Monday Digest
Posted 14 April 2025
Ceasefire, not truce, in global trade war
Last week had eye-watering ups and downs. US bond yields spiked, prompting Donald Trump to pause his “reciprocal” tariffs for 90 days on all countries except China, which faces a whopping 145% – although somewhat lessened with the exceptions to smart phones and other electronics. Markets welcomed all tariff relief, but the overall average tariffs are still high. The dollar slid, despite higher yields, suggesting the US may no longer be a safe haven.
Trump eventually bowed to pressure from markets and his allies. This was mostly about the US bond selloff – which felt like Trump’s ‘Liz Truss moment. The Truss episode required Bank of England intervention in 2022, and the Federal Reserve may yet have to step in, considering yields haven’t fully recovered. In any case, it’s comforting that the bond vigilante remains powerful.
We will hope for some policy calm, but the Trump show must go on. This weekend sees high stakes negotiations with Iran, and Trump has threatened force if they fail. We must watch this space. The 90-day tariff reprieve could also obstruct tax cuts, as tariff revenues were supposed to fund them. If Trump pushes ahead anyway, a second ‘Donald Truss’ moment could ensue in bonds.
After Trump’s capitulation, investment banks are divided on whether a US recession is coming this year. Even with smart phone exceptions the 145% Chinese tariff means huge disruption to global trade and can seriously hurt both the world’s largest economies. The current Q1 earnings season has started well, but markets’ focus is all on what happens from here. We could actually see a short-term consumption boost if Americans rush to buy in the 90-day window, but that wouldn’t change the fundamentally weaker outlook. Companies’ forward guidance statements are therefore important.
It’s a challenging environment for equities – with weaker growth prospects and more risk-averse markets. Washington stepping back from the brink is positive, but businesses and investors will be wary of putting their money to work. That likely means lower trading volumes and choppy price action.
US exceptionalism has a credit problem
Trump’s obsession with ‘fixing’ the US trade deficit causes such allergic reaction in US markets, in part because the trade deficit is to some extent why so much global investment flows toward the US. The dollars Americans spend on imports often return to buy US capital assets – considered the world’s strongest and safest. Part of that reputation is the “exorbitant privilege” of owning the world’s reserve currency, and part of it is the America’s track record for profit growth. That has led to a tremendously negative Net International Investment Position (NIIP), the amount of US assets owned by foreigners. The capital flow into the US markets has benefitted asset valuations, and hence US companies.
Some call this a virtuous cycle, but the NIIP isn’t all rosy. Assets are supported by continual flows, which you might cynically call a Ponzi scheme. Even disregarding cynicism, it means a big chunk of US profits go to foreign stockholders rather than Americans. Trump has even called this a national security concern, with regards to Chinese ownership.
Cutting trade deficits stops the flow of dollars out – but that also means reducing American consumption, which has been the lynchpin of US growth. Profits become less exceptional and so valuations fall.
This adjustment has been made worse by Trump’s chaotic execution. Investors started panicking that high US valuations were built on sand. This was initially a problem for equities and the dollar, but last week the panic spread to bond markets – a sign that the trade war had uncovered landmines in global finance. There is now a risk that the dollar loses its reserve status. This is still unlikely, but it gets more likely the worse the policy outlook (and markets’ reaction) gets.
Central banks have already been swapping dollars for gold since Russia’s SWIFT exit. If Trump is not careful, he might get the weaker dollar he wishes for.
Anatomy of a bond rout
Spiking government bond yields last week felt like Donald Trump’s ‘Liz Truss moment’. The equity selloff after “Liberation Day” originally pushed bond yields down, as global growth prospects dwindled, but that suddenly reversed last week. China was rumoured to have started the bond selling, but it snowballed due to leveraged traders (hedge funds) selling bonds to cover their equity losses. The problem in US bonds spread to the closely correlated UK market – while European yields reacted more mildly.
People call government bonds “risk free” but we have two important measures of their risk: the spread between long and short-term yields (term premium spread) and the spread between government yields and interbank swap rates (the swap spread). These measures have been worsening for a while.
If we think central banks will print money for their governments in a pinch, then higher swap spreads make bonds look cheap. Hedge funds have been able to make money off this spread, but last week’s yield spike wiped out the differential and forced them to close their positions – including one highly leveraged Japanese fund that reportedly went bust. This short squeeze on yields doesn’t show weakness in the bonds themselves, but rather that overleveraged hedge funds didn’t have enough cash to meet margin calls. That’s the same problem UK pension funds had during the Liz Truss fiasco.
The end result is that bonds look cheap – particularly in the UK, where the spike seemed to purely be a reaction to the US. You could argue US government debt has a “moron premium” right now, but that’s not the case for the UK, which has consistently displayed fiscal resolve and has funding options available. If we step back from the panic and stay level-headed, long-term UK bonds look like a buying opportunity. And when markets lose their heads, keeping yours often pays off.