The past week in the U.S. Treasury market was a reminder of the power and influence of bond markets, as well as the potential consequences of unpredictable policy decisions.
In a week that felt like a financial thriller, the U.S. Treasury market, a cornerstone of the global financial system, experienced a dramatic selloff. This was sparked by President Donald Trump's announcement of hefty tariffs on several countries, only to hit the brakes on these duties a week later.
What happened next was a big mess in the Treasury market, which is essential because that's where governments get loans, and it's worth a whopping $29 trillion. Investors were biting their nails. After everything calmed down, Trump said the bond market was "beautiful" . But what really went on during that crazy week?
Well, people started selling their U.S. government bonds like hotcakes, which made it more expensive for the government to borrow money. The interest rate for a 10-year loan soared, the most it's gone up in more than ten years, before it came back down a little.
Source: MarketScreener
This market is a big deal because it affects everyone. If the government has to pay more to borrow money, then regular folks might see higher rates on things like home loans. For example, the rate for a 30-year mortgage is connected to the 10-year government bonds, which went up sharply. Companies that want to borrow money found it more expensive too. Even other countries such as Britain and France felt the pinch because their borrowing costs went up.
During this sell-off, hedge funds and the likes had to quickly get rid of their risky bets. Even though Trump's advisors said everything was under control, there were signs that things were a bit shaky. Before Trump changed his mind on tariffs, it was getting harder to buy and sell bonds without losing money, bid-ask spreads widened significantly, indicating market strain. Some compared this week's events to the March 2020 "dash-for-cash," when a Treasury market crash prompted a massive Federal Reserve intervention.
The return of bond vigilantes
The current selloff has been exacerbated by the unwinding of the "basis trade," a hedge fund strategy involving cash and futures Treasury positions. It consists of taking advantage of the price differences between bonds and financial contracts linked to these same bonds, by borrowing massively to amplify the gains. But as these strategies rely on a very large leverage effect, they become dangerous when the market becomes unstable: if prices move too fast, these funds have to sell urgently, which amplifies the shocks. This strategy, closely monitored by regulators, can reduce banks' ability to provide liquidity.
There were also rumors that China might start selling its U.S. bonds, but we wouldn't see that in the numbers right away. China has a huge pile of U.S. debt, only second to Japan.
Some experts said the bond vigilantes were back in action, keeping their reputation as the tough guys of the financial world. The term "bond vigilantes," coined in the 1980s, describes investors who enforce fiscal discipline on governments by raising borrowing costs. This week, the term resurfaced as the bond market selloff was seen as a response to erratic policymaking. Yardeni Research quipped, "The Bond Vigilantes have struck again," noting their unblemished track record in U.S. markets.
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