15-05-2025
Donald Trump's economic agenda could irritate the money market into catastrophe
There are few signs the global financial system is on the brink of collapse… except for one key indicator.
The bond market is flashing red.
It's easy to get lost in the confusion and chaos of Donald Trump's economic agenda, but there's one consistent thread you can follow.
Part of Trump's plan to make America great again is to lower the US budget deficit and thereby reduce foreign debt.
This frees the world's biggest economy to spend big again, without the debt that comes with it.
But this relies on finding new, significant, steady streams of income.
Enter: reciprocal tariffs.
The bond market, however, is proving a key barrier to their successful implementation.
And if Trump's economic agenda continues to irritate the money market, the result could be catastrophic for the global economy.
A few major economic events transpired in early April.
Trump announced reciprocal tariffs on about 90 countries, including China and the European Union.
The size and scope of the tariffs surprised financial markets. Share markets across the globe crashed due to fears the tariff hikes would ground trade, generate inflation and produce a produce a global recession.
Crucially though, the bond market, from April 7, began to dive.
Hedge funds — firms that make money from often complex trades — found themselves in a spot of bother.
They had been making money by profiting from the difference between bond market futures and the spot or cash market.
It's dubbed the "basis trade".
Think buying apples cheaply from the kids' lemonade stand down the road and selling them at the big grocery store up the road, and pocketing the difference.
It's called arbitrage.
Hedge funds employing the popular "basis trade" strategy found themselves forced sellers in early April as soaring volatility and tightening financing conditions rattled markets.
The trade had become so well-known and the margins so thin, these hedge funds had borrowed hundreds of billions of dollars to magnify what would otherwise be small profits.
It caused a huge bond sell-off and the yields or interest rates on those bonds then spiked.
Bond prices move in the opposite direction to yields.
It was all too much for the US president. He framed it the other way around, suggesting the markets got a bit "yippy" or anxious. He began winding back his tariff rhetoric, explaining "deals" were on the way and reassuring financial markets it'd all be ok.
Financial market volatility remained as various "deals" were made public, including with the UK, but the latest talks with China seemed to be a game changer.
The world's two biggest economies agreed to pause their big, threatened tariffs for 90-days, leaving a 30 per cent tariff on Chinese goods entering the US.
Financial markets loved it. It was a massive relief for them and provided some much-needed certainty, at least for the short-term.
But — and that's a big "but" — like the game of whack-a-mole, it's produced another problem: US Treasury bond yields are climbing again.
That's because investors are selling bonds and using the cash to buy stocks, with a renewed sense of optimism about the future.
"The two markets often seem to look at different things and that's the case right now — US shares are celebrating the tariff backdown and bonds are starting to worry more about the US budget deficit with maybe still concerns about US economic policy and its safe haven status," AMP's head of investment strategy Shane Oliver said.
"The deficit is now a bigger problem because the tax package is coming into view and tariff revenue and DOGE spending savings look like being smaller.
"I suspect that the renewed rise in the bond yield could become more of a problem for shares, especially with shares now overbought after their huge rebound.
"US exceptionalism looks to be back — well, maybe temporarily — for US shares, especially technology shares, but maybe not bonds!"
And here's the key point.
Earlier in April the unwinding of the bond market related to fears the US government was losing fiscal credibility.
It saw a highly unusual environment where both shares and bonds were sold off.
"What we had was bond yields rising at the same time that equity prices were falling," Barrenjoey chief interest rate strategist Andrew Lilley said.
"So the problem wasn't increasing bond yields per say. The problem was that is an indication that everybody is very pessimistic about the economy — so pessimistic that bonds are no longer even a safe haven," he said.
This time around bond yields and longer-term interest rates are rising because investors are gaining more confidence in the economic outlook.
The problem is that, in the current highly volatile financial environment, the return to attractive US debt could cause further global economic shock waves, said Jamieson Coote Bonds co-founder Angus Coote.
"I think anything over 5 per cent [for US 10-year US Treasury yields] becomes problematic for not necessarily US government — it will always be able to finance itself. That's the privilege that they have with that.
"But I think the problem is more ... mortgages and stock markets and infrastructure, everything else that's passed off that 10-year [bond return].
"The [10-year US Treasury bond] — if that's getting above 5 per cent," and it's 4.5 per cent, "then that's a very high hurdle for investments to be compared against."
In other words, why would you gamble with a stock market return of, say, 7 per cent when the US government in guaranteeing a return of 5 per cent?
"So I think if we see a 50-basis point (0.5 percentage point) sell off from here, you're going to start to see some rumblings," Coote said.
By "rumblings", Coote is referring to similar financial markets turbulence we saw in April.
"I think they're probably looking at those 10-year US Treasury bond yields and if they get to 4.7 per cent, you start seeing people buy bonds and selling equities," he said.
"So ... if it keeps creeping up, it's not good for the US economy [because] mortgage rates, financing costs, all that stuff goes up."
This is because interest rates in the US, and indeed the world-over, are priced off the US 10-year government risk free bond rate.
"That 10-year bond is the most important asset on the face of the planet, I think," Coote said.
"It [can't] go too hard one way. So you'd be looking at mortgages at 7 per cent. It's expensive and so it slows the economy down."
So, for now, financial markets are cautiously optimistic.
But one of Australia's biggest investment banks, Barrenjoey, is concerned something sinister is lurking in the dark corners of the global economy.
"So the only thing that investors are really concerned with at the moment is ... we're looking at data in a rear vision mirror of about two months and in the last two months we've had a mass panic over a cataclysmic global event," Andrew Lilley said.
"Are we going to see a decline in the economic data that might push the US into a very short and sharp recession? That's the thing that we're still concerned with because sometimes that becomes reflexive.
"Sometimes if there's a slowdown that's large enough, even if everybody thought it would only be temporary, you can start to trigger all these other issues.
"That means that the recession can start feeding on itself."
This financial market turbulence thing? It ain't over.
