Open interest in short-dated Treasury futures contracts fell $80 billion over the past two weeks as the basis trade unwind accelerated. Two-year Treasury yields rose 6 basis points to 4.95 percent, marking a decisive shift away from the leverage-dependent arbitrage that had anchored short-end demand.
Rising overnight funding costs delivered the kill shot. The secured overnight financing rate (SOFR) has held above 5.30 percent for three consecutive weeks, compressing net interest margins for leveraged players to levels that no longer justify the trade. Persistent inflation data added to the pain, making long-duration hedges prohibitively expensive and rendering the carry trade untenable.
Institutional capital is rotating into the long end. The 10-year yield fell 4 basis points to 4.62 percent as demand for belly-of-the-curve duration increased. Pension funds and insurance companies—less reliant on leverage and motivated to extend duration to match liabilities—are accumulating high-quality fixed income at current yield levels. Some investors are layering in swaptions and other derivative strategies to express views on future rate movements without outright long bond exposure.
The two-to-10 year spread has compressed to negative 33 basis points, reflecting divergent expectations for near-term funding versus longer-term growth. Investment-grade corporate spreads have tightened 2 basis points as yield-starved allocators move down in credit quality. Municipal bonds also show the rotation: AAA-rated yields have dropped 3 basis points in the past week.
Mary Chen, head of fixed income strategy at BlackRock, said the market is "recalibrating for a higher cost of capital and persistent rate volatility." She added that "active duration and curve positioning is now paramount for generating alpha."
The Federal Open Market Committee's December 12-13 meeting will test whether this repositioning holds.
