Treasury demand has been gradually shifting away from price-insensitive investors, such as the Fed and foreign sovereigns, towards much more price-sensitive buyers, such as mutual funds, ETFs and hedge funds.
For several decades, global investors have looked to US Treasuries as a safe haven in times of stress. When rising recession risks have rocked stock markets, Treasuries have often rallied in anticipation of Federal Reserve (Fed) rate cuts, providing diversified portfolios with a crucial buffer to offset equity losses.
The sharp selloff in the US bond market witnessed in early April is therefore worthy of examination. Not only did US 10-year Treasuries experience their worst week in almost 25 years, but the move took place in a period when equities were also coming under pressure.
Dissecting the drivers behind rising Treasury yields
The Republican administration’s trade policy is clearly adding to US inflation risks, but it appears that economic fundamentals were not the biggest driver of the April selloff. Over the course of April, medium-term US inflation expectations are relatively unchanged, and actually fell in the first two weeks of the month while Treasury yields rose. In addition, changes in the shape of the US yield curve highlight that there was more at play than simply shifting rate expectations. Two-year Treasury yields did rise by just over 25 basis points (bps) from trough to peak in the first half of April, but this move was dwarfed by the 45 bp rise in both 10 and 30-year yields.
While there is some evidence of a slowdown in foreign demand for US Treasuries, claims that the short-term move in yields may have been driven by mass sales from foreign investors as a form of tariff-related retaliation are more difficult to justify. First one must consider the currency implications of such a tactic. Given that Treasuries are generally held by foreign governments for currency management purposes (rather than financial gain), a decision to sell large amounts of US bonds would require a foreign government to be willing to tolerate significant currency appreciation, which is unlikely in an environment of rising trade frictions. For foreign institutional investors, the requirement to book large mark-to-market losses for US Treasury positions that are still underwater following the 2022 selloff may be another constraint. Treasury holdings data is admittedly opaque, but we note that for China in particular, their official share of the US Treasury market had already fallen from a peak of 9.1% in 2011 to 2.1% at the end of last year.
Shifts in market functioning
Instead, we must consider how changes in the way the US Treasury market functions have removed some of the buffers that have traditionally helped to suppress bond volatility.
The shift in the composition of Treasury investors witnessed over the past decade is one key aspect. Treasury demand has been gradually shifting away from price-insensitive investors, such as the Fed and foreign sovereigns, towards much more price-sensitive buyers, such as mutual funds, ETFs and hedge funds. This pullback from foreign buyers has accelerated recently, with rising yields in markets such as Germany and Japan making US Treasuries less attractive when hedged back to local currency.
When this change in ownership is combined with elevated, and expanding, government deficits, it’s arguably no surprise that bond investors are demanding more compensation for risk. One such measure of this compensation is known as the “term premium”, which bottomed in March 2020 and recently hit its highest level since 2014.
Against this backdrop, primary dealers – who act as market makers in US Treasuries – have found themselves under increasing pressure to absorb excess supply. As Treasury issuance has surged in recent years to fund ballooning government deficits, dealer balance sheets have become increasingly bloated. With leverage ratios constraining the amount of Treasuries that banks are willing to hold, dealers’ ability to play their normal role in balancing out demand and supply has become more constrained.
Combined, these structural shifts leave Treasury markets more vulnerable to short, sharp selloffs going forward. To explain April’s weakness specifically, however, we must also consider the catalysts that combined with this overarching fragility.
Equity volatility stemming from the tariff announcements on 2 April is likely a major culprit. Leveraged investors will often hold a pool of high-quality assets (such as US Treasuries), which can be quickly converted into cash if required to meet margin calls when equity markets fall. This dynamic also helps to explain why the U-turn on tariffs announced on 9 April helped to subsequently stabilise the bond market, given how the sharp rebound in stock markets will have reduced the pressure on equity investors to raise margin.
As US Treasury yields started to rise, hedge fund deleveraging likely amplified the move. Sharp swings in interest rate swap markets suggest that a popular hedge fund strategy trading swaps against cash Treasuries may have been one source of selling pressure. This is different to the “basis trade”, which sees hedge funds selling futures to asset managers and buying cash Treasuries to hedge their exposure, with the hedge funds making a profit from the slight difference in valuations between cash bonds and futures.
Can the Fed act as a firebreaker?
When US bond markets last saw such a squeeze in March 2020, the Fed stepped in to buy huge volumes of US Treasuries to restore market functioning. Unlike today, however, this intervention came at a time when inflation risks pointed to the downside, and therefore the Fed’s actions were consistent with its broader desire to boost economic growth given low inflation.
In many ways, the Bank of England’s actions in September 2022 provide a more appropriate comparison to the situation today. When a major shift in fiscal policy triggered a fire sale of UK Gilts by domestic pension funds, the Bank of England was forced to temporarily intervene in Gilt markets to backstop liquidity, while at the same time guiding towards a tighter path of policy ahead.
The Fed is right to be wary of being perceived to be making political choices, particularly at a time when the administration has been increasingly critical of the current approach to monetary policy. While this hesitancy may result in a Fed that is slower to act than normal, we still believe that the Fed would ultimately intervene to stabilise bond yields if a further rapid surge in yields and the associated decline in bond market liquidity posed a material threat to the financial system.
Short-term volatility, but medium-term diversification
In conclusion, structural shifts in the functioning of the US Treasury market are likely to make US government bonds more vulnerable to short-term episodes of volatility going forward. Price-sensitive buyers are demanding more compensation for risk, and capacity constraints are limiting the ability of primary dealers to play their usual role in absorbing excess supply. When combined with a catalyst such as April’s equity volatility, the risk of short-term episodes where stocks and bonds fall in tandem is clear.
Crucially, however, we still believe that fundamental factors, such as the outlook for growth, inflation and Fed policy, are more important drivers of bond yields over the medium term. The market is currently pricing around 110 bps of Fed rate cuts over the next 12 months, which compares to an average of 200-300 bps of cuts in a typical recession scenario. If a deep recession sees the downside risks to growth overwhelm the upside risks to inflation, we believe that core fixed income would still act as the best hedge against further equity downside over a one-year horizon.
We see three ways for bond investors to approach this complex backdrop. First, diversify globally. Government bonds in developed markets such as the UK, where fiscal mistakes have already been made, appear less vulnerable to policy missteps going forward. Second, consider currency exposure very carefully. The US dollar is a much less reliable diversifier when US policy is the source of the economic shock, leaving bond investors that are heavily allocated to unhedged US Treasuries doubly exposed. Finally, active duration management will be critical. More volatile bond markets require more nimble curve positioning, but if recession becomes the dominant concern, investors will benefit from the ability to rapidly ramp up interest rate risk.