Are bond market technicals better than price action suggests?

Looking at the sharp moves in government bond markets in recent days, one would be forgiven for thinking we are seeing some level of forced selling that is pushing valuations lower.

It is certainly likely that some market players, especially hedge funds, could have been stopped out on positions in rates. Many yield curve “steepener” trades, which gain when long end yields rise faster than short end yields, may have gone wrong. Similarly, there has been some evidence that the “basis trade” so popular with hedge funds in recent years has run out of steam and is contributing to reduced demand for US Treasuries (USTs). In this trade, the funds arbitrage the small price differences buying USTs and selling futures contracts on USTs of the same maturity. However, due to changes in regulation, banks have been able to achieve better economics on this trade, pushing out the demand from hedge funds, which were the second biggest buyers of USTs between 2022 and 2025, according to data from Bloomberg and the Federal Reserve.

However, we see several indicators across fixed income markets that suggest the technical picture behind the price action so far has been relatively orderly, or at a minimum less likely driven by stress, and mostly reflecting a repricing of interest rate expectations given the renewed pressure on oil prices and energy costs more widely. Higher yields are also likely to bring new buyers to the space.

This does not make the sell-off any less painful from a total return perspective for those carrying too much duration, but it should give investors some comfort that this is not being driven by a broader, forced liquidation of positions, as was the case during the UK Gilt sell-off in October 2022 or the US Treasury (UST) sell-off in April 2025 in response to tariffs.

First, swap spreads remain calm. To recap, swap spreads measure the difference between the fixed rate on an interest rate swap and the yield of a government bond of the same maturity. Essentially, swap spreads capture all the other factors that determine government bond valuations outside the market’s interest rate expectations, such as anticipated supply of the government bonds in question and credit risk (the chance of the issuing government defaulting). In other words, sharp moves in swap spreads can indicate severe market stress.

During the 2022 Gilt sell-off, for example, 30-year Gilt swap spreads dropped by around 25 basis points (bp), while amid the tariff-driven turmoil of April 2025, 30-year UST swap spreads fell by around 20bp. In Europe, 30-year Bund swap spreads dropped 10bp after Germany surprised the market with its fiscal reform package in early 2025.

We are not observing the same dynamic here, be it for Gilts, USTs or Bunds (see Exhibit 1). This is reassuring because it indicates that the repricing in yields is driven mostly by expectations of higher interest rates (the accuracy of which are up for debate), which are in turn influenced by higher oil prices.

Second, the credit market is showing little sign of investors rushing into risk-off mode. If we look at the iTraxx Crossover index (Xover), a widely-used proxy for default risk in the European high yield bond market, it is not showing the kind of risk-off move that accompanied the onset of the US-Iran war earlier in the year or the tariff-induced sell-off last year.

The “skew” of the index (shown in Exhibit 2) shows where the index is trading relative to its constituents. Because investors tend to use the Xover index to buy broader protection against their cash positions in individual companies, a positive skew suggests demand for this protection is high or rising (a negative skew is the opposite and suggests investors are confident in the performance of individual credits). The Xover skew is currently marginally positive, but well below the level it reached in those previous periods of stress.

Third, fixed income fund flows do not show a rush for the exits. We have seen a marginal uptick of outflows from euro investment grade funds in recent weeks, but net flows for USD IG funds have been stable. We are also seeing a different composition of buyers, likely driven by higher yields. Fixed maturity funds and insurance firms in particular are on the front foot. Looking ahead, with higher yields, insurers will find it much easier to sell annuities, which offer fixed payouts over the specific life of the investment product. While the surge in government bond yields may see some rotation of insurance allocations out of credit and into rates, strong sales of annuities should drive a strong insurance bid for fixed income in general, further supported by the dynamic of aging societies and the natural need for retirement products.

Overall, we would not minimise the pain that has been felt in total return terms for those carrying too much duration into the sell-off. However, it is worth recognising that the technical picture behind the price action has been relatively orderly, and we think a lot of information has been absorbed by government bonds here as higher interest rates have priced in, while some material hedge fund positions have likely been closed out. Indeed, breakevens have increased significantly; with five-year USTs now trading around 5.06%, for example, they would need to rise to 6.25% for holders to make a negative return in the next 12 months. Equity markets meanwhile have been more stable, which would naturally point to more downside in that pocket of the market.

Despite the orderly moves, there remains a concern that when government bond yields rise aggressively, something in financial markets can break, as it did for liability-driven investment (LDI) funds in the Gilt sell-off of late 2022. However, in that case, 10-year Gilts rose by over 250bp in the space of a month, which included a 100bp move in just three days, and the driver was very clearly a loss of confidence in the government, accentuated by highly leveraged positions in LDI vehicles. This is not the case currently – government bond yields currently appear virtually 100% correlated to oil prices – but this doesn’t make the environment a whole lot more comfortable.