The Calm Before the Storm: Navigating U.S. Treasury Liquidity Risks in a Volatile Tariff Landscape

The U.S. Treasury market has entered a period of unusual calm, with the MOVE Index—a key gauge of Treasury volatility—dropping to a three-year low of 90.3 in June 2025, down sharply from its April peak of 140. This tranquility contrasts starkly with escalating trade tensions and the erosion of historical market relationships, creating a paradox that demands careful scrutiny. Investors must now confront the question: Is the Treasury market's serenity a sign of stability, or a harbinger of systemic risk?

The Illusion of Stability: Treasury Volatility at a Crossroads

While the MOVE Index reflects reduced near-term volatility, the underlying drivers of uncertainty—such as tariff-driven inflation and geopolitical conflicts—have not diminished. The Federal Reserve's cautious stance on rate cuts and the dis-inversion of the yield curve (10-year Treasury yield now 51 basis points above the 2-year) suggest markets are pricing in a less recession-prone outlook. However, this calm masks deeper structural risks.

Breakdown of Historical Correlations

The stock-bond inverse relationship—a cornerstone of portfolio diversification—is fraying. During the April 2025 tariff announcement, stocks and bonds fell simultaneously, a rare occurrence that shattered the traditional hedge provided by Treasuries. This breakdown signals that macro risks (e.g., trade wars, fiscal deficits) now impact both asset classes in sync, eroding the benefits of diversification.

The correlation turned positively correlated in Q2 2025, reflecting shared sensitivity to policy uncertainty. This shift underscores a systemic vulnerability: investors can no longer rely on bonds to offset equity losses during crises.

Liquidity Risks in the Treasury Market

Despite low volatility, liquidity conditions are deteriorating. The Treasury market's trading volume has thinned, particularly in off-peak hours, raising concerns about its ability to absorb large trades without price dislocations. While current liquidity remains “orderly,” the risk of a sudden spike in volatility—driven by a tariff escalation or Fed policy misstep—could trigger a liquidity crunch.

A widening bid-ask spread and smaller average trade sizes since early 2025 highlight growing fragmentation. In a stress scenario, these factors could amplify price swings, disadvantaging investors holding long-dated Treasuries.

The Case for Reducing Duration Exposure

Long-duration Treasury bonds—sensitive to rising rates—are particularly vulnerable. The yield curve's steepness (10-year yield at 4.23% vs. 2-year at 3.72%) implies expectations of higher long-term rates, which could further compress bond prices. With the Fed's policy path uncertain and fiscal deficits expanding, the risk of a “term premium shock” (a sudden demand for higher compensation for long-dated risk) looms large.

Investors should shorten duration by favoring intermediate-term Treasuries (e.g., 5-year notes) over long-dated maturities. Shorter durations reduce interest rate sensitivity and offer better liquidity in stressed markets.

Hedging Fiscal Stress with Inflation-Linked Securities

The erosion of correlations and rising fiscal risks favor inflation-linked bonds such as TIPS. Tariff-driven inflation could outpace expectations, and the Treasury's reliance on debt issuance to fund deficits may pressure real yields downward. TIPS offer protection against both inflation and nominal yield increases, making them a safer haven than traditional Treasuries.

In Q1 2025, TIPS outperformed nominal bonds by 120 basis points when inflation expectations surged, illustrating their defensive role.

Conclusion: Prepare for the Unseen Storm

The Treasury market's calm is a tactical reprieve, not a strategic victory. With liquidity risks mounting and correlations breaking down, investors must prioritize resilience over yield. Reduce duration exposure, favor inflation hedges, and maintain flexibility to pivot as trade tensions evolve. In a world where volatility can resurge overnight, preparedness is the only sure strategy.

The next leg of the market's journey may prove less forgiving. Stay vigilant.