Don’t be beguiled by the apparent calm reigning in US bond markets

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Right now the world is watching America’s elections with bated breath. For while a new FT survey implies that Republican contender Donald Trump has a slim lead over vice-president Kamala Harris, the race seems set to remain on a knife edge until election day. But as pundits parse the polls, Paul Tudor Jones, the hedge fund luminary who first rose to fame by predicting the 1987 equity crash, thinks that investors would do better to watch something else — American bonds.

He insists that neither candidate is “suited for the job ahead of them”, in terms of crafting policies that are credible to markets. Citing the economist Hyman Minsky’s observation that investors can ignore risks for ages until confidence suddenly cracks, he told CNBC this week that the “question is after this election will we have a Minsky moment here in the United States and US debt markets?” He added: “What they’re [both] talking about is fiscally impossible, financially impossible.” Indeed, he is now so alarmed that he has dumped all US fixed income products and is shorting long-dated Treasuries too.

Should other investors follow Tudor Jones? At first glance it might seem not. Overall market conditions, after all, appear calm. So much so that the IMF noted on its blog this week that its “standardised measure of [market] volatility has drifted far below geopolitical risk measures”.

Meanwhile the bid-to-cover ratio in Treasury auctions (the total amount of bids divided by the total amount of Treasury debt offered for sale) “hasn’t moved very much in the past several years”, as a Brookings report notes. And while US long market rates have risen, creating a steeper yield curve, neither the rate levels or term premium look extreme.

But there are at least three factors that threaten this calm. The first, as Torsten Slok of Apollo notes, is that America’s government deficits are now so big that the ratio of debt to GDP is about to smash through the 100 per cent level, and could soon hit 200 per cent. This means the US government will have to roll over $9tn of debt (or a third of the total) in the next year, expanding auction sizes by some 30 per cent.

Second, debt issuance is exploding just as the footprint of price-sensitive investors is swelling. That is partly because the Federal Reserve has stopped quantitative easing, and is no longer gobbling up bonds. But the other issue, the IMF notes, is that hedge funds are buying so many bonds that they now own 11 per cent of the market, up from 3 per cent in 2021.

Dealer banks’ holdings have also risen in this period, the IMF adds, from 2 to 5 per cent. That is moderately reassuring since it suggests that dealers can still act as market makers, in a crunch. But that dealers’ footprint is far smaller than before 2008 — and half that of those potentially flighty funds. And while foreign Treasury holdings recently hit a record high of $8.3tn (which seems reassuring), the third, fourth and fifth-largest source of demand came from the UK, Luxembourg and the Cayman Islands. This is less reassuring, since it is probably driven by hedge funds too.

The third issue is policy uncertainty. If Harris becomes president, we can expect her to unleash more so-called Bidenomics, a mix of social spending and investment. The Penn Wharton business school estimates this would add another $2tn to the debt. But if Trump wins, all bets are off. According to Penn Wharton, his administration will aim to unleash a fiscal package that will add at least $4tn to the primary deficit, while also weakening the dollar, undermining the independence of the Federal Reserve and introduce tariff and immigration measures that could be highly inflationary.

That would be risky for bonds in any circumstances. But it looks doubly explosive at a time of expanding auctions.

But some of Trump’s advisers, such as Scott Bessent or Kevin Hassett, have told the FT that Trump would actually pursue entirely prudent measures. And his pledged trillion-dollar fiscal packages will be a pipe dream unless the Republicans win the House and Senate.

The key point, then, is that it is hard to use any past economic model to predict what a Trump victory might do to Treasuries. And what makes predictions even more difficult is that recent technical “changes to the yield curve are fairly unique and could lead to indeterminacy in investors’ asset allocation and more volatile markets”, as the IMF says.

In plain English this means that the US election is not just tossing us into uncharted waters for the political economy and legal system — it is pushing us into unfathomable territory for Treasuries too. Maybe America’s reserve currency status means it can keep defying financial gravity. But I think it would be deeply foolish to ignore Tudor Jones. After all, it takes a hedgie to know what a herd of hedgies might do if the outcome of the election does indeed lead to a new crisis of American confidence.

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