Mid-week market update: Is this Donald Trump’s Liz Truss Moment? In the fall of 2022, UK prime minister passed a series of unfunded tax cuts. The bond market rebelled and sold off hard, especially in the long end of the yield curve. The massive sell-off forced a number of “hedged” pension funds into technical insolvency, which eventually led to the political downfall of the prime minister.
Here is where we stand today. The 10-year Treasury yield and other long yields have spiked. The MOVE Index, which is the VIX of the bond market, is up sharply. The yield curve is has marginally recovered from inversion, but nevertheless indicates tight monetary conditions. The trade war factor, which measures the performance of stocks with domestic revenues relative to the S&P 500, has surged.
Even as investors fret about how tariffs are affecting the stock market, the real action is in the bond market.
Bond market tantrum
As investors focused on the dramatic bearish reversal in stock prices in gains yesterday, a more important development was happening in the tanking Treasury market. It’s unusual to see both bond and stock prices falling at the same time during periods of market stress. An equally anomalous development was the weakness in the USD.
The combination of these events sparked stories that the Chinese were retaliating by selling their Treasury holdings. A glance at the accompanying chart dispels that rumour. If the Chinese were selling the holdings in size, where would the funds go? If it stayed in USD, we would have seen buying pressure in other asset classes, such as Agencies, or stocks. If it was repatriated, the yuan would have appreciated instead of experiencing a minor depreciation. The chart shows the price of the 10-year Treasury note in different currencies. If there was an unknown seller engaging in forced selling and repatriation, it would be in the euro or the Yen. The greatest sign of possible repatriation flow was the Swiss Franc. I suppose that it’s possible that the Chinese were selling their Treasury holdings and converting the funds into Swiss Francs, but highly unlikely. The price of the 10-year note in Chinese yuan (bottom panel) barely budged, and outperformed the price in USD (top panel). So much for the Chinese repatriation story.
Torsten Sløk at Apollo believes that the bond market tantrum can be traced to an unwinding of the basis trade.
In the basis trade, hedge funds put on leveraged bets, sometimes up to 100 times, with the goal of profiting from the convergence between the futures price and the bond price, as the futures contract approaches expiry.
How big is the basis trade? It is currently around $800 billion and an important part of the $2 trillion outstanding in prime brokerage balances. It will continue to expand as US government debt levels continue to grow, see charts below.
Why is this a problem? Because the cash-futures basis trade is a potential source of instability. In case of an exogenous shock, the highly leveraged long positions in cash Treasury securities by hedge funds are at risk of being rapidly unwound. Such an unwind would have to be absorbed, in the short run, by a broker-dealer that itself is capital-constrained. This could lead to a significant disruption in market functions of broker-dealer firms, such as providing liquidity to the secondary market for Treasuries and intermediating the market for repo borrowing and lending. For example, during Covid, the Fed was at the peak buying $100 billion in Treasuries every day.
In case of an exogenous shock, the highly leveraged long positions in cash Treasury securities by hedge funds are at risk of being rapidly unwound. Such an unwind would have to be absorbed, in the short run, by a broker-dealer that itself is capital-constrained. The
Financial Times reported that “Hedge funds have been liquidating US Treasury basis trades furiously,” according to one fund manager.
This could lead to a significant disruption in market functions of broker-dealer firms, such as providing liquidity to the secondary market for Treasuries and intermediating the market for repo borrowing and lending. We are now seeing a stampede for the exits in the bond market, though it’s unclear what’s causing the stampede. It is nevertheless suspicious that the latest downdraft in Treasury prices began last Friday when China retaliatory tariffs in the after hours. Equally puzzling is the upward pressure on non-U.S. bond rates, such as gilts, Canadas, and JGBs. Is it Chinese selling, non-Chinese foreign selling as evidenced by USD weakness, or just a “sell everything” hedge fund unwind?
Investors can only observe the effects: “Banks are selling Treasury holdings to raise cash and adding swaps contracts to maintain exposure to interest rates, leading to a record low spread between swap rates and Treasury yields in the 30-year maturity” – “30-year SOFR spreads closing in on an almost unimaginable -100 bps. That’s enough to raise some concern about Treasury liquidity and the hoarding of bank balance sheet access…hardly the sort of thing that potential borrowers need right now”
The Bank of England (BoE) has warned that hedge funds are facing substantial margin calls from prime brokers due to extreme market volatility triggered by U.S. President Donald Trump’s tariff announcements, and cautioned that the risk of further sharp market corrections remains high. The BoE’s Financial Policy Committee, after reviewing the situation, found that the hedge funds have been able to meet these margin calls for now.
Fortunately, the 10-year Treasury auction went well today. This was a moment when the Fed Put could have come into play. This seize-up of the banking system’s plumbing is the sort of situation where the Fed could credibly step in in the name of financial stability. While it wouldn’t cut interest rates, it can flood the banking system with liquidity by buying long-dated Treasuries, either on a hedged (by selling futures) or unhedged basis, in order to stabilize financial markets, much in the manner of the Fed intervention during the COVID Crash “dash for trash” episode.
Regardless of what caused the Treasury market’s risk-off stampede, the long-question remains. If Trump reduces the trade deficit, which leaves foreigners have fewer USDs in their hands. Where will the buyers of Treasury’s issuance come from, in light of America’s large deficits? Does that mean bond yields rise, which pushes up the cost of capital for companies using USD financing and reduce the competitive advantage of U.S. companies?
This latest episode is a lesson from the bond market shows how this could have been Trump’s Liz Truss moment. The bond market rebels, and financial systems shake. Was Trump’s announcement of the 90-day pause in reciprocal tariffs and a temporary reduction of the tariff rate to 10% for all countries except China his way of blinking in the face of the bond market’s pressure?
Washed-out Stocks
Meanwhile, the stock market looks washed out. Many of my indicators show that the margin liquidation stampeded from last week has run its course. Different indicators of the price momentum (fast money) to high quality (patient money) factor responses have stabilized.
The same can be said of the big macro rotation trades. The price momentum unwind within the U.S., and the U.S. tech to China internet and U.S. to European financial rotation trades have all normalized.
Global rotation is now trendless. The stampeded out of U.S. equities is over.
The total put/call ratio showed a continued elevated reading yesterday, indicating high levels of fear. More importantly, both the equity-only put/call ratio, which is an indirect indicator of retail sentiment as individual investors tend to trade individual stocks, and the index put/call ratio, which is more reflective of institutional activity which uses index options to hedge positions, are high, which indicates fear.
The stock market is washed-out and poised for a rally. The failure to weaken prices further on today’s news of Chinese and EU tariff retaliation is a constructive development. It just needed some positive news. Trump’s announcement today seems to have been the spark.
Keep in mind, however, that this is just the end of the first phase, which I call the escalation phase. Next comes the ups and downs of the negotiation phase. Tactically, the short-term S&P 500 upside target is the 50% retracement of 5400. Secondary resistance can be found at the next Fibonacci retracement of 564-/
My inner trader continues to be (painfully) long the S&P 500. The usual disclaimers apply to my trading positions.
I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account. Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.
Disclosure: Long SPXL
The question still remains: is this an administration driven by logic or emotions of the few?
Jamie Dimon, the godfather of Wall St, visited Trump Tue night which prompted Trump’s pause. People in the know already tried to frontrun at the TUE market open, but it failed with a very large 6% reversal. They made it back on Wed session. The Dimon visit was because of hedge fund margin calls. VIX/MOVE usually is the most common VaR criteria and is usually self-reinforcing. Bond dealer roll is much thinner after GFC because of new Congress legislation. Dimon thinks the disorder might get too big and morph into another crisis. The current dealers are mostly big banks which have raised a lot of cash for loan loss provision back in 2022 to prepare for a recession that never came. So they have since reduced the reserve until Trump’s tariff move. Now they are raising it up again to prepare for potentially another recession such that they don’t want to absorb too many bonds. For once hedgies saved equity markets even when they were killed.
Coming up next is, according to many participants, to at least get to 61.8%, aka 565 spy, and consolidate and retake 200DMA. History says staying above 61.8% would have higher chance to move up and above 200DMA is self-explanatory. Let’s see what happens during these highly uncertain times.
It could have been his Bill Clinton moment — “”You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?”” — but of course, Trump isn’t really seeking re-election. And he may still think he can push the Fed around.
I would say it wasn’t Trump’s Liz Truss moment, because LT was damaged goods after that, while Trump still thinks he has options. I think the true Liz Truss moment will happen when $TNX rises to 6% or whereabouts, or if the budget passes as currently planned, with massive unfunded tax cuts.
It would be wonderful to have a line to the collective bond market vigilante psyche, to understand at what point they’ll go for the kill.