We have seen a great deal of commentary that the misbehavior of long-term interest rates was one of the main factors that prompted Trump to pivot.
No one knows for sure exactly what transpired in White House discussions, but the subject of long-term interest rates must have played an important role.
The administration may have expected some degree of stock market volatility following Liberation Day. This was obviously not desired but was presumably seen as a manageable short-term side effect.
But at least, if risk appetite declined and stocks fell, declining bond yields would make it easier to refinance the trillions of dollars of government bonds that will mature this year and beyond.
Instead, the opposite began to happen. Bond yields rose as selling pressure on Treasuries offset any safe haven buying.
What’s driving bond yields?
Forced selling from hedge funds involved in the basis trade appears to be one major reason.
The basis trade is a highly leveraged strategy in which fund managers buy Treasuries and sell related futures contracts. Losses in the strategy caused by the spike in volatility appear to have led to significant selling of Treasuries.
There has also been speculation that China has been dumping Treasuries to prevent its own currency from collapsing (by using the proceeds to buy yuan).
If China has indeed been selling Treasuries, it may also have other motivations, whether as a form of retaliation against the U.S. or perhaps even to raise funds to buy gold.
Another interpretation of the weakness in Treasuries is that U.S. government bonds are reacting negatively to the rising unpredictability of U.S. economic policy.
The thinking is that Treasuries are, at least for the moment, no longer seen by investors as offering the same degree of safety that has been historically attributed to them.
Damage control
Liberation Day may have been successful in terms of bringing other countries to the table. There currently appears to be overwhelming interest in renegotiating trade deals.
The problem now is that the shock to markets has taken on a life of its own. We are also now seeing signs of significant impacts on the real economy.
Consumer sentiment has rapidly deteriorated. As Americans watch their investment accounts decline, they are potentially going to change their behavior.
While it may be true that most American have relatively small exposure to the stock market or none at all, consumer spending is primarily driven by high income households.
Approximately 50% of all consumer spending is linked to households with incomes in the top 10%, according to Moody’s.
As the tariff dynamic plays out, we expect the administration to juggle to two competing goals.
On the one hand, they need to stick with the idea that the U.S. is prepared to impose stiff tariffs on countries that are unwilling to make meaningful modifications to trade practices that are harmful to U.S. exporters.
At the same time, they need to take steps to prevent financial contagion and give the market assurances that its tariff policies will not produce a catastrophic economic slowdown.
Seizing the moment
The Trump administration may have gotten more than it bargained for with its tariff strategy and now has to deal with a new set of financial market problems.
We expect the administration to continue to take steps to minimize these problems, like the recent exemption of electronic goods (even from China), which was announced on Friday night.
As the more acute problems associated with tariffs get sorted over time, investors have the opportunity to buy into high quality businesses at prices substantially lower than prior peaks.
Risk perceptions may be high right now—and they could stay high for some time.
Market conditions like these historically provide good (if not great) entry points for investors in stocks with strong long-term prospects.
In our high experience, high quality stocks are often the first to recover as volatility subsides and investors start feeling more comfortable about putting capital back into equity markets.
