Update Bonds - UST market vs US administration: Round 2
The de-escalation between the US and China in the ongoing trade war has allowed markets to move beyond the initial concerns sparked by the tariff announcements on ‘Liberation Day.’ For now, this relief persists as long as the pause on higher tariffs remains in place and negotiations with other countries proceed.
Reflecting on recent developments, it is now widely believed that the US Treasury market played a major role in the US administration’s decision to backtrack on its tariff policies. The combination of rapidly rising yields and a weakening currency, which threatened financial stability, may have forced them to reverse course. If the bond market indeed restrained the Trump administration, it might be called upon to do so once again - this time to prevent the US debt trajectory from spiralling out of control.
This week, Republicans have been working hard to progress US President Donald Trump’s big tax and spending package. This bill includes an extension of the 2017 Tax Cuts and Jobs Act. It also includes several of Trump’s campaign promises, such as a tax exemption for tips and overtime pay. This package is set to further increase the budget deficit. It comes at a time when there is widespread consensus that the US debt trajectory is already unsustainable in the long run, even without the additional impact of this bill.
A warning signal from Moody’s, a credit agency, emerged last week when it lowered its credit rating on the US from Aaa to Aa1. However, both Trump and Treasury Secretary Scott Bessent were quick to dismiss the rating agency as lagging indicators. While it is true that credit ratings have good predictive power regarding the probability of default, they often change slowly over time. Typically, these ratings lag behind news updates and financial markets. Nevertheless, we consider it concerning that this warning seems to be ignored, as the message is that debt is on an unsustainable trajectory.
If the plans for the fiscal largesse move ahead there is a risk that yields could spiral out of control, as bond investors would start to demand much higher yields. Indeed, we have seen the US Treasury curve bear steepening, which means that the yields on long-term US government bonds are rising faster than those on short-term bonds, substantially this week. This development is a warning signal to the Trump administration. This move accelerated following a disappointing 20-year UST auction on Wednesday.
We must wait and see how the bill progresses and observe how the bond market reacts. However, the risk of a new conflict between the Trump administration and the US Treasury market seems elevated. We see this as a reason to remain cautious on US Treasuries and all USD denominated bonds.