Regulators warned the US bond market was vulnerable. Trump is proving them right

About 18 months ago, some of the world’s most important financial regulators warned of a risk lurking within the arcane plumbing of the US financial system.

The Bank for International Settlements, the US Federal Reserve Board, the Financial Stability Board and the Bank of England all pointed to the risks of financial market turmoil latent in an increasingly popular hedge fund strategy.

Donald Trump took umbrage at remarks by Federal Reserve chair Jerome Powell.Credit: Bloomberg

They were referring to a relative value, or arbitrage, trade – commonly referred to as the “basis” trade – which exploits minor differences in the prices of US government debt securities within physical and futures markets.

Hedge funds buy US Treasury securities, borrow against them in the short-term funding market and then take a short position in the futures market, where prices are generally marginally higher than that of the bonds.

To generate meaningful profits from the minuscule margins in the trade, the funds use financial leverage – lots of it – that is amplified by the synthetic leverage inherent in using the futures market, where the margins they have to fund are fractions of the value of their positions.

That vulnerability in the heart of the US bond market [remains]. Trump’s erratic policy agenda is the potential tinderbox.

The regulators witnessed the near-implosion of the British bond market when former prime minister Liz Truss unveiled a mini-budget containing major unfunded tax cuts. Bond investors revolted; yields soared and the pound plummeted.

The regulators were concerned about the risk of something similar occurring within the US bond market, the world’s most important financial market.

It has. After US President Donald Trump unveiled his baseline and “reciprocal” tariffs this month, there was a near-seizure in the bond market.

Yields spiked as hedge funds scrambled to cash out their positions. There was also a rush to quit US dollar exposures: the dollar slumped against the currencies of America’s major trading partners. The US sharemarket fell heavily.

It is most unusual for bond yields to rise and the dollar to fall during times of financial stress. Traditionally, they have been the world’s havens in times of stress and capital has flowed towards them during outbreaks of volatility and risk. This month, however, they – and Trump’s tariffs – have been sources of stress.

After Trump backed down and announced a 90-day pause on the implementation of his “reciprocal” tariffs, along with an exemption for electrical goods from his 145 per cent duty rate on imports from China, bond yields fell back a little (but they remain higher than before the tariff announcements) and the sharemarket stabilised, although the dollar has continued to depreciate.

While trading in the bond market appears to have normalised after nearly seizing up, the episode did, however, highlight the acute sensitivity of US financial markets to Trump’s tariffs and it tended to confirm the regulators’ fears about the prospect of the basis trade blowing up the bond market.

Ever since the 2008-09 financial crisis, regulators have been tightening regulation of the banks that were at the epicentre of that crisis. Global capital and liquidity requirements have been imposed on banks internationally to try to minimise the risk of a similar crisis recurring.

In fighting the last crisis, the regulators have created a new source of risk.

Banks used to supply liquidity to financial markets but their capital and liquidity are now quarantined to protect, primarily, the interests of depositors and the economies within which they operate.

Their former role in underwriting the functioning of markets has increasingly been taken up by hedge funds and other “shadow banks”, or unregulated/lightly regulated institutions.

Unlike the Federal Reserve-authorised dealers that used to underwrite the functioning and stability of bond markets, those institutions cut and run at the first signs of stress.

That’s what happened in response to Trump’s tariffs. The panic subsided only when he announced the pause.

That structural vulnerability within the heart of the US bond market remains. Trump’s erratic policy agenda, particularly his trade policies, is the potential tinderbox.

The resilience of the US bond market will be tested.

Trump’s tariffs (and even with the pause and the withdrawal, temporarily, of those on electric goods they are at levels not seen for a century) will disrupt the US economy and global trade, add to US inflation and interest rates and reduce US economic growth.

That will create pressure on not just households but on the corporate bond market, particularly the high-yield, or junk bond market and on trade-reliant or trade-exposed and/or leveraged US companies. The odds of a US recession have risen significantly.

At the same time, Trump and Elon Musk have been ravaging the US bureaucracy, with heavy losses of experienced people and institutional memories while also mounting an assault on regulations and regulators.

Late last week, the Office of Information and Regulatory Affairs told a range of supposedly independent agencies – including the two key securities regulators, the Securities and Exchange Commission and the Commodities Futures Trading Commission – that the White House has to be involved in, and approve, all stages of their rule-making.

Also included in that directive (which follows on from an executive order Trump signed in February) was the Federal Reserve Board’s role as a bank regulator. Its monetary policy functions remain, for the moment, independent.

How long that independence lasts is a significant question for investors and financial market stability.

Trump last week took umbrage at remarks by Fed chair Jerome Powell, who made it clear that the Fed would put US rates on hold until the impact of Trump’s trade policies became clearer, at which point it might be forced to choose between prioritising fighting higher inflation or rising unemployment in a slowing economy.

The markets are, on any day, at risk of another seizure in response to an unexpected Trump social media post.Credit: Getty Images

“Powell’s termination can’t come fast enough,” Trump, who wants the Fed to lower US interest rates, wrote in a social media post. He said on Thursday that he had the power to dismiss Powell.

“If I want him out, he’ll be out of there real fast, believe me,” he said, while his National Economic Council director, Kevin Hassat, said the president and his team would continue to consider whether he is able to fire Powell, whose term as chair (but not as a Fed governor) is scheduled to expire in May next year.

Any attempt to sack Powell would ignite a backlash from financial markets because it would damage the Fed’s credibility as an independent, non-political central bank that will respond predictably to defend its charter of controlling inflation and maximising employment.

If the White House were ever to exert influence over the Fed, it is likely that US monetary policies would become more stimulative and more pro-cyclical (and inflationary) and the US economic cycle more volatile and risky.

That would have seriously adverse implications for the US bond market and the dollar and the funding of the US government and its $US36 trillion ($56 trillion) – and climbing rapidly – of federal government debt.

The combination of the dollar’s status as the world’s reserve currency and the Fed’s credibility has made the US bond market the world’s haven. That, and the reserve currency status, could both be at risk from Trump’s attacks on Powell and his trade war on everyone.

Trump’s policymaking is erratic and the on-off-on nature of his tariff roll-out has induced enormous day-to-day volatility within financial markets. The markets are, on any day, at risk of another seizure in response to an unexpected Trump social media post.

The post-GFC regulatory architecture, heavily focused on regulated banks, wasn’t designed to cope with the erratic and chaotic nature of this administration.

There is an omnipresent risk of a disorderly and financial stability-threatening scramble by highly leveraged shadow banks for the exits from markets in response to a Trump post.

There’s also, as the continuing dollar weakness shows, a continuing leakage of funds from the US to perceived more stable jurisdictions such as Japan, Germany and Switzerland.

If that dollar depreciation and capital flight were sustained, they would have implications for the US government’s massive refinancing task this year.

US interest rates would be higher than they might otherwise be and liquidity in the bond market would be shallower, making the market even more vulnerable to stress than it might otherwise be.

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