By Kristen Kelly & Jen Saarbach, Co-Founders of The Wall Street Skinny
We think the Treasury market was the ultimate impetus behind the 90 day pause in reciprocal tariffs. Why?
Let’s get back to macro theory.
If there’s a “normal” negative shock to the U.S. economy — say, a spike in oil prices — and it really only impacts companies’ growth projections, what should happen?
- Equities should get hit. S&P down, NASDAQ down, Russell 2000 down, etc… not pleasant, but all to be expected.
- Corporate credit spreads also probably widen. Why? Well, if it’s more expensive for companies to make the goods they sell, and they can’t grow as quickly — or need to shrink — that impacts their ability to repay their debt, and should make it more expensive for them to borrow (all else being equal).
- Investors will then reallocate their money out of riskier assets (like equities and corporate credit) into safer assets, like U.S. Treasuries.
Remember, U.S. Treasuries are bonds issued by the U.S. government, and carry zero risk of default — in theory. Why can’t the U.S. default on its bonds? Because we issue bonds in our own currency, and we can print more of our own currency to pay back those debts if absolutely necessary.
This risk allocation is what we’d expect for a normal shock to the equity markets.
This is not what we saw this past week.
Instead of a flight to quality trade, where investors selling out of U.S. Equities move their money into Treasuries… Treasuries sold off, too.
In fact, pretty much everything that was denominated in U.S. dollars (including the U.S. dollar itself) underperformed.
Why are Treasuries the canary in the coal mine?
Well, over the past half a century of liberal* trade policies (*meaning, relative to protectionist), we’ve been flooding our trade partners with US dollars in exchange for their goods.
And since the middle of the 20th century, the U.S. dollar has been the global reserve currency.
What do foreign countries do with all those U.S. dollars?
They buy U.S. dollar denominated assets — specifically, U.S. Treasuries.
Federal Debt Held by Foreign & International Investors (source: fred.stlouisfed.org)
As of Q4 2024, foreign investors currently own about 23.4% of US Federal debt.
So why might a global trade war negatively impact more than just equities?
- If foreign investors liquidate their holdings either out of lack of confidence in the U.S., fears of inflation devaluing the dollars they receive, or more sinisterly, to retaliate against U.S. policy, that should cause rates to sell off.
- If rates sell off, it makes it more expensive for the U.S. government to fund itself when it issues new debt, which it already does every week just to stay running. Every month, the Treasury holds a series of staggered auctions, issuing new debt in maturities ranging from four weeks to 30 years.
- At those auctions, foreign governments are usually large participants in buying new bonds. They often (though not always) participate as “direct bidders”, and direct bidders tend to range from about 10-30% of the auction takedown, depending on maturity.
- If those bidders do not show up at U.S. Treasury auctions, that debt likely gets issued at much higher rates. U.S. Treasury auctions are DUTCH auctions. So if $25bn 10YR notes are being auctioned off, the auction stops at the lowest yield someone is willing to accept for the $25,000,000,000th 10year note — no lower.
- Tuesday’s 3YR auction saw the lowest direct bidder participation since COVID. Wednesday’s 10YR auction saw direct bids of 1.4% vs. an average of 17.5%. By comparison, after the 90 day tariff pause was announced, today’s 30YR auction saw high direct bidder participation of 25.8%!!
If the interest rate on US Treasuries increases beyond a certain point without sufficient growth to pay down our debts, the end outcome is a debt trap. Debt traps occur when you need to issue new debt just to pay down the interest on your existing debt, let alone pay off existing debts.
The history of countries that have found themselves in debt traps is not pretty.
So, if you’re not watching Treasury auctions…or you think all you should care about is the equity markets right now… think again.
To give you a sense of how exciting Treasury auctions can be, take a look at the price action for today’s bond auction:
30 Year UST yields intraday
That giant cliff at 1pm EST? That’s when the auction stopped through, meaning: bonds were issued rich relative to where they were trading going into the auction, signaling stronger demand than the market anticipated, with HIGH direct bidders relative to the past two auctions.
Perhaps a message from foreign investors after the 90 day tariff pause… play nicely and we’ll buy your bonds?