Last week, US Treasury yields rose significantly; the 10-year 50 basis points, and the 2-year 31 basis points. While not unprecedented amounts (the 2-year moved this much over 5 business days last October, and the 10-year in 2022), what is nearly unheard of is that it did it in a week with negative economic data and stable inflation expectations. The only other time something like this has happened was the 9-day period between 3/9/2020 and 3/18/2020 during the pandemic.

The Lantern Daily Economic Index (LDEI, a real-time measure of the totality of economic data), fell a large 17.5 points last week from falling confidence in the NFIB small business and University of Michigan consumer surveys as well as falling rates of inflation in the consumer and producer inflation reports (CPI and PPI). Outside of 5-year inflation expectations rising in the University of Michigan survey on Friday (which is the outlier versus other measures), market-based inflation expectations were nearly unchanged.

There was positive news mid-week from President Trump’s 90-day pause of tariffs which temporarily stabilized the stock market but most other things worsened through the week. As of Friday, Trump thought he fixed the problem because the stock market has been ok. On Air Force One from Washington to Mar-a-Lago on Friday, Trump was asked about the bond market [video],

Reporter: What about the bond market right now? The 10-year is…

Trump: I think the bond market is going good. It had a little moment, but I solved that problem very quickly. I’m very good at that stuff, you know I solved it very quickly. I didn’t know I solved it that well, but we had the biggest day in history [referring to the stock market].

But, consider the following five market elements showing financial system strain which generally finished at their worst levels on Friday. These will be important to monitor going forward.

1. Dollar/yield divergence. For most of the last two years, the dollar has largely represented the level of US interest rates; the 10-year Treasury yield. This all changed last week from Tuesday as the 10-year yield made a sharp divergence from the dollar.

2. U.S. sovereign credit default swap rates (protection against the U.S. defaulting on its debt) rose substantially last week and worsened after Trump’s 90-day tariff pause.

3. SOFR swap spreads to Treasuries have fallen dramatically across the yield curve. SOFR swaps are expectations for average Fed Funds over different terms (i.e., 1yr, 2yr, 3yr….30yr). Unlike interest rate swaps before Libor was retired in 2023, SOFR swaps don’t have a credit spread because the SOFR rate they reference to is secured against Treasuries versus Libor which was an unsecured rate. This means that the difference between SOFR swap rates and Treasuries for the same term mostly represent the preference of Treasuries versus the outlook for Fed Funds; a version of term premium. This is an inverse relationship, the more these spreads are negative, the higher the term premium. Some outlets have suggested this spread is falling from idiosyncratic reasons like the collapse of a hedge fund trade expecting Treasuries to become less regulatorily burdened from a new Fed Vice-chair for Supervision (Bowman) or is evidence of the basis trade unwinding, but I think these descriptions are too narrow.

It isn’t just SOFR swap rates showing this behavior, it is SOFR futures too which are predictions of where SOFR (think Fed Funds) will be at fixed dates in the future (not averages like the swaps). The SOFR futures market is huge. The number of contracts outstanding (open interest) of the first 8 quarterly SOFR futures, which cover the period of the 2-year US Treasury, represent $187.7mm of Dv01 (dollar value of a basis point). The sum of all 24 2-year Treasury note issues outstanding have a smaller $157.3mm of Dv01, meaning that SOFR futures are the short-term interest rate market, not an arcane corner. When US credit risk comes into play, SOFR futures better reflect the outlook for inflation and growth than Treasury yields do.

For instance, the SOFR futures strip that I own (a little shorter than the 2-year) rose 21 basis points last week compared to the 2-year rising 31 basis points. The strip 3-months longer, which is a fairer comparison to the 2-year, rose 26 basis points. That 5-basis point difference between 26 and 31 for the 2-year represents the same effect as is being discussed in swap spreads, a preference away from Treasuries—the 2-year swap spread fell a very similar 3 basis points last week. It isn’t that SOFR rates are too low as implied from the idiosyncratic descriptions, it is that Treasury yields are too high and it isn’t a particular trade causing this, it is a broad and wide aversion to Treasuries which implies that cash is needed over Treasuries.

4. Bid/offer spreads for the 30-year US Treasury show worsening liquidity conditions.

But, they aren’t as high as what caused the Fed to intervene in 2020 during the pandemic.

5. The basis trade is being associated with the Treasury movement last week, but it didn’t show any weakness (net basis higher) until Wednesday and isn’t as bad as it got to in the similar period in March 2020.

Here are the takeaways:

1. Markets are showing serious problems, particularly in the dollar and SOFR swap spreads to Treasuries.
2. The problems are bigger than hedge fund trades. The basis trade, while en vogue to talk about after the Brookings paper suggesting its risks at the end of March, isn’t really a point of stress, at least yet.
3. The 90-day tariff pause on 3/9 didn’t help much, most things shown above closed at their worst levels on Friday.
4. Things aren’t as bad as they were before the Fed’s 3/15/2020 “bazooka” during the pandemic.

And so, I don’t see the Fed intervening because so far, this is mostly a US credit risk problem, not a broader credit or global problem. For instance, corporate high yield spreads were lower by 9 basis points last week and municipal spreads to Treasuries mostly recovered in the latter half of the week. Although I can’t see exactly what will cause this to turn around, I don’t expect this episode to last long because the Treasury market divorcing from its fundamentals can’t be allowed to continue. The Treasury department, for one, can’t let this go on for too long and expect for big buyers to stay committed— a big appeal of Treasuries is that they reflect their fundamentals. The Fed can’t let this continue too long lest the problem spreads.

As far as the economy, the Fed effectively tightened policy last week with rates rising a lot outside of any economic or inflation heat. This adds negative pressure on the economy right when it can least take it. I expect the Fed to soften their resolve to hold rates just as soon as the labor market starts to weaken. Weakening labor implies less inflation from the Phillips curve.  Challenger layoffs and contracting employment components of the ISM surveys two weeks ago show this isn’t far away. Despite the large adjustment, the trend of Treasury yields (and future SOFR rates) is lower as the economy weakens in the process approaching a recession.