A week on from ‘Liberation Day’, Trump’s tariffs have not landed well in the financial markets, especially with a tit-for-tat trade war now breaking out between the US and China. That much is obvious. But there is still a lot to unpick.
The simplest place to start is the stock markets. The US S&P 500 had lost 12% of its value in just four days by the close on Tuesday, driven mainly by worries about the impact of a trade war on the US and global economy. European equities slumped by similar amounts, including in the UK, with bigger falls in Asia and in the smaller emerging markets hit hardest by the new tariffs.
This is not necessarily a good reason to panic. These declines may still be temporary, and, in the meantime, most investors are still only suffering losses on paper. Indeed, the latest fall in the S&P 500 has only taken the US market back to where it was last summer, before valuations in the tech sector began to look really silly. If you had bought US (or global) equities at almost any point in the last few years you would still be well ahead.
Nonetheless, these falls cannot be dismissed lightly. The stock market remains an important barometer of sentiment towards the real economy, which is clearly fragile. The latest headlines alone will also undermine the confidence of businesses and consumers, adding to the downside risks to growth.
Moreover, the fact that most equity indices are still near historic highs could also be interpreted to mean that they still have a lot further to fall. We might just be in the early stage of an almighty crash (though I do not expect this to happen just yet).
The adverse reaction in the stock markets is at least relatively straightforward and predictable. The swings in the bond markets are more difficult to explain.
The impact of a trade war on US Treasury yields could have gone either way, depending mainly on whether the markets put more weight on the downside risks to global growth or the upside risks to US inflation. In the event, yields initially fell, driven also by ‘safe haven’ flows out of riskier assets including equities.
Some Trump fans have also argued (rather heroically) that the additional revenue from tariffs will transform the outlook for the US public finances, reducing the government’s cost of borrowing. Among other things, this ignores the reality that most of the economic burden of higher US tariffs will be borne by US taxpayers.
But Treasury yields have since rebounded anyway, dragging the cost of borrowing higher again in the UK and the rest of Europe too. This is despite the fact that the markets are now expecting central banks to cut official interest rates more aggressively. So, what’s going on?
Again, some context is helpful. The yields on US government bonds are still close to the middle of their ranges over the past year, albeit with some unusual volatility.
The main reason for the latest jump in Treasury yields appears to be forced sales of US government bonds to cover losses elsewhere. This includes margin calls on equities, but also what are known as ‘basis trades’, where funds take large leveraged positions to arbitrage small differences in prices between cash Treasuries and futures.
The latter has similarities with the LDI crisis in the wake of the UK mini-Budget in September 2022, when the Bank of England had to intervene to buy gilts and stabilise the market. The US is not there yet, but some limited intervention by the Fed is possible too. If so, Treasury yields could quickly fall back again.
There is also plenty of speculation that the sell-off in the Treasury market reflects a shortage of foreign buyers, and even active selling by China – the second largest foreign holder of Treasury securities, after Japan.
To be clear, there is no hard evidence to support this speculation. China’s holdings of about $760 billion also still represent only a small proportion of the total stock of US government debt, which is about $36,000bn (of which about $29,000bn is traded on open markets and the rest held by other parts of the government). Indeed, the UK is still the largest foreign holder of US securities overall.
In addition, China has already been diversifying out of US assets for some time, including into gold. Accelerating this process could just create bigger losses on the rest of the country’s bond portfolio.
Of course, the speculation alone is a helpful weapon for China in a trade war, as well as another way in which Trump’s tariffs could backfire on the US. Given the close correlation between Treasury and gilt yields, any further sell-off in US government bonds would add to the collateral damage to the UK too.
However, if the trade war does trigger a global recession (again, not yet my base case), yields on government bonds should still fall sharply, especially if central banks do then cut official rates aggressively. This in turn will provide at least some protection in a diversified portfolio.
The upshot is that it is too soon to draw any firm conclusions from the recent gyrations in either equities or bonds. The swings in the US Treasury market are adding to global uncertainty, but if recession fears are proved right, global bond yields should still fall sharply. And in the meantime, the best investment advice is probably just to continue to ride this one out.
Click here to subscribe to our daily briefing – the best pieces from CapX and across the web.
CapX depends on the generosity of its readers. If you value what we do, please consider making a donation.
