Understanding the U.S. Bond Market: Secondary Trading and Its Impact on Equities Amid Tariff Turmoil
Last week, we saw Trump blink in his trade war against the rest of the world. The cause of that hesitation was not diplomacy, reason or even a modicum of common sense. It was a slap from the bond market, which caused an already fragile equity market to drop its bundle. Many try to explain markets and their interrelationships as some form of interconnected clockwork machine. I think a more appropriate metaphor is as a loose spiderweb that at times is fixed in its cause and effect and at other time and at other times quite loose.
Whatever the structure or the intensity of the interrelationships, it is worth knowing something about bond markets and how they impact equity markets.
The Mechanics of the U.S. Bond Market.
The first step in understanding bonds is to recognise and understand the distinction between the primary and secondary markets.
Primary vs. Secondary Markets
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Primary Market: This is where new bonds are issued. For U.S. Treasury securities, the Department of the Treasury conducts regular auctions where institutions and individuals can purchase newly issued bonds directly.
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Secondary Market: After issuance, bonds are traded among investors in the secondary market. Unlike stocks, which typically trade on centralized exchanges, most bonds are traded over-the-counter (OTC). This decentralized nature is due to the vast diversity of bond types, maturities, and issuers, making standardized exchange trading less practical.
Over-the-Counter Trading
In the OTC market, transactions occur directly between parties, often facilitated by brokers or dealers. Prices are negotiated based on various factors, including prevailing interest rates, the bond’s credit rating, and market demand. This system allows for flexibility but can also lead to less transparency than exchange-traded securities.
The April 2025 Bond Sell-Off: A Case Study
In early April 2025, the U.S. bond market experienced a significant sell-off, with yields on 10-year Treasury notes spiking sharply. Escalating trade tensions primarily drove this abrupt movement, as the U.S. administration imposed sweeping tariffs, including a 10% universal tariff and a 145% tariff on Chinese imports. These actions raised concerns about inflation and economic growth, leading investors to reassess the risk profile of U.S. government debt.
Investor Reaction
The sell-off was exacerbated by hedge funds liquidating complex debt positions, contributing to the instability in the bond markets. The Federal Reserve’s limited ability to respond due to tariff-driven inflationary pressures and political threats to its independence further unsettled investors. Foreign investors, traditionally significant buyers of U.S. Treasuries, began reconsidering their exposure amid fears of capital restrictions and erosion of U.S. economic exceptionalism.
Foreign Holdings of U.S. Treasuries
Foreign investors play a pivotal role in the U.S. Treasury market. As of December 2024, foreign holdings of U.S. Treasury securities totaled approximately $8.5 trillion. Japan and China are the two largest foreign holders, with Japan holding around $1.06 trillion and China approximately $759 billion. These holdings represent significant portions of the respective countries’ foreign exchange reserves and reflect their deep financial ties to the U.S. economy.
These reserves also represent a weapon of mass destruction in any long-term trade war.
Interest rates and bond prices have an inverse relationship: when interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This is because newly issued bonds offer higher yields in a rising-rate environment, making existing bonds with lower fixed interest payments less attractive. As a result, the price of existing bonds must decrease to offer a competitive yield. Conversely, in a declining-rate environment, older bonds with higher coupons become more valuable, pushing their prices up.
In simple terms, this means that if Japan and China sought to sell their bonds interest rates in the US would go through the roof. Something no government, not even one as incompetent as the Trump administration, could tolerate.
Impact on Equity Markets
The bond market’s turmoil had immediate repercussions on equity markets. Rising yields increase companies’ borrowing costs, potentially squeezing profit margins. Additionally, higher yields make bonds more attractive relative to stocks, leading investors to reallocate assets away from equities.
Market Volatility
The simultaneous decline in the dollar and Treasury bond prices signaled waning investor confidence in U.S. assets. This broad-based sell-off created volatility in stock markets, with major indices experiencing significant fluctuations. The uncertainty surrounding trade policies and their economic implications made equities less appealing, prompting a shift towards safer assets like gold and the yen.
What does it all mean?
For the average investor, the only thing you really have to grasp is the relationship between bond prices and interest rates. If bond prices go down, then interest rates go up, and this negatively impacts equities. If bond prices increase, then interest rates decrease, which is positive for the equity market.
This does raise the question of what the future might hold. All I can say is watch this space; we have four more years of this idiocy,
