It is a common grouse that globally, financial markets are fickle and get more attention than they deserve. Many folks dislike the markets for enabling speculation, over-shadowing developments in the real world and over-reacting to events. All this is true.
But last week’s events showed us that financial markets do have their uses. They act as a check on governments and wayward politicians when they try to implement irrational policies. They are also able to speak truth to power, in a way that the army of advisers surrounding world leaders are quite unable to.
Un-reciprocal tariffs
Though President Trump’s plan to impose tariffs was well-known, actual tariffs of 10-50 per cent announced on April 2 were much higher than anyone expected.
This is because these tariffs were not really “reciprocal”. Instead, they were pegged to trade deficits that trading partners ran with the US. The formula shared by the Trump camp suggested that to be eligible for a 10 per cent tariff, a country had to wrestle down its trade deficit with America to zero. Op-eds from economists and warnings from market mavens on the impracticality of this idea went unheeded.
But a sudden spike in US treasury yields from April 7 brought about a change of heart. On April 9, after calling an emergency meeting of his advisers, Trump announced a 90-day pause on tariffs and slashed them to 10 per cent for all trading partners save China. Explaining the move, Trump told reporters: “I thought people were jumping a little bit out of line. They were getting yippy, a little bit afraid”. (Getting yippy, we learn, is a golfing term for nervousness).
Of course, with the US sticking to a 145 per cent duty on Chinese goods and China imposing tit-for-tat tariffs of 125 per cent, the situation is still fraught. But the world seems to have won a 90-day reprieve to negotiate with Trump, dialling down the immediate possibility of a global trade freeze and a US/China recession that seemed the likely outcome of the original plan.
Yippy bond markets
When the tariff plan was announced on April 2, US stock markets were quick to signal their displeasure. The Dow Jones index crashed 12 per cent and wiped out about $6 trillion in market wealth in a week. But it seems to be the bond market scare that really forced Trump’s partial retreat.
Bond markets seemed initially pleased after Trump put the Department of Government Efficiency (DOGE) to work hacking away at federal spending. Between January 13 and April 4, 2025, the yield on the 10-year US treasury note eased from 4.8 per cent to 3.9 per cent as bonds rallied.
This was very much what the Trump administration wanted, because one of its primary campaign pegs was whittling down the $36 trillion pile of US government debt. Lower market yields would have allowed cheaper refinancing of $9 trillion of debt coming due in 2025.
But as the war of words between the US and China escalated, US treasuries began to see a sharp sell-off from April 7. The yield on the 10-year bond shot up at record speed from 3.9 per cent to 4.4 per cent by April 9.
This dashed hopes of cheaper refinancing of government debt. A bigger worry was whether the sell-off would scare away bidders for upcoming treasury auctions, which would make refinancing difficult.
Sell-off makes sense
Several explanations have since surfaced for what sparked the bond sell-off. One is that the largest foreign holders of US treasuries (Japan and China with $1,079 billion and $761 billion holdings) were behind it.
They could have sold US treasuries in a fit of pique with Trump. The initial sell-off seems to have escalated due to a blow-up in the “basis point” trade. Hedge funds with highly leveraged positions in cash-futures arbitrage in treasuries may have had to unwind, due to the sudden fall in prices.
They are said to hold over $1 trillion of such positions. Despite some conciliatory noises from the Trump camp since then, bond yields have continued to head North.
Even if one discounts some of these as conspiracy theories, there is nothing very mystifying about the US treasury sell-off. Trump’s tariff plans have created a very good fundamental case for investors to sell US treasuries. Tariffs are expected to sharply peg up US inflation for the foreseeable future. The US Federal Reserve is currently in an easing cycle, but higher inflation could prompt a pause or even a rate hike. Rate hikes would subject treasury holders to capital losses.
To add to the mix, members of Trump’s inner circle have been calling for a devaluation of the dollar. A weaker dollar would further decimate returns for US treasury holders.
Whatever the reasons, the timing of the treasury sell-off is not very propitious for the Trump administration. It has led to questions of whether US government bonds and the dollar are losing their global safe haven status. In the past, during every major global crisis — including the sub-prime crisis, the taper tantrum and Covid — global investors made a beeline for US treasuries.
This would lead to gains in the dollar and a fall in US bond yields, shielding the American economy from the worst effects of the crisis.
This time around though, US stocks, bonds and the dollar are all tumbling in tandem, leaving the US economy short of this protective shield. Whether this is a knee-jerk response, or a tipping point in the status of the dollar remains to be seen.
Incompatible aims
Going forward, it is not clear what America’s trading partners are expected to bring to the table, for a climb-down on tariffs. Signals from the Trump camp on what America needs to become Great Again, are confusing.
One, Trump’s critique about trade partners “ripping off” the US with their tariff and non-tariff barriers on US goods is quite valid. But he has already turned down zero-tariff deals with Europe and Vietnam.
The Trump formula clearly shows trade deficits and not tariffs to be the sticking point. Given that the US is no longer a competitive manufacturer of goods, lower tariffs will not automatically lead to US imports finding ready takers in other countries. Therefore, US trading partners can cut tariffs, but they have no way of guaranteeing zero deficits.
Two, Trump has been talking of quelling inflation and lowering rates to ward off recession. But this is incompatible with high reciprocal tariffs which promise to sharply escalate prices for US goods. While tariffs may force some large exporters to relocate manufacturing to the US, the labour force and supply chains needed to onshore a chunk of US imports cannot come up in a trice.
Three, Trump supporters want the dollar to retain its safe-haven status, while also devaluing it. They seem to believe that the dollar’s status is so secure that large trading partners can be talked into appreciating their own currencies and paying a user fee for dollar holdings.
But a shrinking trade deficit of the US would automatically reduce their large dollar reserves. Besides, unsustainable US government debt undermines this leverage.
Overall, a resolution to the tariff war can only be found when Trump realises that his policy aims are incompatible with each other and decides to throw in the towel on some of his MAGA objectives. It is moot if his advisers will tell him this. But we can depend on the financial markets to bell this cat.