Bonds, The Basis Trade, and a Market in Transition
Tariffs, Volatility, and the Basis Trade: Anatomy of a Tariffic Catastrophe...
Hey guys,
This report is a big one, number 200 for Market Macro Hub!
MMH started in March 2022 with Joe who built this platform to what it is now, he began as a market enthusiast and is now at a L/S equity hedge fund in Mayfair so it’s fair to say that there’s been some true progression.
He has passed on a message… “We are back!”
He is watching from the sidelines, he really never left.
I can't wait for the next 100 reports — things are only going to get better.
Let’s dive into this crazy market.
Q2 recommendation update
Someone on X said - “This week has been a long month” - I truly felt that this week as many other people in the industry did.
Market Macro Hub’s Q1 and Q2 recommendations have seen some astronomical gains, if you acted on last week’s report you’d be seriously in the green. Indices and Dollar shorts have been so great. The “sell everything American” move has been quite a funny one, you could’ve literally woken up, hit the short button, go to sleep and wake up in the green.. Quite amusing.
There’s no need to find excuses for it to reverse, we may get some natural unwind of this huge sell but nothing to cause a shift in sentiment/bias.
Bonds, indices and the rest
Let’s get up to date with the dynamics of this week with some quick bullet points:
Total effective tariff rate on China - 145%
US rate cut expectations jumped between 3 and 5
Divergence in “normal” correlations
90-day pause from the U.S. on reciprocal tariffs (excluding China)
Europe pauses tariffs on the U.S. for 90 days
Recession probability jumped to over 50%
U.S. CPI dropped 40bp yet had no positive impact for U.S. assets
Gold, Yen, Swiss Franc and Euro see large “safe haven” gains
Countries who didn’t impose a reciprocal tariff will be “rewarded”
The stock market has seen a sharp selloff, with the VIX soaring to 50 — a level rarely reached. At the same time, U.S. Treasury yields have jumped, with the 10Y climbing more than 50bp in just five sessions (crazy, I know). Meanwhile, the U.S. dollar is plunging, down c.4.5% against the Euro since early April. This unusual mix of moves suggests we’re entering a very different and volatile market regime. According to Goldman Sachs, hedge funds executed their largest ever net sales of equities after the Trump tariff release, retail are the last to sell.
Typically, when market sentiment turns notably negative, U.S. yields decline, and the US dollar strengthens. However, this time the reverse is true.
Bond yields aren't rising due to inflation fears, but rather coming away from inflation expectations. The move appears driven by other forces including forced selling, portfolio degrossing, and the potential presence of activist sellers. Rising yields are being fuelled by upcoming U.S. debt refinancing pressures and the unraveling of the bond basis trade, a heavily leveraged strategy that profits from small differences between bond prices and futures.
Being out of negative territory on the 2s10s curve is good, but steepening due to negative sentiment isn’t. Bear steepening this week has fuelled the 2s10s spreads wider. The bond market impact is contagious too, the recent rise in 10Y yield sends rising depreciation pressure on EM currencies, forcing central banks in EM to sell treasuries so they can intervene to defend their currencies, further sparking this trend. That depreciation pressure has abated a bit for now, the 10Y is ending the week more tamed. The sentiment across VIX and MOVE just really sums up how fearful investors are, both seeing extreme levels.
A very good play in the markets this week was fading the temporary “Trump pump” across equities/indices. I managed to fade the S&P500 and FTSE100 moves for c.2.8% profit and to me, this was a high probability play. Temporary sentiment drove that move higher but it made no sense at all, tariffs are still at the highest levels seen in nearly 100 years with many tariffs still over 20%. Even in a scenario where tariffs are completely deleted in 4 weeks (almost a 0% probability, but I’m giving an example), there will be some transmitting that they’ll do even for the small amount of time they’ve been in place, negative for equities. This was the c.7.94% pump that the Nasaq 100 see just after Trump’s 90-day pause on reciprocal tariffs:
I can’t go on without mentioning yet another disoriented correlation, oil lower while yields are pumping. These correlations are skewed across all markets, not just the U.S. dollar and bonds. The lower oil prices have been predominantly down to future growth expectations, but we can’t forget that OPEC+ will be increasing supply by 411k bpd in May so that added to the downside pressure. The probability of a recession in the U.S. reached over 60% this week and that was not random, that is a fair outcome for the current dynamics. Although Trump has tried defending U.S. markets with his statement - “It’s a great time to buy” - the market doesn’t want to hear it as downside pressures persist.
Scott Bessent, on the other hand, has remained realistic in his speeches this week being more transparent about the “short-term pain” the U.S. will need to go through to achieve independence and reshore many industries, particularly manufacturing.
This is what oil had to say this week:
Although markets are fragile and uncertain, I think the game plan from Trump is becoming a little more easier to read (to an extent…). He simply wants everyone against China, isolating them against the RoW. This is evident in his openness to pause reciprocal tariffs on global economies while doubling down on China, reenforcing his opinion that they are the “wort offenders” in terms of unfair trade deals against the USA. We have seen the USD/CNY peg move slightly higher (7.40) as the week has gone on, signalling China may be artificially weakening their currency to mitigate some tariff impacts, which Bessent urged them not to do.
The U.S. will experience the short-term pain, but there’s two losers in this tariff war (US vs China), Goldman Sachs estimated, when 34% was the highest tariff on China, that a 34% tariff would weigh on Chinese GDP by at least 0.7 percentage points this year, so imagine what the current 145% effective tariff rate will do to their growth. If we work on simple maths terms, the weight on Chinese growth with 145% ETR could be c.3%, but maybe not that much in real terms because of the likelihood of negotiations plus at a certain tariff rate, any extra increase has less impact. But to keep it simple… big affects on growth, negatively.
China exports more consumer goods to U.S. than other countries, so boosting that (to 145% ETF) relative to others will boost the hit to consumption goods. See Figure 6 below for that breakdown:
Now many may say that China can reroute their trade to the U.S. via third party countries, but Trump won’t let this happen easily and has already made that clear. This is why he is trying to get the RoW on his side so that the ease of rerouting exports to the U.S. from China stay ultra low.
The infection across markets has reenforced the safe haven Gold play, reaching new ATH’s against the USD. It’s simply down to investors running out of options on places to put their money. The so called “safe play” in buying bonds which has been in effect for so many years just isn’t realistic right now because of the risk they pose. Other options like DM equities or DM currencies are also too volatile to place large amounts of your portfolio in, so Gold it is.
Now you ask - “What’s the play?”.
There is not one strong enough for me right now. My calls for Q2 trades are in the green so heavily that positioning into them at these extreme prices just wouldn’t make sense. The regime broken down in this report keeps me:
Bearish on equities/indices for AT LEAST near-term (2-4 weeks)
Neutral on bonds because a continued selloff will lead to capitulation so I think policy makers will intervene prior, limited downside here in my opinion