Bond-market convulsions look extremely dangerous

Of all the lines that could have rebounded, this might be the worst. During Asian trading hours on April 9th the yield on ten-year American Treasuries leapt to 4.5% (see chart), with 30-year bonds rising even higher. Early on April 7th the ten-year yield had been just 3.9%. Such yields normally fall when share prices plunge and panic is in the air, since they move inversely to bond prices and investors usually flock to the safety of America’s government debt in times of anxiety. Now stockmarkets are in freefall and yields have jumped anyway.

It is the most worrying sign of financial distress yet—and there have been plenty. Traders are paying soaring premiums to protect themselves against volatility, businesses are facing increasingly bad terms on borrowing and a dash for cash has sent the gold price down. Spiking Treasury yields are even more ominous, since they drag up other borrowing costs with them. In short, they are not just a symptom of market stress—they are a cause of more to come.

The precedents are deeply uncomfortable. The last time the Treasury market seized up was during market convulsions that accompanied the onset of the covid-19 pandemic. Back then, heavy trading led to liquidity drying up, meaning that the difference between “buy” and “sell” offers widened sharply. Those trades that could take place moved prices far more than they normally would have done. Eventually the Federal Reserve had to buy large quantities of bonds to stabilise the market.

“Swap spreads” suggest something similarly alarming is happening today. These measure the difference between Treasury yields and interest-rate swap rates, which are the average of the overnight rates traders expect. The two usually move together, since an alternative to buying a Treasury bond and receiving its fixed yield is to deposit money in the overnight market and earn a rolling interest rate there instead. But yields on ten-year Treasuries are now a record-breaking 0.6 percentage points higher than the rate on equivalent swaps. Whether that is down to a lack of liquidity, nervousness about Treasuries or some combination of the two is anyone’s guess. Whatever the reason, the growing gap suggests that usual customers are reluctant to buy, given the enormous uncertainty haunting markets, says Martin Whetton of Westpac, an Australian bank.

Fire-sales might be exacerbating the damage. Wall Street banks have hit their hedge-fund clients with the steepest margin calls since 2020, meaning they must stump up cash to cover their lossmaking positions across asset classes. Government bonds are among the easiest assets to sell to raise the necessary funds (as is gold). In 2022 British pension funds rapidly offloaded holdings of gilts to meet such margin calls, sending prices down and yields up even faster.

Today a doom loop could arise from the “basis trade” that is popular with hedge funds. The trade, which has minted fortunes at some of America’s largest hedge funds, attempts to profit from the difference in price between Treasury bonds and Treasury futures contracts. This small discrepancy arises because of high demand for the futures from asset managers; traders take advantage by buying Treasuries and selling such contracts. Leverage is obtained by lending Treasury bonds in repo markets, and then recycling the cash received into even more Treasuries. One imperfect measure for the size of the basis trade is the notional value of short positions taken by funds, which currently sits at around $1trn. For as long as the cost of borrowing and margin requirements are lower than the difference between Treasury bonds and futures, the trade is profitable—with ample leverage, it can be immensely so.

But “it is like picking up nickels in front of a steam roller”, bristles one hedge-fund manager. Funds can easily get squashed in a dislocation, either because they are unable to roll over their short-term funding or to meet margin requirements required by their short position in futures markets. When the bet is unwound, perhaps because yields have moved sharply and unexpectedly, they are forced to sell Treasuries quickly—compounding the selling to meet margin calls in other asset classes. In 2020 dealer banks were overwhelmed by the volume of Treasuries being sold and liquidity dried up. Something similar seems to be happening today. Before Donald Trump’s tariffs the inventories of banks were already stocked full of Treasuries, giving them little capacity to handle more selling. Whereas the Fed stopped the bleeding in 2020 by buying huge quantities of government debt, doing so might be harder today, as central banks are attempting to shrink their balance-sheets.

So much for threats from within the financial system. The bond market’s moves also reflect economics and politics. Few doubt that Mr Trump’s tariffs will whack economic growth, both in America and elsewhere, which is why share prices have fallen so much. Market participants and consumers alike expect that price rises on Main Street will worsen. Such stagflation—a  nasty combination of inflation and stagnant growth—would put the Federal Reserve in a bind. Officials would be unable to cut rates as much as they might like to stimulate the economy. Fears of hawkish central bankers and runaway inflation both send Treasury yields up, whatever else investors are worried about.

More worryingly, on a fundamental level, Mr Trump’s assault on global trade has dented confidence in American policymaking. It is only natural for investors to conclude that the country’s sovereign debt has become less safe. Similar jitters apply to its currency. The shift in sentiment was underlined by analysts at Goldman Sachs, a bank and American mascot, in a note published on April 8th. By putting both consumers and corporate profits at risk, they argue, the new trade restrictions could “crack the central pillar of the strong dollar”. Sure enough it has weakened amid the market turbulence. These are nervous times for investors, policymakers and just about every American. ■

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