Bond Market’s Turbulence
On April 2, Trump unexpectedly announced indiscriminate high “reciprocal tariffs,” triggering an unprecedented storm in the global financial markets. The global stock and bond markets suffered an epic bloodbath, with no one spared. U.S. stocks experienced their largest single-day drop since the onset of the COVID-19 pandemic in 2020, with the Dow Jones Industrial Average losing over $6 trillion in market value. The S&P 500 and Nasdaq indices fell more than 20% from their peak in December last year, entering a technical bear market. Asian stock markets, including Taiwan and Hong Kong, saw single-day declines exceeding 10%. The market capitalization of the seven major U.S. tech companies evaporated by over $2 trillion in just one week. Panic spread rapidly, and even U.S. Treasury bonds, which are typically seen as a safe haven, surprisingly lost their hedging function, with yields soaring and prices plummeting. The yields on 20-year and 30-year U.S. Treasury bonds briefly surpassed 5%, while the yield on the 10-year Treasury bond surged to 4.5%. Ultimately, this situation became a crucial factor in Trump’s decision to delay the implementation of the reciprocal tariff policy by 90 days.
Figure 1: US Treasury Benchmarks(10, 20 and 30Years)
Source：LSEG Workspace
The imposition of equivalent tariffs has a direct impact on the profits of multinational corporations, leading to a recession in the U.S. and global economies. The effects on the stock market are evident and understandable; however, why has the bond market also experienced such significant turmoil? How should bond market investors respond? Normally, when U.S. stocks experience a sharp decline due to unexpected negative news, market funds tend to seek safe-haven assets like U.S. Treasuries or the U.S. dollar. However, this time the situation is quite the opposite, resulting in a scenario where U.S. stocks, Treasuries, and the dollar all decline simultaneously, breaking the usual negative correlation among them. This phenomenon is primarily caused by the unusual sell-off of U.S. Treasuries and the butterfly effect of global deleveraging.
The Importance of U.S. Treasuries
U.S. Treasuries are an important financial tool for regulating the supply of funds in the U.S. capital market and are also one of the main assets in the foreign exchange reserves of various countries’ central banks. Currently, global central banks hold over $8.5 trillion in U.S. Treasuries, with Japan, China, and the UK being the largest creditors. Changes in U.S. Treasury yields have significant implications for countries, banks, corporations, and even consumer spending. An increase in Treasury yields will directly affect the borrowing costs for the American public, potentially leading to higher repayment amounts for various loans, which in turn could suppress consumption. Additionally, the borrowing costs for corporations will also rise, potentially having a negative impact on capital investments. Furthermore, U.S. banks hold a large amount of bonds, and a decline in Treasury prices will lead to increased paper losses, which could trigger credit risks and, in the worst-case scenario, even lead to bank failures.
More importantly, the United States has a budget deficit every year, and the national debt increases year by year. The U.S. government needs to pay a large amount of interest on the national debt each year, and this interest continues to rise. These payments come from the U.S. fiscal revenue. The U.S. government is living beyond its means, continuously borrowing to pay off old debts since 2001, leading to a vicious cycle in U.S. finances. The total national debt of the United States has now surpassed $36 trillion, which is more than 130% of its GDP. Annual interest payments amount to as much as $1.2 trillion, accounting for 4% of the U.S. GDP and nearly a quarter of federal fiscal revenue.
Abnormal sell-off of US government bonds
Regarding the recent abnormal sell-off of government bonds and the sharp rise in bond yields, one explanation is that the sudden plunge in global stock markets has led to turmoil in the financial markets. Professional investors, such as hedge funds, are selling government bonds to cover their losses, while also reducing their basis trades in U.S. Treasury futures and spot markets. Basis trading is a common arbitrage strategy used by hedge funds, where they simultaneously “buy” spot U.S. Treasuries and “sell” corresponding Treasury futures contracts, aiming to profit from the small yield spread between the two. However, most of these hedge funds operate with high leverage, borrowing large amounts of capital from banks or the repurchase market to purchase government bonds. Such high leverage poses no issues during stable market conditions, but when the market faces unusual negative shocks and volatility increases, lenders demand more collateral or may even refuse to lend, leading to a funding chain break. In such cases, these highly leveraged positions are forced to liquidate, effectively resulting in a reverse sell-off of government bonds, which causes yields to spike and leads to severe fluctuations in the bond market.
In addition, the market is concerned that the escalating trade conflict between the U.S. and China may lead China, which holds a large amount of U.S. Treasury bonds, to take action to sell them off, which would have a significant impact on the U.S. bond market. The Trump administration originally hoped to increase fiscal revenue through the tariff war, lower bond yields, and alleviate pressure on national debt. However, the trade tensions caused by reciprocal tariffs have led to a rise in risk aversion in global markets, resulting in funds not flowing into the U.S. bond market and the dollar as expected. Instead, due to increased uncertainty, there has been a sell-off of U.S. bonds, unexpectedly pushing yields higher, which indicates an increase in borrowing costs for both the government and businesses, further exacerbating fiscal pressure and creating a vicious cycle.
In the face of the severe volatility in the bond market, how should bond market investors respond? U.S. government bond funds or ETFs generally have a longer duration, making them more sensitive to changes in market interest rates. According to statistics from Lipper, as of April 10, in just a few trading days, the average performance of U.S. government bond funds or ETFs registered for sale in Taiwan has dropped by 5.3% since April, reflecting the volatility risk of soaring long-term bond yields. Future actions will depend on the decisions made at the Federal Reserve’s interest rate meetings. However, there is currently a significant divergence in market expectations regarding the Fed’s subsequent monetary policy. Following the announcement of the latest round of high tariffs in the U.S., market risk aversion has sharply increased, with expectations that there will be 5 to 6 interest rate cuts this year. Citigroup predicts that the Fed may cut rates as early as May or June, while JPMorgan forecasts that the timeline for rate cuts will extend to September. Morgan Stanley even believes that the Fed will not cut rates before next year.
US Fed’s Monetary Policy Matters
The Federal Reserve recently released the minutes from its March meeting, indicating that officials unanimously believe that the tariff policies of the Trump administration have led to extremely high economic uncertainty, which could increase unemployment and inflation. The U.S. economy may face the risk of “stagflation,” where inflation rises while economic growth slows. As a result, the Federal Reserve will continue to pause interest rate cuts until the situation becomes clearer. The Chicago Mercantile Exchange’s (CME) FedWatch tool predicted that the probability of a rate cut in May dropped sharply from 57% to 15%. Although the market still anticipates the possibility of continued rate cuts before the end of the year, several Federal Reserve officials have pointed out that the difficulty of cutting rates has increased. Federal Reserve Chairman Jerome Powell also indicated that, given many uncertain factors, there is no rush to adjust interest rates. Therefore, it is recommended that investors choose to gradually allocate their investments when yields rise sharply to lower investment costs and wait for clearer interest rate decisions from the Federal Reserve. For those looking to stabilize their income without taking on too much bond volatility risk, investors may consider “short-term bonds” with relatively shorter maturities.
Bond Market Outlook
Investment-grade (IG bonds) and non-investment-grade (non-IG bonds) are currently at the epicenter of the bond market turmoil. This is mainly due to the increasing risk of an economic recession in the United States, which could lead to a rise in corporate default risks. However, according to S&P statistics, the long-term average default rate for investment-grade bonds rated BBB and above is less than 0.2%. The actual yield on U.S. BBB-rated corporate bonds remains as high as 5.8%. Morgan Stanley has also lowered its forecast for the U.S. non-investment-grade corporate default rate in 2025 to 1.25%, significantly below the long-term average of 3.4%. The actual yield on B-rated corporate bonds is as high as 8.6%. Investors looking to enjoy a yield advantage higher than government bonds while maintaining low investment risk can consider investment-grade bond funds or ETFs. Non-investment-grade bonds, with their high coupon characteristics, also create opportunities for capital gains as spreads widen. With the combination of high coupons and high spreads, non-investment-grade bonds may become a safe haven for funds. However, due to the uncertain economic outlook in the U.S. and globally, and the increasing risk of recession, it is advisable to avoid bonds with excessively low credit ratings.
