Let’s attribute this to the bond vigilantes.
This term is often used to characterize investors who react to what they see as irresponsible fiscal or monetary policies by selling government bonds, which subsequently drives up yields or implied borrowing costs.
In the aftermath of Donald Trump’s introduction of tariffs on global trade, the market focus in the past week has primarily revolved around the disastrous stock market response.
This was something that was previously believed to be taken seriously by Mr. Trump.
During his initial term in office, the president viewed the performance of U.S. equities—specifically the S&P 500—as a gauge of his administration’s success.
Donald Trump in the Oval Office today. Pic: Reuters
Over the past week, he dismissed the dismal equity market response to his tariffs as merely “medicine” that needed to be taken to amend what he viewed as detrimental global trade imbalances.
Nevertheless, as is often the case, it has been the bond markets that have compelled Mr. Trump to reconsider – and make no mistake, he has indeed reconsidered.
Initially, after the introduction of his tariffs—defended by dubious mathematics and a spurious equation complete with Greek symbols—bond prices surged as equities fell.
This is not unusual: significant equity market declines, like those seen in 1987 and 2008, are typically paired with bonds rallying.
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What it’s like on the New York stock exchange floor
However, the events of this week have been starkly different, with equities persisting in their decline and US government bonds following suit.
At the start of the week, the yields on 10-year US Treasury bonds, typically regarded as the safest investments, stood at 4.00%.
By early yesterday, these yields had surged to 4.51%, a significant increase by most investors’ standards. This development is crucial.
The 10-year yield influences interest rates on a variety of financial products vital to the average American, including mortgages, car loans, and credit card borrowing.
As a result of raising the yield on such securities, bond investors were acting in accordance with their strategies. It is not an exaggeration to compare this situation to what Liz Truss and Kwasi Kwarteng encountered when the latter introduced his mini-budget in October 2022.
Similar to the aftermath of that incident, the sharp reaction in the bond market was driven by forced selling.
Much of the selling seems to stem from a widespread assumption among investors that Mr. Trump’s tariffs would significantly increase inflation in the U.S. economy—which is anathema to all bond investors.
Additionally, the U.S. Treasury experienced the weakest demand in nearly 18 months for $58 billion worth of three-year bonds that it attempted to sell on Tuesday.
However, the primary motivation behind this selling appears to be investors, particularly hedge funds, unwinding what are termed ‘basis trades.’ In simplified terms, this strategy aims to capitalize on the price difference between a bond trading at, say, $100 and a futures contract for that same bond priced at, say, $105.
Under normal circumstances, a hedge fund would purchase the bond at $100 and sell the futures contract at $105, anticipating a profit as the two prices converge in what typically represents a low-risk transaction.
This trade is often perceived as so risk-free that hedge funds will use leverage—borrowing heavily—to maximize returns.
The abrupt and forceful decline in U.S. Treasuries this week demonstrated that hedge funds were compelled to close these positions by selling Treasuries.
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Trump freezes tariffs at 10% – except China
Faced with the looming threat of increased borrowing costs for millions of American homeowners, consumers, and businesses, the White House has decided to scale back its tariffs, a wise decision.
This shift received immediate rewards with a vigorous rally in equity markets—the Nasdaq experienced its second-best day ever, achieving its best performance since 2001, while the S&P 500 recorded its third-best session since World War II—and a surge in U.S. Treasuries.
The influential Wall Street bank Goldman Sachs subsequently reduced its prediction of the likelihood of a U.S. recession this year from 65% to 45%.
Yet, Mr. Trump is unlikely to concede that he has stepped back, instead claiming last night that some investors were “a little bit yippy, a little bit afraid.”
And it is entirely plausible that the markets may experience more turbulent days ahead: the prospect of Mr. Trump’s tariffs being reinstated in 90 days still looms, and a full-blown trade war between the U.S. and China is actively unfolding.
However, Mr. Trump has indeed retreated. The bond vigilantes have managed to bring him to heel. This president, who, through his assertive use of emergency executive powers, appeared to possess more authority than his predecessors, will never seem quite so powerful again.
