The curious case of rising Treasury yields

US Treasury yields increased sharply after falling leading up to and immediately after the April 2 tariffs announcement. The tariff reprieve on April 9 initially quelled the surge, but rates remain elevated. The surprise is that typically when global risks increase, the flight to quality trade ensues—UST yields go down, prices go up and the dollar gathers strength. The opposite has occurred on all accounts. 

To add to the confusion, markets began to price in more Fed cuts for the year, as fear of the tariff-prompted slow down grew into increased expectations of a full-blown recession. But the trend up in rates, and the Federal Reserve’s current tone don’t quite match that budding expectation.

So, what might be causing the paradoxical upward pressure on yields? A number of issues are likely prompting the move, and predicting longer-term outcomes perhaps is more problematic than ever. 

Foreign owners of UST could be selling. While this may serve as retaliation for US tariffs, there are also other attractive options (namely, German bunds). The largest foreign holders of UST among the top twenty are Japan at $1079 billion and China at $761 billion (although they have been reducing their positions since 2011). The source for this data is the Treasury International Capital (TIC) flow report that will be released mid-month, but has a two-month lag. We won't really know for another couple of months what countries were reducing their positions since the tariff announcement on April 2nd. China is a primary target of the tariffs, but selling UST has negative implications for the value of its reserves. The fact that China does not disclose its trading activity adds to the mystery.

Hedge funds and other large investors may be forced sellers. UST are the day-to-day currency and collateral of sophisticated investors and traders. Market volatility has likely prompted the unwinding of leveraged basis trades that seek to profit from the price differences between UST and interest-rate swaps or futures. Again, in a typical risk-off scenario, large investors sell risk assets and buy UST, taking the opposite tack when conditions are improving.

Doubts and lack of confidence in American “economic” exceptionalism are exploding. Just like that, discord and mercurial policy making are forcing global market participants to rapidly reconsider their options. The current trading path of the USD, hitting a three-year low, supports this point.

Market expectations of how to price risk have shifted. Tariffs can produce two overlapping problems, at least for a time, with either extending: negative economic growth and growing inflation. The long end of the UST yield curve will attempt to price in all risks, including inflation and governance issues, as well as the federal deficit and funding costs. So even if the Fed is forced to cut overnight rates in an economic slowdown, given inflation and other issues, the longer end may not (and likely does not) shift down in a parallel fashion. 

Markets now seem to be waiting for a rescue by the Fed. Options abound, notably excluding UST from the SLR (“Supplementary Leverage Ratio”) calculation, which would permit the largest US banks to buy more UST, improving market liquidity. The Fed could also step in and buy UST, but while that might cure the immediate problem, it sends a difficult signal. On the bright side, last week’s auctions were largely fine, with the 3-year on Tuesday a little bit weaker than expected while the 10-year and the 30-year bond sales were better than expected.

Overall, the only known is the uncertainty which begets volatility. The market is pushing for agreements and improved certainty across the board.