The trade war is catalyzing a global downgrade of everything American
US stocks have derated versus their international peers by the most on record, and buying Treasuries has become a “political issue.”
The pre-Rose Garden status quo of global trade and capital flows was, to simplify: the US bought a ton of stuff from the rest of the world, and in return, the rest of the world bought US bonds and stocks.
In mid-March, Jon Turek, founder of JST Advisors, warned on how a trade war could wreak havoc on one of the biggest sources of American exceptionalism in the stock market: the ability to command increasingly high valuations. The outsized profit growth plays a starring role, but there was an undercurrent of another virtuous cycle at play, he noted.
“The current setup between trade and capital has been: US imports goods => Rest of world surplus => RoW exports capital => US assets richen => Excess US demand => US imports goods,” Turek wrote. “US assets have had a step level appreciation in multiples partly because of foreign demand for US assets surging.”
Premium valuations for US multiples now appear to be collateral damage in the push to undo the dominant paradigm of cross-border trade through tariffs. Over the past two months through Tuesday, the 12-month forward price-to-earnings ratio for the S&P 500 has come down by 4 points, the sharpest such decline since the 2020 Covid crisis. But what’s remarkable is how much more US stocks have derated relative to the MSCI World ex-US Index: by more than 2.5 points, the most on record (based on data going back to 2006). In short, global investors are downgrading America.
When ratings agency Standard & Poor’s downgraded the US credit rating below AAA in August 2011 amid the debt ceiling saga, it didn’t matter a lick beyond producing fodder for a nightly CNN segment from Erin Burnett on what we were doing to get it back. Yields went down. US assets were still the safest assets on the planet, and everyone knew it. Unfortunately, while this self-wrought aversion for US assets is best demonstrated by what’s going on in the stock market, there’s an element of this at play in the US Treasury market, as well.
Typically, when recession fears are mounting — like they are now — Treasuries rally, as markets price in easing from the Federal Reserve to offset the potential economic pain. But longer-term US government bonds have not been offering shelter from the stock market storm. Ten-year Treasury yields are up about 20 basis points from the time of President Trump’s Rose Garden announcement, even as the S&P 500 has slumped double digits over the same period. From a cross-asset perspective, the scariest moment of the sell-off came on Tuesday afternoon, when long-term Treasury yields soared as US stocks nosedived.
These worries, to be sure, are distinct from and more nuanced than your bog-standard doomsayer take about foreigners dumping US bonds as a method of financial warfare. As an example of the nascent aversion to US bonds, Guy Lebas, chief fixed income strategist at Janney, notes that Tuesday’s auction of three-year Treasury notes was noteworthy for the pullback in demand from foreign buyers (emphasis added):
“To say that [Tuesday] afternoon’s 3yr auction was not great is an understatement. In isolation it wasn’t great, but when you combine it with other, ‘international relations’ issues, a story emerges. Total demand for the 3yr was on the weaker side and the ‘direct bidders’ were the lowest in five years, taking only 6% of the auction. ‘Direct bidders’ is a category that includes big US asset managers and foreign central banks and official accounts. It’s usually a pretty stable group, but when you consider some of the big changes in the international financial order over the last week, it’s pretty clear why. Foreign official accounts probably stepped back from today’s 3yr sale on the margin. Why? Suddenly buying a 3yr UST, which used to be normal course of business for a central bank in, say, Asia, isn’t normal. It’s a political issue. So if I’m the head of a CB desk, I’m probably calling my boss before I decide to participate in the auction. And maybe she’s calling her boss. And maybe he’s calling the national treasurer. And maybe that person is too busy and doesn’t respond, and so the CB doesn’t participate in the auction.”
But there’s also a massive pair of elephants in the room for the Treasury market that likely far outweighs the nascent “aversion to US assets” dynamic for bonds. Those were expertly chronicled by the Financial Times’ Kate Duguid and team here. To summarize…
The first is the basis trade: this is hedge funds playing for US Treasury futures to cheapen relative to cash bonds, a position that uses lots of leverage. Volatile markets can upend the trade through higher collateral demands (which, if not met, would force an unwind in the position marked by the selling of cash bonds, pressuring yields higher). Or if the fund is taking a bath on its other, unrelated trades, a broad culling of positioning can also have the same impact.
The second trade is related, but different: a play for US Treasuries to outperform interest rate swaps. These wagers became en vogue amid the belief that the Trump administration would pursue regulatory changes that would prompt banks to buy more US government debt. An oversimplification of Trump 1.0 policy sequencing is, do the pro-market stuff first, and then disruptive measures second. That has not been close to what we’ve seen this time around, and those hoped-for regulatory tweaks have yet to be made.
Addressing dysfunction in US Treasury markets is certainly something that’s within the Federal Reserve’s remit, and the central bank has tools to do so even without a change to policy rates.
George Saravelos, Deutsche Bank’s head of currency strategy, reckons that there is no choice “for the Fed but to step in with emergency purchases of US Treasuries to stabilize the bond market (‘emergency QE’)” if these dislocations swell.
“On monetary policy, if the Fed moves to save the plumbing, it won’t be a signal the Fed is moving to support economic demand. It’ll just be to save the plumbing,” 22V Research’s Dennis Debusschere and Peter Williams wrote.
Regardless of the different elements at play, the bottom line is that the long-held reputation of US assets to be the cleanest dirty shirt, or the best house in a bad neighborhood, in times of market tumult is absent during this rout.
“In a typical crisis environment the market would be hoarding dollar liquidity to secure funding for its underlying US asset base,” Deutsche Bank’s Saravelos wrote. “Dynamics here seem to be very different: the market has lost faith in US assets, so that instead of closing the asset-liability mismatch by hoarding dollar liquidity it is actively selling down the US assets themselves.”
