The markets have now entered an irrational phase with a level of panic that we have not seen since the GFC. Long term readers of our material will remember, that on many occasions, we have referred to and quoted the movies ‘The Big Short’ and ‘Margin Call’. These are worth watching again in the weeks ahead because like the GFC the fuel for this violent market sell off preceded the trigger event which was the ‘Liberation Day’ tariff announcement.
First a little bit of history, if only for therapeutic reasons, because the GFC had a profound impact on the psychology, wealth, career and knowledge of many of us that endured it.
The GFC arguably commenced with the collapse of Bear Sterns in May 2007. After its closure it was subsequently sold to JPMorgan Chase. The company’s main business areas before its failure were capital markets, investment banking, wealth management, and global clearing services, and its large holdings of subprime mortgages. In the years leading up to the failure, Bear Stearns was heavily involved in securitization and issued large amounts of asset-backed securities. As investor losses mounted in those markets in 2006 and 2007, the company kept arranging new issues of asset backed securities and actually increased its balance sheet exposure, especially to the mortgage-backed assets that were central to the subprime mortgage crisis. In March 2007, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved, however, and was sold to JPMorgan Chase subsequently.
The markets then actually rallied to record fresh highs by the end of November 2007 with many dismissing the Bear Sterns collapse as an aberration rather than an indicator of a systemic problem.
Then in early January 2008 several European investment banks became aware that Society Generale, the French Investment Bank, had been very active across a number of futures markets (everything from currencies to commodities). When questions were asked about these positions and the answers were not forthcoming, the market began to panic, and Society Generale was forced into a rapid unwinding of its positions that brought about a euro $4.9bn loss that jeopardised the bank. The following account is one version of what happened and is not entirely accurate. 2008 Société Générale trading loss – Wikipedia
This time, unlike with Bear Sterns, the markets did not recover, and asset volatility remained at a high level for a prolonged period. It was the recognition of how this high level of volatility impacted the pricing of the derivatives being used by the investment banks to hedge their balance sheet exposures that is portrayed in the movie, ‘Margin Call’. It only took one bank to recognise the problem and make the decision that it would be better to first out and survive, for the GFC to be triggered.
When this one bank’s actions triggered a fall in prices and rise in yields on all mortgage-backed securities the marked to market losses caused the collapse of Lehman Bros and a domino like process commenced. If Treasury Secretary Paulson had not made the difficult decision to step in on September 17 and save AIG from following Lehman Bros into administration, then the entire US financial system would have collapsed.
What followed the GFC was a prolonged period of economic stagnation in which the US household debt to income ratio fell, due to a combination of the debt being repaid and household incomes gradually rising. This period of time ended in March 2020 and is referred to as a period of secular stagnation (Harvard’s Larry H. Summers on Secular Stagnation – IMF F&D).
The following chart shows the decline in US household debt to income into March 2020 and the rapid increase in 2024. From an Australian perspective we should note that back in 2007 both Australia and the US had the same Household debt to income ratio.
All of this history brings us to the here and now. Since March 2020 excessive financial liquidity and fiscal expansion that commenced to combat the impact of the pandemic lockdowns but remained in place long after the economy had fully recovered, pushed all asset prices up to extreme valuations. All of this excess culminated with the ‘Trump Bump’ after he won the 2024 Presidential election with a promise to change America. By January 2025 nearly all asset markets had reached extremely overvalued levels:
- Overvalued equities on a PE, Yield and ROE basis.
- Tight credit margins on floating rate bonds.
- A currency market distorted by the policies and actions taken by several of the central banks.
So, when Trump surprised some with the size of the tariffs on April 2 a few market participants determined that an economic contraction would occur and began to unwind their positions rapidly. This has now brought about a widespread panic in the equity markets.
US Tariff policies
There is a lot of misinformation being published by academics and market strategists. The markets will not remain irrational for very long, so the following is a guide to what we expect when the smoke clears and rational analysis returns.
Why are the markets all of a sudden panicked by the Tariffs imposition?
- Did not expect Trump to follow through on his election promises?
- Did not think the tariffs would be proven to be lawful? The power to impose tariffs resides with Congress and so we could see legal appeals that block Trump’s tariffs.
- Expected that the tariffs would be explicitly targeted to get other countries to change their behaviour:
- Stop Fentanyl exports into the US from Canada and Mexico
- Stop illegal immigration into the US from Canada and Mexico?
- Unwind existing tariffs or other trade barriers? Here we have a mechanism through the WTO (that the US no longer recognises) to appeal unfair trade practices but the WTO success has been limited and largely ignored by non-developed nations.
- Academics and some market strategists are stoking a fear of a recession. They are basing this on the impact of the Smoot-Hawley Tariff Act 1930 that was imposed after the 1929 crash that triggered the Great Depression. The US imposition of the Tariffs is considered to have prolonged the Great Depression because other countries responded with retaliatory tariffs. The Smoot-Hawley Tariff act was imposed at a time when currencies had fixed rates and in the US case the USD was tied to the gold standard.
- The inconvenient truth is that the US equity and credit markets were overvalued so could not absorb the uncertainty of the Trump approach to economic policy.
No legitimate economist would claim that these tariffs are good economic policy for the US, but the real impact is not likely to be as dire as the markets are indicating. The following is a guide to what we expect to unfold:
- In the short term the tariffs have inflationary implications as higher import prices unavoidably feed into the US supply chain. Fed Chair Jerome Powell last week commented that tariffs are “highly likely” to cause “at least a temporary rise in inflation” but caveated that the FOMC is “obligated to keep longer-term inflation expectations well anchored and to make certain that a one-time increase in the price level does not become an ongoing inflation problem.”
- In the medium term (90-180 days) the inflationary implications will be greatly diminished by free floating currencies adjusting to offset the tariffs and China devaluing its fixed exchange rate. China is in a very good position to do this because at this time it does not have to worry about a lower currency feeding into inflation. China is suffering disinflation. The Chinese retaliatory tariffs of 34% on Friday are then a disappointing reaction but then if China invades Taiwan all its exports will be sanctioned anyway.
- In the long term the diversified US industrial base has the ability to substitute the imports with domestic production, but this is unlikely to be as efficient an outcome so it will have some inflationary implications.
- It is not clear, at all, that the tariffs have negative implications for US GDP growth. If it was clear, then Trump and his team would not have considered them. The misinformation being peddled by many, that should know better, is that the increase in import prices as a result of the tariff imposition will lead to lower US consumption activity. If this is the way the economy worked then we would never have inflation, a central bank or a need for economists! Comparisons are being made to the increase in taxes by the Nixon Administration in 1969 that led to a sharp decline in household consumption. The Nixon tax increases were on company and personal incomes so made a direct impact on spending. Tax Reform Act of 1969 – Wikipedia. It is not at all clear yet the extent to which the US supply chain will pass these tariffs through to consumer prices.
The impact on Australia will be inconsequential because:
- Our free-floating rate currency will fall and offset the tariff impact (already underway)
- The US has a beef production shortage so is likely to keep buying our beef.
- The ban on US beef that Trump referred to was lifted in 2019. This ban was due to the Mad Cow disease outbreak in 2003, and our biosecurity laws still require that US exporters prove that the beef they are exporting was bred and grown in the US only.
- US domestic beef prices are much higher (50%) than Australia’s so even without our biosecurity laws US producers would not logically export to Australia for a lower price outcome.
- Trump tariffs: US claims Australia unfairly bans US beef imports are wrong, say local producers
- Australian exports are almost entirely minerals and agriculture. They are of such high quality they will either continue to be purchased by the US at the higher cost or they can be sold elsewhere.
- Calls in the media by attention seeking mavericks or inherently conflicted economists that work for banks that have a business model based on borrowing short to lend long for now, 4 interest rate cuts are absurd. The Aussie dollar is already falling to equate out the tariff impact and given the amount of finished goods Australia imports this is inflationary. If anything, the RBA may sometime this year be forced to raise rates because under a flexible exchange mechanism the transition path of monetary policy into the real economy is via a change in the exchange rate.
- There is only one reason Trump has imposed this tariff on Australian beef and that is to raise tax revenue at the expense of the US Consumer. In the short-term consumers may switch away from Beef consumption because there are substitutes but in the longer term, they will demand a higher wage to afford the increased cost of beef.
What we expect in summary:
- A short-term increase in US inflation and a medium-term increase in Australian inflation.
- A rise in the USD that largely mutes the impact of the tariffs. That fact that the dollar fell last week is not a connection to the tariffs but the irrational panic that had all asset type positions being unwound. Watch for the USD to be strong in the week ahead.
- Higher long term US inflation to some extent. The exporting of inflation to China and Southeast Asia over the past decade will no longer occur to the same extent.
- Higher US bond yields as interest rates will have stay higher for longer and there is now a bigger sovereign risk.
- Factors of production being moved from export industries (and the government sector) into import substitution industries after the USD increases. This was something that had to occur even without the price signal from the tariffs because the western developed world needs to rebuild its industrial base so that it no longer exposed to the kind of supply chain disruptions we saw in the pandemic or would see it there was a war in the Pacific when China blockades Taiwan (something that is possibly imminent and may be another reason for the sharp equity sell off on Friday night Experts say barges could be used in PLA invasion – Taipei Times Taiwan’s top security official visits U.S. for talks – The Japan Times)
- No real impact on the Australian economy unless a severe economic contraction in China reduces demand for our key exports.
Interest Rates
The markets have now turned irrational, so we need to judge the moves in bond yields through this lens. The sharp fall in US bond yields as the equity market melted down was not a reflection of the outlook for inflation or eco growth but merely an irrational flight to safety and a mark down to economic growth. Markets completely mis-read Trump’s tariff moves and are now melting down that there is no Trump or Fed out to rescue them. The much stronger than expected jobs report on Friday night showed once again that the US economy remains robust and so bond yields were mostly unmoved from Thursdays close. Prior, treasuries for the week fell about 0.25% across the curve. We expect that bond yields will rise into Easter with a realisation that the tariffs are certainly inflationary, but it is most uncertain whether they will cause an economic contraction.
Australian rates were not immune from the global rush to bonds, the comm. gov. 10-year yield finished down 0.29% for the week at 4.17%. Shorter term rates fell more as the market forecast for an RBA cut in May intensifies given tariff instability. The RBA at the April 1 meeting keep rates on hold.
Major Credit Markets
The US investment grade (IG) bond market buckled to the tariff shock, in that all companies, IG or not, will be impacted, with the degree at this stage uncertain for most. Spreads jumped dramatically late in the week, the IG iTraxx index spread up 0.05% on Thursday and then 0.10% on Friday, a rise for the week of 15 pts, large off a base of an average spread YTD of 0.61%.
Initial moves in credit markets were deemed to be relatively orderly until Friday when the China Tariff retaliation triggered a big shift wider in credit spreads. Part of the problem here is that credit spreads were unrealistically tight before the tariff announcement so there was very little room for error. Light trading volumes are expected to continue until after Easter with new issues delayed and market participants standing aside until the equity markets stabilise. When the credit market does begin to recover it will be the covered bonds that lead the way. The Aust. iTraxx rose by 0.14% for the week to 0.96%, a 6-month high.
High Yield Markets
US high yield (HY) spreads got smacked over the week, the average HY spread jumping 0.77% to 3.90%, a 6-month high. Nearly all signals conflated against HY – huge equity market falls, tariff and economic uncertainty and potential inflation. The missing factor at this stage is actual company results. Conversely lower yields, if they hold, will help companies future funding rates.
Hybrids had held up well in recent weeks despite some widening in credit spreads and softer equity markets. However, the huge jump in equity market volatility and a fall in the major bank stocks of 1.71% for the week impacted hybrid margins. The average major bank hybrid margin rose by 0.17% for the week to now be 2.10%. This is shown for individual hybrids in the commentary on the next page. Hybrid volumes were modestly elevated above average but lower than previous weeks. The long dated MQGPG again was the largest in turnover, followed by Dec 27 NABPH and the longer dated CBAPM and WBCPM.
Listed Hybrid Market
Hybrids pause and retreat
What a difference a week makes, especially when a huge bout of volatility strikes markets. As mentioned above, hybrid margins were softer last week. This has been after several weeks of solid support against the trend of softer credit markets post the AN3PH redemption. The chart below shows how individual margins have moved in the past week. Most recent margins are shown by the blue dots, the red for a week before. All issue margins have moved wider, especially CBAPL, WBCPH and NABPK. Only AN3PJ and AN3PL showed small moves wider. When such dislocation hits markets trading opportunities based on relative value emerge. WBCPH is a standout for short term maturity. The short tenor is valuable in volatile times as the yield should hold with credit duration being much lower than other issues. CBAPL also looks cheap as the best value hybrid with a maturity past 2025.
Forward Interest Indicators
Australian rates
Swap-rates show large falls as bond rates retreat.
Swap rates:
- 10-year swap 4.04%
- 7-year swap 3.83%
- 5-year swap 3.62%
- 1-month BBSW 4.10%
