AMERICA´S FINANCIAL SYSTEM CAME CLOSE TO THE BRINK / THE ECONOMIST

On the edge

America’s financial system came close to the brink

Chaotic markets threatened to trigger a full-blown crisis

For a good few hours on April 9th, disaster beckoned. 

Share prices had been falling for weeks. 

Then the market for American Treasury bonds—normally among the safest assets available—started convulsing, too. 

The yield on ten-year Treasuries leapt to 4.5% (see chart 1), up from 3.9% days earlier. 

That meant bond prices, which move inversely to yields, had cratered. 

The failure of both risky and supposedly safe assets at once threatened to destabilise the financial system itself.

Then everything changed. 

Late in the day, Donald Trump blindsided investors by saying he would delay many of the tariffs that had sparked the panic, for 90 days. 

Share prices surged: America’s S&P 500 index closed up 10%, marking its best day since 2008. 

Treasury yields remain elevated, but as the chaos elsewhere subsides, that has less potential to cause damage.

The financial system came perilously close to the brink, and it is important to understand why, since the turbulence may well return. 

Warning bells have been ringing everywhere. 

Volatility gauges, derived from the insurance premiums traders pay to protect themselves from wild swings, have soared, though after Mr Trump’s announcement they fell back somewhat (see chart 2). 

For risk managers at banks and hedge funds, such moves can be a prompt to tell trading desks to offload risky positions, lowering the chances of a big loss. 

If this happens at many institutions at once, the selling can make markets even wilder. 

The dash for cash even sent the gold price down for a time.

Such stresses are deeply uncomfortable because they recall the last time the Treasury market seized up, at the onset of the covid-19 pandemic. 

Back then, heavy trading led to a liquidity shortage, meaning the difference between “buy” and “sell” offers widened sharply and the market became much less able to absorb large orders. 

Trades that could take place moved prices far more than they normally would have done, adding to the volatility. 

Eventually the Federal Reserve had to buy large quantities of bonds to stabilise the market.

“Swap spreads” suggested a similarly alarming dynamic was in play this week. 

These measure the gap between Treasury yields and interest-rate swap rates, which are the average of the overnight rates traders expect. 

The two usually move together, since an alternative to buying a Treasury bond and receiving its fixed yield is to deposit money in the overnight market and earn a rolling interest rate there instead. 

But on April 9th yields on ten-year Treasuries rose to a record-breaking 0.6 percentage points higher than the rate on equivalent swaps. 

The growing gap suggested that usual customers were reluctant to buy, given the enormous uncertainty haunting markets, according to Martin Whetton of Westpac, an Australian bank.

Fire-sales probably exacerbated the damage. 

Wall Street banks have hit their hedge-fund clients with the steepest margin calls since 2020, meaning they must stump up cash to cover their lossmaking positions across asset classes. 

Government bonds are among the easiest things to sell to raise the necessary funds (as is gold). 

Yet if it is losses on these positions that triggered the margin calls in the first place, selling can make things worse. 

It pushes prices down further, creating a self-reinforcing “doom loop” in which margin calls prompt sales, which prompt yet more margin calls. 

This is what happened in 2022 when British pension funds rapidly offloaded holdings of gilts to meet margin calls, sending prices down and yields up even faster. 

Eventually the Bank of England had to step in to break the spiral.

A particular worry in the Treasury market is that a doom loop could arise from the “basis trade”. 

This is popular with hedge funds and has minted fortunes at some of America’s largest. 

It attempts to profit from the difference in price between Treasury bonds and Treasury futures contracts, caused by high demand for the futures from asset managers. 

Traders exploit this by buying Treasuries and selling futures contracts. 

To amplify the returns, they borrow using the Treasuries they have bought as collateral, then recycle the cash into even more Treasuries. 

Thanks to this procedure, hedge funds are short some $1trn-worth of Treasury futures.

The trade is profitable for as long as the cost of borrowing, and meeting margin calls, remains lower than the difference between Treasury bonds and futures. 

With lots of leverage, it can generate vast returns. 

But “it is like picking up nickels in front of a steamroller”, bristles one hedge-fund manager. 

Funds can get squashed when markets plummet, either because credit dries up and leaves them unable to renew their borrowing, or because they must suddenly meet large margin calls on positions that have plunged into the red.

Crack of doom

When the bet is unwound, perhaps because yields have moved sharply and unexpectedly, funds are forced to sell Treasuries fast—compounding the selling to meet margin calls in other asset classes. 

In 2020 dealer banks were overwhelmed by the volume of Treasuries being sold, meaning that liquidity dried up. 

Something similar may have happened this time, too. 

Before the ructions, banks’ inventories were already stocked full of Treasuries, giving them little capacity to handle more selling.

Should trading seize up once again, the Fed would have to intervene, acting as buyer of last resort and offering emergency loans to systemically important firms in need. 

Today’s political backdrop would put central bankers in an invidious position, however. 

It was one thing for policymakers to backstop Treasuries when the problem they faced was a liquidity crunch brought on by covid lockdowns. 

This time, it is anyone’s guess how much of the move in Treasury yields was down to the system malfunctioning, and how much reflects a loss of faith by investors in the bonds themselves. 

After all, Mr Trump’s assault on the global trading system has dented confidence in American policymaking. 

It is only natural to conclude that the country’s sovereign debt has become less safe, and that Treasury yields should accordingly incorporate more of a risk premium.

Were the Fed to intervene in markets, in other words, it would prompt questions over whether it was simply protecting financial stability or also trying to suppress such a risk premium. 

Then there is the question of how far central bankers can use monetary policy to ease financial conditions and reduce the risk of systemic damage. 

Under other circumstances, they might opt for rapid rate cuts. 

Yet even though Mr Trump delayed his tariffs, investors are still betting inflation will rise. 

They fear stagflation—a nasty combination of inflation and stagnant growth—that would constrain any doves at the Fed.

The greatest threat surely still comes from politics. 

Even as some trade barriers have been postponed, those between America and China have been ratcheted to ludicrous levels. 

And it would be reckless to assume the shocks are over, or that foreign investors’ faith in American assets, now shaken, can be magically restored. 

How much more can the system take before something really does break?