US Treasuries Shaken by Rising Tariff Fears, Basis Trade Unraveling

Article originally posted on HERE on April 11, 2025

The new U.S. tariff regime has upended market expectations and introduced meaningful new variables into the global investment equation. While the immediate market reaction has been sharp, it has not been irrational. Investors are doing their job by repricing risk amid fears that higher inflation, slower growth and an uncertain Federal Reserve response will increase the risk of recession.

For bondholders, the volatility underscores a precarious balance: U.S. Treasuries offer safety but face price risks if yields spike. The Fed’s reluctance to intervene, as Chair Jay Powell emphasized understanding tariff impacts first, leaves markets vulnerable to further swings.

This has shifted market expectations. Markets are now increasingly expecting the central bank to lower interest rates by at least 100 basis points this year, possibly through four 25 basis-point cuts starting in June. Traders had been factoring in about 75 basis points of cuts before the tariffs were announced.

Despite various indices signaling potential recession risks, high-yield spreads indicate a 0% likelihood of an economic downturn. Analysts at Société Générale developed a model to calculate high-frequency Bayesian recession probabilities embedded in asset prices. Their findings suggest that financial assets are reflecting “very little” concern about a recession.

“High-yield spreads are still below 4%, and we have never been in recession with high yields spreads below 4.5%,” according to data dating back to 1987, analysts said. “In other words, U.S. high-yield credit spreads are pricing in 0% recession probability.”

In contrast, Société Générale’s model shows the VIX (VIX) implying an 81% recession probability; short-term interest rate markets, including U.S. Treasuries (US2Y, US5Y), TIPS (TIP, TIPX), and interest rate swaps, suggesting 52%; manufacturing at 41%; the Merrill Lynch Option Volatility Estimate (MOVE) at 16%; year-over-year profits at 15%; U.S. GDP at 9%; and aggregate spreads at roughly 3%.

Meanwhile, GDP Now estimates from the New York Fed and St. Louis Fed indicate a recession probability below 10%, whereas the Atlanta Fed’s gold-adjusted GDP, at -1.4%, points to a 73% likelihood.

The credit strategy team remains optimistic, and spreads may not widen as much as in past cycles due to structural shifts in asset classes. Still, if a notable growth slowdown occurs, credit appears to be the asset class least prepared, based on historical patterns.

Volatility Reigns

Investors initially rushed to safer assets like U.S. Treasuries (and to a lesser extent defensive stocks in the healthcare sector). The U.S. 10-year yield sliced well below 4% last Friday (the first time since October 2024), dropping more than 50 basis points in the past two weeks, and over 90 basis points from its peak in January.

However, so far this week we have seen a massive selloff in government bonds, reportedly driven by an unwinding of basis trades (exploiting the gap between cash Treasuries and futures with leveraged borrowing). The outcome has been unprecedented disruption, with the spread between 10-year U.S. Treasury yields and swaps—a critical basis trade indicator—ballooning to 64 basis points, the widest ever recorded, signaling acute stress in the arbitrage market. This upheaval has pushed the MOVE index—akin to the VIX for bonds—to nearly 140%, the highest since May 2023, reflecting a year-to-date surge of almost 40%.

Overall, fixed-income securities are still posting broad gains in 2025, with 10-20-year U.S. Treasuries and inflation-indexed bonds leading with more than 3% year-to-date gains, outpacing the broader bond benchmark at 2.1% and contrasting with the DJIA, down more than 10% and in correction territory, and the Nasdaq, down nearly 21% and in bear market territory. This flight to safety reflects investor concerns about economic prospects, driving demand for U.S. Treasuries and pushing yields lower on longer maturities.

Ed Al-Hussainy, rates strategist at Columbia Threadneedle Investment, said “the market is betting that recession risks and the tightening of financial conditions will force the Fed to cut aggressively.”

Tariffs, Growth and Inflation 

Signs of decelerating U.S. economic growth, even before the tariffs, are evident, yet inflation remains “sticky,” hovering above the Fed’s 2% target. The introduction of tariffs adds a layer of complexity. This dual pressure raises the specter of stagflation—a scenario where growth slows but inflation persists—posing a near-term challenge for policymakers and bond investors.

The White House’s commitment to its policy agenda underscores that macroeconomic uncertainty will likely persist. This disrupts the traditional playbook for predicting economic and market outcomes, leaving both the Fed and investors in a reactive stance, heavily reliant on incoming data – or a change of heart from the administration.

The Fed’s Dilemma 

The current U.S. economic landscape is complicating the Fed’s monetary policy decisions as it grapples with whether inflation or economic slowdown poses the greater risk. Typically, one of these priorities dominates, allowing for a clear strategy. However, the current combination of slowing growth and stubborn inflation muddies the waters.

The futures markets reflect this uncertainty, pricing in a 100% chance of a rate cut at the June 18 meeting, suggesting a tilt toward prioritizing slower growth. Yet, the May 7 meeting is expected to maintain a wait-and-see posture.

Risks and the Stagflation Threat 

A key concern is the potential for a “mini stagflation” scenario. BCA Research’s Dhaval Joshi notes that the U.S. economy is supply-constrained—labor demand exceeds supply by 1.7 million workers, with unemployment at 4.2% below the 4.6% job vacancy rate. This dynamic reduces the likelihood of a demand-driven recession but supports the mini-stagflation risk. In such a case, the U.S. 10-year yield could remain range-bound between 3.50% and 5.00%, as investors balance safety with inflation-driven yield demands.

A more severe “supply-driven recession” remains possible if labor supply shrinks significantly, requiring a loss of over 2.6 million jobs annually, exceeding the 1.5% labor productivity growth rate. Should this materialize, the Fed might hesitate to cut interest rates, limiting bonds’ upside potential.

Outlook and Implications

Softer activity with cooling inflation would pave the way for the Fed to cut interest rates, forcing yields lower. Conversely, persistent inflation amid slower growth could stall rate reductions, pressuring bond prices as yields rise to compensate for inflation risk. The 10-year yield’s current price action reflects this tension.

For investors, bonds—especially longer-dated Treasuries and inflation-protected securities—offer refuge, but vigilance is key. Inflation surprises or sharper growth declines could shift the narrative. The Fed’s tightrope walk, compounded by policy unpredictability from the White House, suggests a bumpy ride ahead.