While the market participants, who include brokers, traders and investors, said the selloff was orderly, indicators such as bid-ask spreads -- or the difference between buyers' and sellers' asks -- were widening on Wednesday. One trading desk said the bid-ask spread was double its normal levels.
Treasury yields pared back some of their gains on Wednesday after President Donald Trump's sudden U-turn to temporarily pause tariffs although were still higher for the day. At different points during volatile trading, the run-up in yields this week topped the biggest weekly jump since 2001.
Investors and analysts likened this week's moves to the frantic "dash-for-cash" of March 2020, when a crash in the Treasury market forced the Federal Reserve to step in with a massive $1.6 trillion bond-buying rescue.
Bill Campbell, portfolio manager for the DoubleLine global bond strategy, said trading conditions were particularly difficult overnight on Tuesday.
That's when hedge funds began unwinding relative value trades, where they use leverage, or debt, to take advantage of small price dislocations among similar assets. The unwind strained bank balance sheets, he said.
"With the selling that happened overnight in Asia and then through Europe, you started to get the warning signs that there was potentially stress building up in the system, and had it continued, then you start to run the risk that bigger things would happen," Campbell said.
One market participant, who requested anonymity to speak candidly, said his firm had extended some clients more financing on Wednesday as some banks pulled back. The person added that while the market worked as it should, everyone was on alert for signs of stress.
The $29 trillion U.S. Treasuries market is the bedrock of the global financial system, with banks, investors and companies relying on it for funding and access to low-risk assets.
Dislocations in the market can cause broader financial stability issues. It can also hamper policymakers’ ability to pursue their agenda, as a rapid rise in yields can make it punitively expensive for governments to borrow – a phenomenon called bond vigilantism.
In a sign the market was on his mind, after pausing the tariffs, Trump said the “bond market now is beautiful.”
Even so, the dislocations in Treasuries have left some market participants questioning if the harm to U.S assets could persist in the long term.
"The damage has been done ... both in terms of relative economic growth outcomes and foreign investor willingness to fund the U.S. external deficit," said Deutsche Bank analysts in a note.
RELATIVE VALUE
Hedge funds have become big players in Treasuries, usually using leverage in short-term repo markets, where they borrow against the securities to juice up returns. Hedge funds had $2.5 trillion in borrowing in the repo market in December, according to the Treasury's Office of Financial Research.
Some of those trades came under pressure as the market sold off, sparking demand for additional collateral from counterparties, the market sources said.
"In volatile times like this, the provider of leverage to a hedge fund with a highly levered portfolio gets nervous and may want to make a capital call to get extra collateral," said Symon Drake-Brockman, co-founder of Pemberton, a private credit manager.
"If they haven't got the money, these hedge funds start unwinding the trades," he said.
A rates trading desk saw such de-risking mainly in the long U.S. Treasuries swap spread trade, as Treasury yields soared. That trade, popular among investors due to expectations of banking deregulation, is essentially a bet that the difference between interest rate swaps, a type of derivative, and Treasuries will widen.
Another relative value trade, called the basis trade, where traders exploit the pricing difference between a Treasury bond and its derivative, had not seen a meaningful deterioration, two of the sources said.
"We've seen more (unwinding) activity in the swap spreads ... There is some cash-futures based activity, but we're not seeing huge stress there," said Bhas Nalabothula, head of U.S. institutional rates at trading platform Tradeweb, on Wednesday.
Campbell said trading conditions improved on Wednesday morning as New York started trading.
"Dealers saw that they still had decent capacity, and we started to see markets regulate themselves without the need for any intervention," he said.
The situation eased further after a 10-year note auction by the Treasury, seen as a key test of demand for government paper, particularly by foreign investors, saw robust demand, alleviating some market anxiety.
Then, later on Wednesday, catching market players off-guard Trump announced the pause on tariffs on some countries, leaving investors pondering where-to-next.
"The age of U.S. exceptionalism (at least financially) has come to an end," Westpac analysts said in a note.
"The ultimate risk-free curve, of US Treasuries, the ‘golden collateral’, the actual instrument any investor from Tennessee to Tokyo can buy, is being challenged."
