Reality bites

Both ultimately saw budgetary denial of reality founder on the rocks of the bond market’s forced imposition of objective fact.

The circumstances are somewhat different. Truss’s catastrophic 2022 mini budget was the apparent product of slavish devotion to an economic orthodoxy that ran out of road a decade and a half previously – that the fiscal devastation wrought by endless tax cuts would magically be repaired by hitherto reluctant economic growth.

Unfortunately for Truss’s chances of a second full month as UK prime minister, bond investors insisted on maintaining the reality that forgoing swathes of revenue while maintaining spending does not make for good budgetary practice.

It wouldn’t be surprising to find that Truss has spent much of the past two-and-a-half years lamenting being held to fiscal rules that did not appear to apply to the US. With neither side of politics in the US having even a passing interest in balancing the budget, it must have been galling to the hapless UK PM to see capital markets treating the US with insouciance.

Until 7 April 2025. That was the date on which US Treasury yields started to climb alarmingly – out of line with Bund and Japanese government bond (JGB) pricing – in response to Trump’s attempt to dismantle the global trade system.

It turns out that the circumstances do, after all, exist that could persuade global capital to reconsider the US Treasury market’s status as the ultimate safe haven. Indeed, testing this norm to its breaking point might end up being Trump’s most impressive achievement. Another way to view it is that the bond market remains undefeated in the face of fiscal lunacy.

In the wake of the tariff fiasco, the bond market response and Trump’s – apparent – climbdown, some market participants have started to speculate about the potential for this temporary shift in global risk behaviour to become a more permanent feature of the market.

This would be a truly epochal change in capital market norms, upending the order that has persevered for nearly a century. On the other hand, there is some logic behind it. Bond market pricing still reflects lenders’ judgement of the reliability of a borrower, and there are certainly grounds for doubt about the US under its current idiocracy.

Attempts to rationalise Trump’s trade policy include the concept of a “Mar-A-Lago accord”. The bright idea here is that the US bullies other nations into measures designed to devalue the US dollar, thus supporting US manufacturing and exports. Almost invariably, some form of debt coercion or de facto default is included as a component of this strategy, such as forcing foreign bondholders to convert their exposures to 100-year bonds.

Should the Mar-A-Lago accord ever emerge as a policy option Trump may actually follow, it seems all but inevitable that the Treasury market would enter a tailspin; it is hard to imagine many global investors willingly holding, let alone taking on new exposures to, an asset class that is likely to be rendered all but worthless.

At this point, given the US’s budgetary profligacy, the Federal Reserve would likely need to step in to prevent bond yields spiralling to the point where the federal government quite literally cannot keep the lights on. Tempting though it is to wonder whether Elon Musk has considered forcing federal employees to work in the dark as his latest DOGE brainwave, what would likely ensue is yield-curve control (YCC) at an unprecedented scale.

At this stage it is worth remembering that, for all the talk of foreign investors selling their US Treasuries, 75 per cent of US government bonds are held domestically. It is hard to imagine that wiping out the wealth of domestic savers – not to mention the cataclysmic inflationary consequences of QE on this scale – would be a vote winner for the MAGA movement. Perhaps they can blame Barack Obama.

It might not even take a Mar-A-Lago accord to make the global market reconsider the US’s position as the safe-haven asset. US exceptionalism is unwinding in global trade and diplomacy. While Trump’s clown show is clearly accelerating the process by which the US is no longer considered to be, effectively, the world’s risk underwriter it would not be unreasonable to suggest that the time is coming at which it can also no longer hold the role of global risk-free asset.

Others are better placed than I to speculate on how plausible a change of this nature really is and over what timespan. Perhaps the biggest challenge is the absence of a like-for-like replacement.

The Bund is a large, liquid market but not as liquid as US Treasuries, and it suffers from the issues of Eurozone fragmentation. Collective EU bond issuance is a relatively new phenomenon – the sector will only have a futures market for the first time later this year. There are in theory plenty of JGBs to go round but most of them are held by the central bank and the market is only just starting to emerge from decades of YCC.

One option might be a tradable instrument based on the International Monetary Fund’s special drawing rights. The appeal here is that a disparate basket of currencies – and, presumably, sovereign debt markets – is a better fit for a more diverse global power structure. It would also help cushion the blow of idiosyncratic political risk, in a world in which governments are supplanting central banks as the primary market driver.

Still, it is hard to imagine a new trading instrument being created whole-cloth and growing to become a global reserve asset in any plausible timeframe. This would likely be a multidecade proposition, which – in a world where Trump’s next brain fart could wipe out trillions of dollars of investor value – is probably not going to work.

More likely seems to be a gradual reweighting of global portfolios away from the US, potentially to the point where there is no established safe-haven asset that provides a flight to quality in all circumstances. Investors will still prioritise liquidity but will also be more prepared to seek alternatives in the face of specific risk factors. This would likely mean increased volatility, as markets readjust to events on the fly.

Of course, another thing bond markets are traditionally very good at is kicking the can down the road. If Trump truly does not have the bottle to see through his crackpot take on trade policy, it may be that the market comes to consider April 2025 as a shot across the bow that had the desired effect.

On the other hand, none of this changes the reality that Trump has no plans for fiscal discipline: the chaotic and ineffectual DOGE charade is largely window dressing on the expenditure side ahead of an extension of an unfunded tax cut Trump expectorated in his first term – the sort of policy move that was sufficient to do for Truss, it should be remembered. Even before the tariff shambles, observers were starting to question for how long US government debt could climb unabated before the bond vigilantes started to push back.

For many years, I have written about how the biggest failing of our social discourse is the refusal of influential figures – most notably, but not exclusively, politicians and media figures – to engage with the public on a nuanced basis.

Populism is, fundamentally, the proposal of simple ‘solutions’ to complex problems – and by refusing to engage with the complexity of our issues we create fertile ground for the populists.

Tariffs are not the answer to declining standards of living any more than dramatically curtailing immigration is, yet I can’t think of the last time I heard a politician make a case for the value of immigration in an ageing population.

Similarly, commentators have often rushed to ‘sanewash’ the Trump agenda.

Perhaps tariffs are a line in the sand. Most of the coverage I saw in the plausible media made sure to note that there is little or no support for a tariff regime on economic grounds. If opinion polls are to be believed, aligning with Trump has been a vote loser for the Liberal Party in the Australian federal election.

The fact that there is support for tariffs in the US speaks to a number of things. But perhaps the most significant is that the benefits of free trade – which I suspect all KangaNews readers would agree are very real – have not been fairly distributed. The populist response is to blame free trade. If we are to retain at least some of the world and market order we have grown used to, it may be time to think seriously about wealth distribution rather than just generation.