (known) by the Treasury Secretary and the Federal Reserve. That is the probable reason why we expect a deal to be done by the US Administration with Europe and China.
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