US Bond Market Turmoil Sparks Fears of Financial Crisis
The recent turmoil in the US bond market has sparked fears of a potential financial crisis, with some market analysts warning that the situation could be more precarious than it appears. According to a report in the Financial Times, US Treasury Secretary Scott Bessent attempted to calm investor nerves last weekend, stating that most Americans with a 401(k) retirement plan were only down 5-6 per cent on the year. However, his reassurances did little to alleviate concerns about the bond market’s sudden and unexpected decline.
Typically, when equity prices fall, bond prices rise, as investors seek safe-haven assets. However, this has not been the case in recent days, with bond prices plummeting alongside equity prices. This double whammy has only been seen previously during the Covid-19 panic, and it has left many market analysts scratching their heads. As Larry McDonald, a market analyst, noted, "during stock market crashes in 2008, 2001, 1997 or 1987, bond prices rose."
The reasons behind this unusual market movement are multifaceted. One possibility is that investors are worrying about rising inflation due to tariffs imposed during the ongoing trade war between the US and China. Another explanation is that some investment funds are dumping their most liquid assets to meet margin calls. However, a more ominous explanation is that hedge funds are being forced to unwind their so-called "basis trades", which involve making leveraged bets on the convergence between the futures price and the bond price.
According to Torsten Slok of Apollo private capital group, these trades have exploded in recent years, with some estimates suggesting they are worth $1tn. The International Monetary Fund (IMF) recently estimated that these trades are a significant part of the $2tn outstanding in prime brokerage balances. As bond markets tumble, it seems likely that some funds are being forced to unwind trades, creating a whiplash effect similar to the one seen in 2020.
The situation is further complicated by the risk that the US-China trade war turns into a capital war, prompting Beijing to run from dollar assets. This week, the Chinese government let the renminbi weaken against the dollar, raising the prospect of currency wars. As the head of FX research at Deutsche Bank noted, "Beware a trade war shift to a financial war." This has led some market luminaries, such as Ray Dalio, the founder of Bridgewater, to issue dire warnings about America’s surging debt and putative future default risks.
Ed Yardeni, a macro strategist, has warned clients that the Trump administration is now "playing with liquid nitro" with Treasuries. While it remains to be seen whether the Federal Reserve will intervene to calm the markets, or whether Trump’s announcement of a 90-day pause on reciprocal tariffs will have the desired effect, one thing is certain: the bond market’s turmoil has raised the stakes and highlighted the fragility of the current financial system. As the Financial Times reports, "maybe Bessent’s soothing words can calm investors down… but until then, Yardeni’s analogy is correct; we could be sliding towards a financial crisis."
The turmoil in the bond market has also raised questions about the potential for a financial crisis. The market’s reaction to the recent Treasury auction was particularly telling, with poor demand leading to a sharp decline in bond prices. This has led some to speculate that the market may be pricing in a putative debt swap or quasi-restructuring. While the White House insists that such scenarios are ridiculous, traders know that when Trump was "just" a businessman, he repeatedly defaulted on his own debt.
In conclusion, the bond market’s sudden and unexpected decline has raised more questions than answers. As the Financial Times notes, "the bond vigilantes still rule the roost". With the US-China trade war showing no signs of abating, and the risk of a capital war rising, market analysts will be keeping a close eye on the situation in the coming days and weeks.
The publication Financial Times quotes macro strategist Ed Yardeni saying that there is a risk that Trump’s team are now “playing with liquid nitro” with Treasuries.
