Gentlemen prefer bonds: Swings in dollar, govt bonds will sway discussion on reserve currency, US hegemony

Last week, the world woke up to the weight of the bond market. A leviathan in the finance world, it occasionally writhes to remind others that some rules are sacred. Lodged in their humdrum world, the methodical bond boys keep a dignified distance from their jumpy peers in the stock market, deriving a quiet pride in being more cautious and cerebral, even if a tad boring. Notwithstanding the crooks and the reckless among them, the catchline, ‘Gentlemen prefer bonds’, has stuck.

For days, Donald Trump has been testing their patience with pinpricks like tax cuts and tariff plans which would bloat the budget deficit and harden inflation—outcomes that would depress bond prices. Then, at some point, something snapped in the market for US treasury bills (USTs), the world’s most actively traded bond.

It’s unclear what exactly sparked a sell-off—perhaps, a margin call, or bond sales to cover equity losses, or a stop-loss trigger. It could be anything. But the sharp fall in UST prices stunned everyone as huge positions, layer after layer of leverages, were liquidated. Within hours, Trump declared a tariff truce, even if it’s a lull before another storm. Regardless of whether bond traders forced the president’s hand—they probably did—the market spoke its mind: it doesn’t care if there is a method in Trump’s madness as many have been trying to figure out; bond prices will fall if the market fears UST bill issuance to fund deficit could rise or sticky inflation could keep interest rates high.

A sudden slide in bonds can be more unnerving for a government than a stock crash, despite the latter’s optical importance. Given large bond holdings of banks and systemically important institutions, a collapse in bond prices can be damaging and contagious. Also, it makes government’s borrowing more expensive as lower bond prices mean higher yields (or annual returns)—causing investors to demand more return for subscribing to government bonds.

The price fall probably wasn’t caused by China or Japan dumping UST bills in angst or retaliation. Central banks hold short-term bonds while the sharp jump in yield (or fall in price) was seen in UST bills of longer tenures. The fall is believed to have stemmed from private financial houses unwinding ‘basis trade’, a term that became familiar during the week.

Known as ‘bond-future basis’, these are trades where banks and asset managers undertake ladders of transactions with arbitrage and leverage built in each rung. They buy bonds in the spot (or cash) market and sell in the futures market, resulting in small gains as the futures price is higher than the spot price. But it doesn’t stop here with a wafer-thin profit. These large financial investors then pledge the bonds bought in the cash market to raise money to buy more bonds for another round of buy-spot-sell-futures deals. This happens many times, with money borrowed against bonds.

Another variety of this trade is ‘bond-swap basis’. Here, a large investor buys UST bills in the cash market (receiving, say, 4.4% return) and does an interest swap (which is used to shift from a fixed rate to a floating rate, or vice versa). A deal is struck with a bank that agrees to pay a floating rate to the investor and receive a fixed swap rate (say, 4.3%, as it's typically lower than the yield, which is 4.4% here). The difference of 10 basis points is locked in as a gain, and the deal is repeated 50 times with leverage.

But such best laid plans can go awry if prices of UST bills, placed as collateral, fall—forcing lenders to sell the pledged papers. When this happens, as it happened last week, UST bill prices fall (and yields soar).

Over the last few years, these seemingly safe trades have grown as many investors betting on bonds of frontier markets (Pakistan, Croatia and Vietnam) for higher returns, went for less-risky, steady arbitrage earnings through UST bill leverage. Interestingly, the Fed and US authorities were fine with basis trades as they multiplied the demand for UST bills, particularly when government borrowing surged during Covid. Now, under another regime, it has pulled a surprise.

As investors sit on the edge, what should one watch out for?

• For a long time, a higher UST bill yield went with a higher dollar. Higher returns drew more inflows into the US. This has been reversed with the dollar falling and the yield rising. Would this continue?
• Would the Fed step in to calm the markets, or tweak rules on capital to help banks hold more UST bills?
• Would yields on short-term UST bills rise? This would indicate that the Chinese or other monetary authorities have joined private firms to offload American sovereign papers.

These trends, if they stick, would add fuel to raging conversations about America’s waning ability to lure capital and decline in the dollar’s hegemony. Indeed, Trump has led us to a point where it makes more sense to read the markets than track the man.