Despite President Trump’s decision to place a 90-day pause on the introduction of “reciprocal” tariffs on all countries with the exception of China, the volatility of markets since his “liberation day” announcement and continuing uncertainty over what happens next have caused alarm in the global economy.
The plummeting value of US treasuries has unsettled investors and raised concerns that hedge funds, which have invested heavily in these bonds, might go bust, triggering financial problems at investment banks that have lent them huge amounts of cash. The fear is that bad debts could undermine the viability of some institutions, as occurred during the financial crisis of 2008.
In simple terms, US treasuries are IOUs issued by the American government in exchange for a loan. They are effectively documents from the US Treasury promising to give the holder a fixed amount of interest each year and pay back the balance in full at the end of the term. The IOU does not have to be kept until the date it matures, it can be sold to other investors, and its price in the open market changes daily depending on factors such as expectations of inflation.
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Scott Bessent, the US Treasury secretary, said that the US was negotiating with trading partners to reach deals
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Why is falling US treasuries value causing such concern?
Global investors are not used to seeing rapid changes in the value of US treasuries because the government has long been considered the most dependable institution in the world. But on Wednesday, as Trump escalated his trade war with China, the price fell sharply as large numbers of hedge funds started selling their holdings at the same time. Rapidly falling values discouraged global investors from buying new IOUs issued by the American government, raising concerns about whether the Trump administration would even be able to borrow enough to finance its ongoing operation.
Falling US treasury prices also means the cost of borrowing increases for the government, putting greater pressure on US public finances and taxpayers to service those debts. Also the interest rates on US treasuries have long been considered a benchmark against which all other interest rates are set — national and corporate — so if they rise it could mean higher borrowing costs for businesses and consumers around the world, triggering an economic downturn.
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Why do interest rates rise when the price of US treasuries falls?
The easiest way to understand is through an example. If someone lent the American government $1 million in exchange for the promise of a yearly payment of 5 per cent interest and the return of their cash in ten years’ time, it would be called a ten-year US Treasury note. The value of this note would initially be $1 million but if inflation rose, for example, eating away the real value of the money to be returned, investors in the open market would not be willing to pay as much. However, the note will always pay $50,000 interest a year so if someone bought the note for $500,000, the interest rate they receive would effectively be 10 per cent.
If this investor can receive 10 per cent on an old note then they are not going to want to buy a new one paying only 5 per cent so the government has to increase the interest rate it pays to tempt buyers, driving up its borrowing costs.
Values of stocks and bonds fell sharply across US exchanges before the hold was placed on tariffs
YUKI IWAMURA/AP
Why were so many hedge funds selling US treasuries?
This is where things get really complicated. One of the main ways that many hedge funds have chosen to make money in recent years is known as the “basis trade”, which is a strategy to make money from small price differences between US Treasury futures — effectively contracts that promise to buy or sell the government IOUs at a set price in the future — and the actual US Treasury price.
These two asset types are usually priced similarly because they are tied to the same thing — government debt. However, a small gap sometimes appears between them. Hedge funds try to profit from this gap by selling the asset with the more expensive price and buying the cheaper one. However, the profit margins are tiny meaning decent money can only be made if they do this in huge volumes.
To enable this, they borrow cash from investment banks, which will assess the trade and agree to lend a multiple of the amount the hedge fund deposits. The multiples offered depend on the perceived risk of the trade and the desire of the bank to make money but can be up to $100 for every £1 deposited.
In effect, the hedge fund is making a huge bet with very little cash and when US treasuries prices are stable, the risk is low. However, in recent days, the price has fluctuated wildly, making banks nervous that their clients may be losing large amounts of money. To mitigate this risk, the banks started asking these clients to deposit more cash with them, a process known as a “margin call”.
The only way hedge funds can usually afford to front up the extra money is to unwind their trades or in effect, sell the US treasuries they have bought. On Wednesday, multiple banks made several margin calls on their hedge fund clients, forcing them all to unwind their positions at the same time, causing the price to slump.
How near did we come to financial contagion and collapse?
That is hard to know, but the situation was sufficiently serious for Trump to pause his tariffs policy. City insiders say that while the day was stressful, the unwinding of the basis trade was generally orderly. So far no hedge funds have gone bust so the situation seems to have been contained.
How can this have been allowed to happen?
One City insider said that banks and regulators are usually very good at mitigating the risks of the last significant problem they faced but not very good at anticipating new ones. In short, no one saw this coming. The banks also make good money lending to hedge funds, which tends to drive the amount of cash they are prepared to lend ever higher to win business.
There is also an incentive for a bank’s staff to underestimate the risk of a client’s trading strategy because then they can lend more cash and make greater profits. Questions are already being asked about whether there should be tighter rules about the amount investment banks can lend hedge funds.
US stock prices crashed after Trump announced tariffs on almost all countries
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So what happens now?
The bond markets have effectively given Trump a bloody nose in the same way they did to Liz Truss after her disastrous mini budget. Governments can ignore stock price fluctuations but they cannot afford to ignore bond market volatility because it directly affects the cost of borrowing, their ability to raise money and financial security.
While Trump suggested his decision to announce a 90-day pause to tariffs was a strategy to isolate China, it seems he was forced to make the move to stop a potentially disastrous unravelling of the global financial system. The bond market’s tantrum probably means the president now has a less powerful hand when negotiating tariffs with other countries because they will know he needs to cut a deal to maintain financial stability. There will no doubt still be brinkmanship on all sides but Trump may now have to be more reasonable.