Update Bonds: Financial (in)stability in the US Treasury market

Initially, safe haven flows pushed yields lower after Trump’s tariff announcements on ‘Liberation Day’. However, this week, as safe haven flows dried up, yields moved back up. On Wednesday, this increase was particularly noticeable in bonds with longer maturities.   This stress in the market risks financial instability. This was likely an important factor for Trump to reverse course and pause all ‘reciprocal’ tariffs beyond 10% for all countries except China. The fact that Trump stopped short of financial instability is a positive sign, eliminating some worst-case scenarios.

It’s probably a combination of factors that caused US Treasury yields to rise. These include a rebound from a sharp move down, together with fears of higher inflation.   There was also a negative sentiment shift, showing up in a weak auction of 3 year notes on Tuesday. Further, hedge funds were probably forced to unwind highly leveraged positions. Additionally, rumours of foreign selling circulated, as China could be selling US Treasuries in reaction to the escalating trade war.  This would mean that the risk of financial instability is not completely gone, but we note this is all still highly speculative.

Financial markets reacted positively to Trump pausing the ‘reciprocal’ tariffs. This resulted in credit spreads erasing some of their widening since ‘Liberation Day’. Bund yields moved up, and the long end of the curve (10 year and longer) came back to similar levels as before ‘Liberation Day’. Short term yields are still lower as somewhat more easing from the European Central Bank is now expected to a greater extent   than before. The Bund curve thus steepened further, a dynamic that we have seen since Germany’s U-turn on fiscal policy.

The macro backdrop looks a lot better following Trump’s U-turn on Wednesday. However, we still have a situation with an escalating US/China trade war and 10% baseline tariffs on all other countries. A growth slowdown is inevitable. On top of that, the risk of recession (or even stagflation in the US) cannot be ignored. Consequently, we prefer to see spreads rise further before closing our underweight stance on credit risk, and we keep our preference for high quality Euro bonds for now.