Since last Wednesday, the day before Trump decided to nuke the entire global economy to hell with his tariffs, the S&P 500 has fallen over 11 percent, which is a technical correction in less than a week. It had already fallen ten percent to its pre-tariff lows, and now it is around 20 percent off this year’s high, a definitional bear market. This all unfolded over the course of a little less than two months, and as much as the stock market plunge has roiled the markets, the bond market selloff is even scarier. Bonds are a much bigger market than stocks, and the yields on US Treasuries are literally called risk-free, as they are a core part of pricing everything in finance.
The ten-year Treasury Note is the cornerstone of global finance. Banks, countries and hedge funds have established entire business models around loaning the US government cash and getting paid back plus interest over ten years. It’s near impossible to say any one financial instrument is more important than the rest, but if there is any single one that is, it’s the ten-year Treasury Note.
And its yield is flying right now. After plunging over ten percent through the end of March as recessionary fears finally came into focus, its yield has been up only this week, rising as much as 16 percent to its peak last night in just a few days. When Treasury yields spike, that means people are selling bonds. If they’re buying them, yields go down. The reasons why people buy and sell bonds are complex, but ultimately inflation is a key aspect of any bond analysis. There is a crystal-clear duration trade happening in bonds right now, but that doesn’t mean duration is the primary reason for the selloff.
Duration is a simple concept, as changes in inflation can alter the return you make from a bond. Shorter term bonds are better at pricing in near-term inflation expectations, but long-term bonds like the ten-year are much more vulnerable to changes in inflation. You don’t want to buy a bond and then watch some jackass slap 104 percent tariffs on China as inflation rises and cuts into your overall returns for the next ten years.
So if you expect inflation to rise, that’s duration risk, and you sell long-term bonds that will be hit harder by a rise in inflation, and that seems to be the concern as long term bond yields are rising faster than short term bond yields right now. Typically, bond sales are reinvested elsewhere in a more efficient asset, but the continued rise in the ten-year yield alongside all other long-term bonds suggests that there are not many buyers right now for long-term US debt at these prices.
But I would not bet on duration risk being the main reason behind the bond selloff, as all markets everywhere are exhibiting a risk-off sentiment as investors flee to cash. Uncertainty is the macro environment all this operates in, as evidenced by indicators like the University of Michigan consumer sentiment survey plunging to historically recessionary levels before Trump was sworn in and deteriorating since. When people are uncertain, they get defensive. Selling any asset for cash is defensive. It is clear as day that Wall Street did not properly price in Trump’s tariffs, per J.P. Morgan and Goldman Sachs’ own admission back in February, and they are only now just beginning to do so by increasing their cash position while decreasing their risk exposure. Duration risk is just one part of the larger Trump clusterfuck the markets are currently digesting.
But if it was just duration risk fueling the bond market selloff, we would not see junk bond spreads widening at March 2020 levels. The fears over the extreme bond market moves are rooted in lessons learned from 2008. Hedge funds are the largest buyers of bonds, as they run a leveraged trade off of them. Banks are effectively leveraged entities too as they buy treasuries and then loan money based off the financial picture painted by their bond portfolio. When Lehman Brothers collapsed in 2008, it started a daisy chain of defaults where the debt they owed to say, Merrill Lynch, could not be paid, which affected the debt Merrill Lynch owed to Goldman Sachs, etc…
The concern is that hedge funds right now are dumping bonds en masse, and not buying them back, suggesting strongly that they are unwinding their leverage. You don’t unwind leverage if you have a rosy outlook of the future, quite the opposite. As Warren Buffett’s partner Charlie Munger famously said, “smart men go broke three ways – liquor, ladies and leverage.” Buffett joked that “the truth is, the first two he just added because they started with ‘L’ – it’s leverage.”
Liquidity is king in markets and leverage restricts liquidity. You lock up your dollars in an asset like a ten-year Treasury Note, and then you take out loans on the value of that asset to buy more assets, further restricting how much cash you have on hand, especially since you have to make debt payments on leverage. Leverage makes everyone look like a genius when markets are going up because you can compound your returns, but it is a classic example of the phrase “stairs up, elevator down.” Crypto is maybe the clearest example of how leverage influences a market, as the wild price swings happen in part when Bitcoin’s price hits a magic number that liquidates a lot of loans at once and creates an army of forced sellers (on the flip side, Bitcoin rises aggressively because people take out loans on their Bitcoin that is rising in value to buy more Bitcoin).
The short story of 2008 is that it was like crypto in that an army of forced sellers emerged, but those forced sellers were major banks selling safe assets like bonds in the trillions because they desperately needed to raise cash. That is the fear again today, that the leverage that Wall Street runs on is deteriorating as firms try to get out ahead of becoming forced sellers. Trump is pleading with the market to “be cool” this morning, further demonstrating how spooked everyone is by this massive bond selloff.
The ten-year Treasury Note has been moving all over the place ever since Trump announced his tariff regime where he fucked up his own stupid math that doesn’t make sense. That movement alone is bad news. Volatility is for stocks and options, not bonds. Wild swings in the bond market have a way of taking out hugely leveraged positions and creating forced sellers, and when that happens, that’s typically when the shit actually hits the fan. There are a lot of debt-based indicators out there are telling us we are approaching genuine crisis territory, and the classic phrase that cash is trash is actually the opposite of how firms operate in times of extreme uncertainty. This is a broader flight to cash across all asset markets, because the logical conclusion of Trump’s trade war is the collapse of the global economy.
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