Attributing this to the bond vigilantes is appropriate.
This term is used to describe investors who react to what they perceive as irresponsible fiscal or monetary policies by selling government bonds, which in turn raises yields, or implied borrowing costs.
In the aftermath of Donald Trump’s imposition of tariffs on other countries, the focus in the past week has largely been on the negative stock market response.
Previously, this was something that was taken seriously by Mr Trump.
During his first term in the White House, the president viewed the strength of US equities, particularly the S&P 500, as a reflection of the success or failure of his administration.
Donald Trump in the Oval Office today. Pic: Reuters
Despite brushing off the negative stock market reaction to his tariffs as necessary “medicine” to correct what he viewed as harmful trade imbalances worldwide, it’s the bond markets that ultimately forced Mr Trump to reconsider his stance.
Following the imposition of his tariffs, bond prices initially rose as equities plummeted, a common occurrence during significant equity sell-offs like those in 1987 and 2008.
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What it’s like on the New York stock exchange floor
However, this week saw a different scenario, with equities continuing to decline and US government bonds following suit.
At the start of the week, yields on 10-year US Treasury bonds, considered the safest investments, were at 4.00%.
By yesterday, they had risen to 4.51%, a significant increase from the perspective of most investors. This rise is crucial.
The 10-year yield impacts the interest rates on various financial products important to everyday Americans, such as mortgages, car loans, and credit card borrowing.
By pushing up the yield on these securities, bond investors were asserting their influence. The reactions in bonds mirrored what Liz Truss and Kwasi Kwarteng encountered during the unveiling of the mini-budget in October 2022.
Similar to that event, the dramatic bond market reaction was a result of forced selling.
Some of the selling seems to stem from investors predicting, reasonably, that Mr Trump’s tariffs would introduce inflation into the US economy – a concern for all bond investors.
Additionally, weak demand for $58bn in three-year bonds that the US Treasury attempted to sell on Tuesday contributed to the selling.
However, the primary reason for the selling appears to be investors, particularly hedge funds, unwinding ‘basis trades’ – a strategy to profit from the price difference between a bond at $100 and a futures contract for the same bond at $105.
Under normal circumstances, a hedge fund might purchase the bond at $100, sell the futures contract at $105, and profit when the two prices converge, in what is typically considered a low-risk trade.
So low-risk, in fact, that hedge funds often leverage themselves to maximize potential returns.
The sharp decline in US Treasuries this week reflects hedge funds having to close these trades by selling Treasuries.
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Trump freezes tariffs at 10% – except China
Faced with a potential rise in borrowing costs for millions of Americans, the White House has decided to scale back its tariffs, a wise move.
This decision was met with a remarkable rally in equity markets – the Nasdaq had its second-best day ever, and its best since 2001, while the S&P 500 experienced its third-best session since World War Two – along with an uptick in US Treasuries.
The influential Wall Street investment bank Goldman Sachs promptly reduced its forecast of a US recession likelihood this year from 65% to 45%.
Despite this, Mr Trump refuses to acknowledge he has backed down, suggesting last night that some investors were simply “a little bit yippy, a little bit afraid”.
While the markets may face more volatility in the future, the threat of Mr Trump reinstating his tariffs in 90 days remains, and a full-fledged trade war between the US and China is ongoing.
Nonetheless, Mr Trump has yielded. The bond vigilantes have compelled him to reassess his position. This president, once seen as wielding more power than his predecessors due to his aggressive use of emergency executive powers, may never appear as dominant again.