25 April 2025

Jonathan Sparks

Chief Investment Officer, UK, HSBC Global Private Banking and Wealth

After a busy week in the markets has ended in a materially more positive tone. It’s not time yet to ring the bell on a turnaround in US equities but there is a stronger case to get invested. It increasingly looks like there are limits to what stress the US administration can stomach, and it’s routed in the bond market.

During US President Trump’s first term in office, the US equity market was perceived as the barometer for success. Repeated reference to all-time highs were seen by Trump as a vote of confidence on his policies. With this in mind, his recent willingness to tolerate heavy equity loses across US equites came as a surprise to some investors. If US policymakers were willing to accept some “short term pain” in equities, then what is going to keep a check on policies that could take a wrecking ball to investor confidence in the US?

We now have good reason to believe this will be the US bond market – specifically the US Treasury (UST) market. This, almost $30 trillion bond market, is nearly two-thirds the size of the S&P 500, and a fraction under the yearly GDP for the US. The yield on these bonds has become ever more critical for US government funding, with the interest costs now larger than the defence budget. Since these bonds are backed by the government of the largest economy in the world, and the market is so easily tradable and “liquid”, these US Treasuries are seen as the benchmark for almost risk-free investing. This perception has meant that the US Treasury has been able to run a near 7% fiscal deficit without run-away yields that marred Liz Truss’ brief time as UK Prime Minister.

If investors lose confidence in the US Treasury market the US has a very big problem. And lose confidence is exactly what investors have been doing over recent months - especially after the “liberation day” tariffs. There are two particular examples of strain in the UST market that have caught my eye: The first was when the yield on the 30-year Treasury briefly rose above 5% during a very volatile week of trading in the week preceding the April 2^nd tariff announcements. The following day Trump announced a 90-day delay on tariffs because 75 countries had reached out to the US trade negotiators to kick-start trade deal discussions. The second was this week, where again bond yields for longer-dated UST’s started to climb. This isn’t always a bad thing and with the US it’s usually a good thing because it typically reflects higher economic growth expectations. But this time yields were rising because investors were applying increasing risks to holding UST’s. Following a series of Truth social posts from Trump attacking Fed President Powell, investors were doubling down in their questioning of whether the UST market was living up to its “risk free” classification. How do I know that it was risk aversion rather than higher growth that cause the spike in yields?  Because: a) the USD was weakening – rising yields would usually attract investors to the US, not repel them, and b) the “term premium” rose, which is essentially extra yield that investors were commanding for holding longer-term USTs.

A rising term premium is bad news for the US. It means that “real” yields rise – that’s the yield on a UST after accounting for expected inflation. It makes it more expensive for the US government to borrow and because it doesn’t come hand-in-hand with higher growth, it worsens the government debt-to-GDP outlook, which was already not looking good. After Trump attacked the Fed President Powell, markets started to question the independence of the Fed. An independent central bank is an institution that markets value highly as it gives stability and confidence in the US bond market. Many will draw a connection between the sell-off in UST’s and Trump’s backtracking on criticism of Powell and tariffs.

This suggests that the US bond market does works as a check on the US administration. The implication is that there is a limit to how far higher real yields will be tolerated. For investors this is an opportunity to invest because real yields are attractive at between 2-3% and there is now an implicit limit meaningful downside to bonds.

For a hold-to-maturity investor this is about as close to a guaranteed inflation beating return as we have seen over the last decade. This spills over to equity too: a reluctance to invest in equity was that, despite the repricing, they just didn’t look that cheap compared to bonds. Yet if the downside risk to bond is more limited, then the better chance of lower bond yields will make equities look better by comparison. Doubts remain over the extent of earnings downgrades, which should become more apparent over the coming weeks, so a tactical overweight isn’t warranted; but at least valuations are now back to where they were before the narrative of AI-lead growth pushed them towards dizzying highs. This makes them a better long-term bet. The 90-day tariff extension still hangs over markets, although any downside risk looks more limited because of US policymakers’ loss of appetite for challenging investor confidence – especially if Trump wants to keep a limit on borrowing costs so he has room to offset tariffs with some more growth friendly tax cuts. Put simply, the downside risks appear less extreme and are more balanced by the potential positives. Add to that, the inflation beating returns for government bonds and the argument to invest stacks up. For me, that’s pretty game-changing.