Pain
Authors: Andrés Larios, Faith Spalding
Editors: Andrés Larios, Faith Spalding
Intro:
Welcome to the Weekly BluRB, a newsletter catered to students and professionals seeking the latest news and insights on global markets. Get prepared for the week by reading four stories circulating around equity markets, macro trends, geopolitics and new business developments. And the best part: we’ll give you an informed view about where we think prices, policy and trends are going in the near future. The content in these writings is for informational purposes only and does not constitute financial or investing advice.
Equity Markets: A basis trade blowout?
Volatility continues to be the name of the game, with most major indexes experiencing losses and gains this week following continued tariff turbulence. After major market losses following President Trump’s “Liberation Day” tariffs, the White House quickly reversed course a week after the announcement, pausing all tariffs besides an increase of 104 -125% tariffs on China. The S&P 500 finished up by 5.7%, the tech-heavy NASDAQ up 7.3% and the Dow Jones up 5% on the week. While the gains may seem like a strong rebound, there are still confounding factors indicating problems ahead: the CBOE Volatility index (VIX) is down mid-Monday by 6.67%, closing Friday at 37.56. The index is a key gauge on market uncertainty; earlier last week VIX spiked to 55, indicating extreme volatility reminiscent of past financial crises.
President Trump’s Tariff Pause
Before the pause was even announced, misleading reports last Monday that President Trump was pausing tariffs sent indexes soaring, with the S&P 500 adding $2.4 trillion in market value in the ten minutes from 10:08 to 10:18 a.m. According to the Wall Street Journal, by 10:41 am these gains had been completely wiped out, coming from unsubstantiated reports circulated by X and other social media users. This “fake news” rally indicates how reactive Wall Street’s trading strategies are to major (or in this case potential) headlines, easily susceptible to misinformation. This simultaneously underscores the fragility of the system, as misinformation can cause stocks to gain and lose billions in under an hour.
After a week of major losses and expectations for recession, President Trump announced last Wednesday a 90-day-pause to his blanket tariffs on every country except China, noting that the bond market was “getting a little uneasy.” Several Trump Administration officials acknowledged the hostility, with White House National Economic Council Director Kevin Hassett quipping to CNBC Thursday, “the bond market was telling us, ‘Hey, it is probably time to move.'”
But another major volatile factor spooking markets is the basis trade, which shot to popularity during the depths of COVID-19 market turmoil. Post-2008, policy makers moved to make banks safer by requiring lenders to hold more capital against potential losses, and that they carry large buffers of high-quality assets that could be easily sold during emergencies. While the purpose of these pivots was to create a safer and secure banking system for both lenders and consumers, liquidity diminished, balance sheets shrank and it was harder and more costly for investors to borrow from banks without leverage. To fix the problem, the basis trade has allowed for hedge funds to bet on price differences between Treasury cash and futures by shorting synthetic futures. The Treasury-cash basis trade functions through futures contracts, standardized agreements to buy or sell an asset at a set price on a future date. In basis trades, Treasury futures serve as a stand-in for actual bonds letting hedgefund captialize on minor price gaps between the two.
The Basis Trade Boom
However, the basis trade has boomed since 2020 lows. Hedge funds have been placing bets with up 50 to 100 times leverage on the price difference between Treasuries and Treasury futures contracts. In the bet, one buys the Treasury bond and then shorts the differently priced futures contract on a similar bond. As the bond comes up on its expiration date, the prices converge, and when the futures price comes down, your short pays off. According to Torsten Sløk, the chief economist of Apollo Management, basis markets are now worth “$800 billion and an important part of the $2 trillion outstanding in prime brokerage balances.”
As the Trump Administration has worked to deregulate, banks and lenders have rushed to de-risk, and the trade has blown up the past several months. Yet the cash-futures trade is a source of incredible instability. Hedge funds that hold large leveraged positions in cash Treasury securities are vulnerable to margin calls and risk having to unwind those positions quickly when investors pull their money during market turbulence. In the short term, this unwind would need to be absorbed by broker-dealers that may already be facing capital constraints. This creates a massive liquidity problem…who will buy US treasuries to help tamper the sky-high deficit?
Last Monday brought massive pressure to US government bonds as hedge funds aggressively unwound risk and investors sought cash safety, triggering one of the steepest selloffs in Treasuries since the peak of Covid-19. The 10-year Treasury yield jumped 19 basis points to 4.18% – the largest one-day surge since September 2022.
Hedge Fund Bailout?
As yields continued to spike last week, Wall Street analysts closely watched for signs that the Fed would be forced to intervene. (There’s precedent for this: at the onset of the looming financial crisis caused by Covid, the central bank bought $1.6 trillion in Treasuries. Yet in a recent Brookings paper co authored by former Fed governor Jeremy Stein along with the University of Chicago’s Anil Kashyap, Harvard’s Jonathan Wallen and Columbia’s Joshua Younger, this solution is less than ideal.
“Without a clear upfront distinction between bond-buying for market-function purposes, verses for monetary-policy purposes, the initial round of Treasury purchases in the spring of 2020 morphed into a broader monetary policy effort that eventually saw the Fed add over $4 trillion to its combined holdings of Treasuries and agency mortgage-backed securities by mid-2022,” the authors held.
Instead, they call for a different approach. To help hedge funds unwind by purchasing Treasuries and selling futures. In turn, they argue this would prevent more reckless behavior, hopefully mitigating the broader potential issue of a 2008-level credit crunch. (We’re not there quite yet.) Overall, it’s hard to source buyers during Treasury sell-offs. Constrained by stricter capital requirements introduced after the 2008 Global Financial Crisis and reinforced through the Dodd-Frank reforms, banks faced limits on their ability to hold risk. However, these rules were temporarily rolled back during the pandemic to encourage greater purchases of US debt, and US Treasury Secretary Scott Bessent remarked Tuesday that these changes should be made permanent as part of a wider effort to loosen regulation.
JPMorgan CEO Jamie Dimon has similarly argued that the world’s biggest lenders can help prevent a credit crunch – when liquidity dries up and the economy is stunted – if Dodd-Frank is rolled back. Dimon is correct that the Federal Reserve can’t allow for markets to dry up the way they did in 2008. However, big banks and broker-dealers can’t step in during times of major Treasury bond unwinding because of the supplementary leverage ratio, which limits the amount of borrowed funds lenders can use to invest. Accordingly, Dimon argues that to prevent the seize-up of the Treasury market, the capital requirements need to be rolled back, allowing big lenders to step in.
Broader Systemic Indicators
The S&P 500 and other major indexes continued to rally Friday after President Trump’s tariff pause, but not because of a major resolution. Instead, these rallies are happening as systemic fragility continues, and lack of confidence in basis trading soars. Wednesday’s rallies follow the same pattern that occurred in 1929, 1931, 1932, 2008, 2020; times where according to EndGame Macro on X, “liquidity spasmed, hope briefly overwhelmed fear, and mispositioned portfolios got violently unwound.” Wednesday’s 9.5% S&P 500 jump fits this same pattern, as minor gains continued to Friday as the index gained 1.81%. With major Treasury volatility, major basis trade stress, collapsing swap spread and exploding gold investment, what we are seeing isn’t recovery.
The US is at a major crossroads; major regulatory institutions are being overhauled, tariff turbulence was only tampered in response to major international volatility and the bond market continues to be in distress. As such, our immediate outlook is not hopeful. The tariff pause will only last 90 days, and there seems to be no immediate and finite solutions that the Trump administration will approach. Tariffs on China continue to be drastic, posing fears that prices for tech-consumers will soar as Apple is affected. And resoundingly, there’s no immediate hope for a Fed bailout to tamper Treasury securities dumping.
We don’t actually know what’s coming next – President Trump’s abrupt tariff reversal means anything is on the table. However, we suspect that pushes for major regulatory changes will continue, from both big lenders and the Trump Administration, with their goal being to prevent a Fed bailout and major economic collapse.
U.S. Economy: The Signals are Blaring – Credit Crunch Incoming?
Although the stock market finished strong this week, there are wider warning signs from America’s credit markets, indicating that the true effect of tariffs in financial markets is yet to be felt. Besides the tariff news, this past week was full of data releases that further the thesis that a recession is near, and that credit markets might begin to falter. In the case of a credit crunch, which is defined as a decline in lending activity by financial institutions brought about by a shortage of funds, there could be a financial crisis that heavily impacts Wall Street and Main Street, not in a dissimilar fashion to the combination of the Great Recession and Great Financial Crisis. The question is, which asset will bring about this credit crunch? There are a number of options due to the structural changes being brought about in financial markets due to the chaos brought about by tariffs.
In light of the stock market chaos, economists and investors are used to seeing the yield curve compress downward, indicating that people are buying Treasury bonds (or safe assets). In this current market environment, that has not been the case at all. In the past week alone, we have seen the 10-year yield climb from nearly 4% to sitting slightly above 4.5%, totalling an increase of 50 basis points via selling on increased sovereign risk. Seeing as foreign central banks hold Treasury bonds as the US Dollar is the reserve currency of the world, institutional investors and foreign central banks alike are likely to have sold Treasury bonds to keep their own monetary regime afloat.
Figure 1: Yield Curve over the Past Two Weeks
As seen in figure 1, the risk outlook for US Treasury bonds has increased massively in the past few weeks, completely erasing the yield curve inversion desired by Secretary of the Treasury, Scott Bessent. Furthermore, due to the ongoing tariff news, the United States Dollar, which is a floating rate currency, has decreased in value relative to other currencies due to a weak economic fundamentals outlook, political instability and an effort to make American exports more attractive. The divergence between US currency and yields seen in figure 2 may also lend credence to the suggestion that foreign Central Banks (Japan, China, etc.) have sold off U.S. Treasury bonds or other Dollar denominated bonds in an effort to stabilize their own currencies and reduce exposure to lower yielding assets with an increased risk outlook. This reaction may signal an expectation by institutional investors for imminent Federal Reserve intervention in the form of yield curve control or stealth quantitative easing to ease longer term credit expectations and prevent an imminent global credit event. As seen in the chart, very rarely does dollar strength and yield direction diverge, highlighting how structural of a shift tariffs could potentially be, and how liquidity and capital may be flowing out of the US financial system and toward alternative safe havens like the Japanese Yen, the Euro or Gold.
Figure 2: Dollar Strength falls as 10-Year Yield Spikes Upward
The policy response by the Federal Reserve is increasingly up for debate. As shown in figure 3, rate cutting probabilities have shifted significantly over the past month on tariff news and debate over whether tariffs will be more inflationary or recessionary. Current consensus sees a higher than average probability of a rate cut (40%) on the May 7th FOMC meeting, however, we maintain the view that there will be no rate cut on May 7th due to the inflationary pressures tariffs are expected to pass on to the US consumer. We believe that a more strategic intervention is more likely due to structural dislocations in bond markets.
Figure 3: Rate Cutting Probabilities for May 7th FOMC Meeting (Saturday, April 12th)
Figures 4 and 5 highlight increasing strain in corporate credit markets. $9 billion in investment grade outflows were tracked last week, showing investors pulling out of American credit markets. Furthermore, credit default swaps for high yield bonds, or insurance on bonds defaulting saw the biggest index increase since the 2023 Regional Banking Crisis. These moves in credit markets highlight stress about liquidity and/or increased possibilities for massive defaults among US corporates as a result of the potential ramifications of tariffs. Hence, while the stock market ended positively for the week, credit markets are not budging, and are showing signs of increasing stress more heavily tied to their current cash flows and balance sheet capacities.
Figure 4: Investment Grade Bonds saw a big outflow last week.
Figure 5: Credit Default Swaps in High Yield Markets Increasing
As mentioned in last week’s BluRB, we believe that tariff news is in part, a form of fiscal guidance by President Trump, to decrease inflation expectations and reduce consumer spending. Due to the ongoing flurry of headlines relating to tariffs and escalation with China, people are confused and are adjusting their basket and overall quantity of goods bought to reflect this new reality. This is reflected in the CPI print released on Thursday morning as overall CPI fell to 2.4% in March from 2.8% in February, falling 0.1% on a seasonally-adjusted month-over-month basis as energy prices and core inflation (everything but food & energy) continue to fall, reflecting less upward price pressure on more long-term goods & services like transportation or medical care. However, when the price effects of tariffs do eventually kick in, the disinflation party is sure to end.
Figure 6: CPI has markedly decreased in the past two months on tariff guidance
Further signals of consumer stress can be seen in figure 5 and 6 as consumer credit decreased unexpectedly in February, and the most recent University of Michigan Consumer Sentiment survey shows incredibly pessimistic outlooks for household balance sheets regardless of income bracket. The decrease in consumer credit came as a huge surprise to investors, yet is supportive of our thesis that tariff guidance is in part, a policy tool to reduce inflationary pressures. Reduced consumer sentiment is now at 2008 levels. This means real people are making decisions under the expectation of an upcoming recession (if it is not already here).
Figure 7: Consumer Credit declined by $810M in February, on expectations of a $15B increase
Figure 8: Consumer Sentiment Falls to 2008 Levels Among all Consumers
In the housing market, 30-year mortgage rates have once again increased to the 6.5%-7.20% range, meaning it is increasingly hard to finance buying a home, a key pillar to the American dream. As mortgage rates began to fall in the first month and a half of President Trump’s term, there also was a surge of refinancing applications, however, 42% of these applications are being rejected on account of poor credit or household balance sheet fundamentals. This is the highest reading since the statistic began being recorded. Thus, it seems increasingly likely that households took on overly high debt capacities in the years following COVID-19, and the long-lasting high interest rate environment has strained their ability to make and maintain long-term debt-financed investments.
Figure 9: 30-Year Mortgage Rates Continue to Remain High
Figure 10: Mortgage Refinancing Applications are Being Rejected En Masse
Last week, credit markets were not reacting to the news. This week, every single American credit market is responding to an increasingly negative outlook due to tariff news and poor consumer tailwinds. We expect the Federal Reserve to intervene in some sort of capacity to ease long term interest rate expectations. We remain extremely concerned by the seeming loss of American Treasury bonds as a safe asset, as well as the current outlook for consumer and corporate credit. Last week, we reduced the probability of a stagflation and increased the probability of a recession. We maintain this call, but are also cautious about an imminent American credit or financial crisis that could bring the Federal Reserve (an independent Federal Agency) to the forefront of market stabilization. In this case, we fear a constitutional crisis may ensue seeing as the US Supreme Court has now authorized President Trump to be able to fire independent agency members. President Trump may employ this new legal precedent if he dislikes the actions taken by the Fed to ease markets (most likely through the means of incurring more debt/more money printing). In this case, we expect permanent flight from American credit markets to alternative forms of safe assets, which would effectively destroy the global financial system we have lived in our entire lives.
Global Macro: Dollar vs. Yuan – The Battle Begins
President Trump’s tariff announcements in the past few weeks have created major convulsions in international markets leading to a pronounced depreciation of the Dollar relative to other currencies. The DXY (the value of the US Dollar relative to a basket of trade partners’ currencies) has been on a sharp decline ever since President Trump’s inauguration and his fluid motions to implement tariffs on major trading partners. In the past week, the DXY dropped from around 103 points to below the ‘psychological 100.00 barrier’. Notably, USD:EUR has depreciated by 4.5%, and USD:JPY has depreciated by 4.6% since April 1st as these currencies have taken the traditional role of the US Dollar and US Treasuries of acting as a safe and stable asset.
Figure 11: DXY Value Over the Past Three Months
Figure 12 shows insight into investors pooling capital away from American assets and into safe European assets, like the 10-year German Bund. As Europe has already lowered interest rates due to their economic slowdown and have strategically positioned themselves as negotiators with both the US and China, investors see the EU as an entity that may have more stability despite the lower interest rates. This is also indicative of the multiple pressures that are classifying US Treasuries as inherently more risky. Despite a high 10-year interest rate, investors (most likely foreign) have sold off their exposure to the United States.
Figure 12: Investors buy German Bunds (Sovereign Debt) amid Treasury Sell-off
The volatility seen in Japanese bond markets is partly attributed to tariff news, but is also due to expectations for more fiscal spending within a historically low-inflation nation. While investors initially began capital flight to Japanese Government Bonds (JGB) amid more tariff news, they quickly reversed this decision through data supportive of a rate hike by the Bank of Japan. This, alongside possible fiscal stimulus due to tariff news, has raised the 10-Year JGB yield more than 200 basis points from the one-month minimum. As the Yen strengthens against the dollar, more liquid short-end yields have dropped. The long-end of the BoJ’s yield curve is not traded frequently, and so another component of this volatility could be how flight to long-term JGB’s spurred trading activity that actively repriced these bonds.
Figure 13: Japanese 10-Year Yield Experiencing Major Volatility
Another safe asset investors have been tracking has been gold, as the price has skyrocketed among fears of global market disruptions. Gold ETFs, which track a pool of Gold stocks, have seen a massive pool of investors allocate money into this asset class. In early 2025, North American and Asian investors have seen massive pools of capital going towards Gold ETFs as recessionary fears have strengthened. Gold is seen as a safe asset due to its liquidity, its provision as a value hedge against inflation and ability to withstand periods of economic strain. Due to reciprocal tariffs between the US and China peaking above 100%, the past week also saw the largest inflow into Chinese Gold ETFs as the Yuan depreciated to 18 year lows in the past few weeks (Figure 16). As China’s currency devalues against the dollar (marking possible inflationary pressure) and economic hardship continues, Chinese investors may want to retain their purchasing power by transferring their assets to gold (figure 15).
Figure 14: Gold ETF Inflows have Increased Significantly in Q1 2025
Figure 15: Chinese Investors Pool Capital in Gold ETFs
Figure 16 shows how China’s currency has depreciated to 18-year lows relative to the Dollar following the reciprocal tariff announcements in the past few weeks. At first glance, this could signal that as the Dollar depreciates, the Yuan depreciates even faster, which could potentially be interpreted as the United States dealing harsher blows to the CCP in this trade war. However, this is misleading. China operates on a fixed exchange rate system, where they use a currency peg against a basket of floating-rate currencies. This allows them to pursue some intervention against wider geopolitical or macroeconomic shocks while keeping their currency weak enough where their exports are seen as extremely attractive by the rest of the world. Hence, a lower exchange rate actually works in China’s favor. However, devaluing too quickly might cause capital outflows and risks to China’s financial systems, especially when considering their fragile local government financing vehicle (LGFV) system for municipal debt. Even so, as this trade conflict just begins, we are yet to see what economic arsenal President Trump and President Xi Jinping have in store.
Figure 16: Chinese Yuan Depreciates to 18-Year Lows Relative to the Dollar
Hence, as this trade war becomes more serious and speculation of long-lasting conflict ensues both countries have already begun to show some pain. This leads us to believe that as long as the Trump Administration believes they have market power over China and enough leverage with the rest of the world, this trade conflict will continue until one of the countries either gives out or its trade leverage is exhausted. This puts both countries at serious economic risk as an economic cold war begins, the likes of which we have never seen before.
Thus, we believe this is a slow-burn strategic devaluation to try to continue incentivizing other countries to trade with China, while also slowing deflation within their borders, bolstering their economic strength and buying time for other countries to take over ‘import control’ that the United States currently holds. This devaluation may also try to incentivize the United States to friend-shore or reshore quicker than initially anticipated which would set the United States up for increased volatility seeing as the fiscal infrastructure or the labor willingness to work in manufacturing is simply not there. Hence, the lesson from this currency devaluation (which is most likely engineered) is that the United States needs to tread extremely carefully and understand how China’s financial system works to hit strategic weak points. Furthermore, there is a need to focus on leveraging their import control, trade and security alliances and multinational corporations to try to close China out of global trade before the Trump Administrations blocks themselves out.