Liberation day?

When Donald Trump announced a swathe of new import tariffs on most countries on April 2, it was unclear how this might affect the US interest rate. The tariffs were announced on ‘Liberation Day’, with rates such as 49% on Cambodia, 46%  on Vietnam, 54% (now 145%) on China, and 20% on the EU.

The White House probably anticipated a significant stock market reaction because it announced the new tariffs after the US financial market closed. The reaction from the world’s stock markets in the following days was significant, with London’s FTSE share index falling 10.5%, Germany’s DAX share index falling 12.2%, Japan’s Nikkei share index falling 12.5%, and the US Dow Jones share index falling 10.9%.

These share price falls worldwide, triggered by the new US tariffs, were an immediate market reaction to the economic problems the tariffs could cause to so many countries. The new tariffs would increase business import costs in the US and decrease the revenues of businesses exporting into the US. Higher costs and decreased revenues for so many organisations globally mean decreased future profits, and this is a major reason why investors sold their shares, causing the stock market to decline sharply.

When stock markets sell off, investors look for safer places to put their money. US government bonds are seen as one of the safest assets in times of stock market volatility.

Government bonds are units of debt that governments sell to fund their expenditure. Banks, hedge funds and pension funds buy large quantities of government bonds, which means they are lending their money to a state for a fixed period of time (normally years), and in return for this, they are paid a fixed rate of interest. The investors can buy and sell existing government bonds in the bond market. When a bond is bought or sold, the fixed rate of interest stays the same. This means a fall in the bond price means the fixed interest rate is effectively a higher interest rate relative to the bond price. This is called an increase in the yield on government bonds. If the price of a government bond increases, the effective interest rate on the bond decreases and its yield falls.

Many market bond market analysts believe that in the days following the announcement of the new US tariffs, investors started to lose confidence in the US government's ability to manage its economy and the financial turbulence caused by the tariffs. This loss in confidence led to investors starting to sell US government bonds, causing their price to fall and the yield on the bonds to increase. This increase in yield meant the cost to the US government of funding its borrowing increased when it issued new bonds. Buyers of US bonds would want a higher interest rate when they bought new bonds if the yield on existing bonds had increased.

Falling US government bond prices are starting to put pressure on money market interest rates in the US to increase because buying existing government bonds with a higher yield is effectively a higher interest rate on those bonds, and other interest money market interest rates are pushed higher by this. So, higher borrowing costs for the government also mean high borrowing costs for private sector households and businesses.

Many commentators believe falling US bond prices and the threat of higher interest rates are the reasons Donald Trump’s government decided to soften its tariff position and call a 90-day pause on the tariffs it announced on ‘Liberation Day’. The same commentators highlighted the power of the bond market in affecting government economic policy.

Possible questions for discussion

1.       What is a government bond?

2.       What is the yield on a government bond?

3.       Why did US government bond prices fall?

4.       How does a fall in US government bond prices affect the yield on the bonds?

5.       How do falling US government bond prices affect market interest rates in the US?