Analysis: The Trump administration came out guns blazing with huge tariffs on imports from other countries on April 2, until the yields on Treasury bonds started increasing and Trump called time on most of the tariffs.
But why? What is the connection between tariffs and yields on bonds? What even is a Treasury bond?
When a government wishes to borrow money, it instructs the Treasury to issue bonds, which are pieces of paper promising the holder a certain amount of money in the future. These are often called bills, notes, or bonds. They’re all the same thing, but their different names mark a distinction between varying maturity periods. Treasury bills have the shortest maturity, usually of 30 days, while Treasury bonds may have duration of as long as 30 years.
Obviously if you want people to buy these bonds then you need to promise them a return; this is the bond yield, effectively the interest one can earn from holding one of these bonds. You might, for instance, buy a bond for $900 today, because it will be worth $1000 in the future, which would correspond to a yield (interest) of around 11 percent. (A $100 return on $900 investment.)
But if no one (or not enough people) want to buy the bond for $900, the government’s only option is to lower the price of bond, say from $900 to $800. If you now buy one of these bonds for $800 then you stand to make $1000 in the future, a return of $200 on $800 or 25 percent.
So, when bond prices fall, the yield (return) on the bond increases.
In the present instance, the problem started with falling prices of US bonds signifying a lack of confidence in the US; that it may no longer be a safe haven for investments causing increasing reluctance to hold US bonds.
The US dollar serves as the reserve currency for most international transactions, in the sense that such transactions are denoted in dollars. US dollar denominated assets are considered safe assets.
If investors or governments wanted to carry out transactions in a different currency then one would need to pay a premium, meaning a relatively higher interest rate since that other currency is not considered as safe as the US dollar.
But if those investors lose faith in the US dollar and take their money elsewhere then this will weaken the US dollar.
Remember that the flip side of falling bond prices is rising yields, the interest payment that needs to be paid on that bond (say 25 percent as opposed to 11 percent as in the example above).
This creates another set of problems.
First, the interest paid by the Treasury on bonds is a key determinant of other interest rates, such as mortgage rates. When bond yields rise, this makes borrowing more costly. Household budgets take a hit (as mortgage rates rise) while the lack of business borrowing may slow the economy down.
The United States runs a budget deficit of trillions of dollars, so when the interest rates go up so do the interest payments needed to service this debt. The government might respond by either raising taxes or cutting spending in order to keep the debt from ballooning further. This also has adverse implications for economic performance.
We should remember that there are other recent historical parallels. For instance, Liz Truss had to step down as Prime Minister of the UK after introducing a budget with large tax cuts that led to a loss in investor confidence and sharply falling prices of UK Treasury bonds.
In recent weeks investments have flocked to the Swiss Franc, raising its value. But, while there are contenders such as the Euro and the Renminbi (aka Chinese yuan), it is not clear what currency can become a successful alternative to the US dollar.
International financial markets can correct wayward economic policy, as it did in the case of the UK. Like Truss, the Trump administration is encountering a significant dose of market discipline that will result in the tempering of their more radical initiatives. Most recently, Trump has made further concessions on automobile tariffs. This is good news both for the US (if not for Trump) and the rest of the world.
The views expressed are the authors’ own and do not reflect those of the university, the Reserve Bank, or its Monetary Policy Committee.