It pays to pay attention to market signals flashing red

Of course, the US bond market is no small matter. At $28 trillion in size, it is a beast of a market that has hitherto anchored the global financial system. When this market shakes, it amounts to a referendum on the world’s confidence in the US. In reaction to Trump’s ‘Liberation Day’ announcements, yields on 10-year Treasury bonds rose 50 basis points in frenetic trading; the yield on its 30-year bond breached 5%.

Also Read: Vivek Kaul: The bond market called Trump’s bluff but the coast is still hazy

If investors are worried about economic growth in the US, yields should be falling, not rising. But yields rose because of extreme uncertainty and the threat of inflation unleashed by America’s unprecedented and chaotically implemented tariffs.

Foreign governments and investors own roughly 30% of all Treasuries, worth nearly $8.5 trillion. Japan holds over $1 trillion of them and the UK as well as China about $750 billion each. India ranks 14th on the list, with about $225 billion. It seems entirely plausible that in addition to US institutional investors dumping Treasuries, some coordinated selling was done by foreign countries, resulting in April’s bond market rout. Diplomatic pushback, newspaper opeds and corporate lobbying apparently had less impact than the bond market’s price signal in just one session.

If the bond market is a beast, the global foreign exchange market, centred in London, is a monster. It is estimated to be $2.7 quadrillion (a thousand trillion) in size, with a daily turnover of $7.5 trillion. Of this sum, spot currency trading (at current exchange rates) accounts for roughly $2 trillion, with forwards and other derivatives making up the rest. With such volumes, currencies can also provide important economic feedback.

In theory, tariffs should inflate the price of imports in the US and the dollar should nominally appreciate to offset the resulting real exchange-rate effects. While that has indeed happened in the case of some emerging market currencies directly affected by US tariffs, such as of Vietnam and Indonesia, the dollar has depreciated against a trade basket of currencies since it hit a high in January. The dollar’s response to tariffs was surprising, given both standard theory and prior patterns, and appears to have been driven by a portfolio reallocation away from US assets towards the assets of other advanced economies.

Also Read: Trump tariffs: The global bond market achieved what diplomacy couldn’t

The foreign-exchange market appears to believe that Trump is bluffing on tariffs and that deals will be made to reduce their medium-term impact on economic growth. So far, it only appears to be reflecting the uncertainty that his policy moves have created.

Another giant market with a daily price signal is the global oil market. Brent crude now trades at about $65 a barrel, 15% below its level at the beginning of the year and about 20% below the prior 6-month average. A significant portion of the decline occurred after Trump’s Liberation Day announcement. The oil market seems to be under no delusion that global growth will slow sharply, and with it, demand for oil.

Global stock markets are also major actors in this drama. They typically hog most media attention, but are notoriously jumpy and prone to providing false signals in both directions. With policy and information in such rapid flux, it is better to look at the ‘price of volatility’ than stock indices. During the chaotic week, one index of stock market volatility in the US, the Vix index, had risen 300% from the beginning of the year. It has cooled a bit since and is now up about 70% year-to-date. On- again off-again tariffs, with arbitrary exemptions and future threats, are a recipe for high volatility.

Another indirect indicator of uncertainty is the price of gold. It is up 25% since the beginning of the year and trades at 10 times its price 25 years ago, besting the S&P 500.

Also Read: Unilateral tariffs risk retaliation aimed at intellectual property

US tariffs are a tax on imports and their stated goal is to cause a change in relative prices in such a manner that businesses are incentivized to change their capital allocation plans and invest in the US. In theory, that could happen in the medium term, but tariffs are a blunt instrument being wielded crudely, and many relative prices in large liquid daily markets are changing rapidly in anticipation of their economic effects. 

The most important of these are the markets for US Treasury bonds, foreign exchange, crude oil and volatility. Three of these markets are currently flashing red to various degrees and signalling a stagflationary outcome for the US, while the foreign-exchange market appears not to have reacted yet in full measure.

In an environment in which the only certainty appears to be uncertainty, one must brace for further price volatility in these liquid markets. From the US point of view, higher long-bond yields, wavering confidence in its dollar and a potential economic recession are self-defeating; they will cause much pain. For the rest of the world, this is an ill-timed setback to an economic recovery from the covid years. Global prosperity will likely be impacted.

P.S: “Clear thinkers take feedback from reality not society," says Naval Ravikant. Is the US bond market real?

The author is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand.