China's bond sell-off threat looms over US economy

Although he previously said he wouldn't back down, on Wednesday, Donald Trump unexpectedly suspended tariffs on certain countries for 90 days, which took effect that morning. The general 10% tariffs and tariffs on China, which as of Friday are already 145%, remained in force. "People were jumping a little bit out of line, they were getting yippy, a little bit afraid," Trump admitted, explaining his decision. He added that he specifically considered the impact on Treasury bond yields.

"The bond market is very tricky, I was watching it. But if you look at it now it’s beautiful. I saw last night where people were getting a little queasy," Trump said. Despite these claims, it is now evident that the bond market remains skeptical about long-term economic prospects. Investors in bonds do not share the enthusiasm visible in stock markets, which experienced a sharp increase after the president announced a temporary suspension of tariffs.

The stock indices reacted with an impressive rise from Wednesday—reaching even 10%. Meanwhile, the bond market shows significantly more restraint in assessing the economic situation. Experts point out that bond investors are more cautious in forecasting the long-term effects of the current administration's trade policy. They also emphasize that the discrepancy between the reaction of the stock market and the bond market may indicate deeper concerns about the fundamentals of the American economy. Investors in bonds are often seen as more conservative in risk assessment and less susceptible to short-term impulses than stock market players.

It's not that bonds didn't move since Wednesday. The movement in this case is simply much smaller than in the case of stocks. In the morning, the yield on the 10-year Treasury bond fell by 7 basis points to 4.326%, and the yield on the 2-year bond decreased by more than 11 basis points to 3.837%. One basis point equals 0.01%—showing that the scale of changes is not large.

A particularly interesting aspect of the market reaction is the quick shift in position by Goldman Sachs. The renowned investment bank withdrew its forecast, which assumed a recession in the U.S. next year as its base scenario, just an hour after Trump announced the suspension of new tariffs.

Economists from Goldman Sachs argue that suspending the introduction of new tariffs reduces the risk of an economic slowdown in the upcoming quarters. The bank's analysts point out that the continued tightening of trade policy could lead to an increase in the prices of imported goods, which would translate into higher inflation and a decrease in consumers' purchasing power.

However, despite Goldman Sachs changing its forecasts, the bond market remains cautious. The history of the Trump administration's trade policy shows that the negotiation strategy often relies on alternating between tightening and easing positions.

The Wednesday trading session, during which there were strong increases, clearly demonstrated the instability of the current financial markets. Market experts note that such volatility is typical for periods of geopolitical and economic uncertainty. Analysts also indicate that investors remain very sensitive to any signals regarding trade relations between the USA and China. Both countries are currently imposing ever-higher tariffs on each other.

Economists remind us that the trade war between the USA and China has been ongoing for several years (initiated by Donald Trump in 2018 during his first term) and has had a significant impact on global supply chains and business investment decisions. Some companies have begun relocating production from China to other Asian countries, showcasing the long-term consequences of trade tensions.

Investors in bonds, unlike stock market participants, focus on the long-term impact of trade policy on the American economy. Their caution may stem from concerns about lasting changes in the structure of global trade and potential inflationary effects from recurring trade tensions.

Why does the bond market hold such significance for the American economy? Because it can affect ordinary Americans. Other countries—including China—own US mortgage-backed securities worth $1.32 trillion, accounting for 15% of the total value of these securities in circulation. A potential sell-off by China could significantly shake the American real estate market.

Furthermore, mortgage rates follow the yield on 10-year Treasury bonds. Some analysts speculate that countries holding US bonds and inclined to harm Trump might sell off US Treasury bonds in retaliation for the president's extensive tariff plan.

Guy Cecala, executive chairman of Inside Mortgage Finance, points out the seriousness of the situation. "If China wanted to hit us hard, they could unload Treasurys. Is that a threat? Sure it is. They’re going to look at pushing levers and trying to put pressure. ... Targeting housing and mortgage rates is a powerful driver of something like that," he states in a comment.

The main holders of American debt securities include Japan, China, Taiwan, and Canada, and their investment decisions can significantly impact the American mortgage market.

China already began selling part of its American securities last year—by the end of September 2024, its holdings decreased by 8.7% compared to the previous year, and by December, the decline reached 20%. Japan, which showed an increase in assets in September, started selling them at the beginning of December.

If China and Japan accelerated this sell-off, and other countries followed suit, mortgage interest rates in the USA would rise. Eric Hagen, an analyst of mortgage credit and specialty finance at BTIG, confirms that these concerns are real.

The concern, I think, is on folks’ radar screens, and being raised as a potential source of friction. Most investors are concerned that mortgage spreads would widen in response to either China, Japan or Canada coming in with a retaliatory objective," Hagen assesses in his commentary.

The US real estate market is already struggling with issues due to high home prices and weakening consumer confidence. Considering the recent stock market crash, potential buyers are increasingly worrying about their savings and jobs.