The announcement of tariffs on April 2, referred to as "Liberation Day," sent shockwaves through global stock markets, intensifying economic uncertainty and increasing recession risks. Invesco Fixed Income reported an elevated probability of a recession following this announcement. However, contrary to expectations, Treasury yields increased, particularly those for longer-term bonds. Typically, in periods of uncertainty and equity volatility, Treasury yields would decline. The temporary tariff pause on April 9 provided some relief to the markets, yet longer-term Treasury yields remain higher than pre-announcement levels. This raises questions about why rates are behaving this way and what it means for investment grade bond investors.
Several factors seem to have contributed to the rise in long-term Treasury yields post-tariff announcements. Market technicalities, fears, and international sentiment appear to be at play. One significant driver was likely the unwinding of a popular trade that sought to capitalize on the gap between Treasury yields and Treasury swap rates. Investors in this trade anticipated future banking sector deregulation, expecting banks to demand more Treasuries, potentially raising Treasury prices and narrowing the yield-swap rate gap. However, with heightened market volatility after Liberation Day, investors aimed to reduce leverage. As they closed leveraged trades, they sold Treasuries and bought swaps, driving Treasury prices down. This unwinding is believed to have partially influenced the movement in Treasury yields in the week following April 2.
Fears surrounding foreign appetite for US Treasuries and a potential increase in Treasury supply also likely contributed to higher Treasury rates. Historically, foreign investors have significantly funded Treasury purchases. If the US decouples from the global financial system, domestic investors may need to step in, demanding higher returns. Additionally, if the US enters a recession, government bond issuance might increase, pressuring yields upward.
The Federal Reserve's next move remains uncertain. While the tariff pause reduces the likelihood of a recession, the Fed's outlook is unclear. So far, it has maintained steady policy. The Fed has time to assess tariff impacts and will likely wait until data indicates real economy effects before cutting rates. It does not seem inclined to intervene solely for financial market stability, which has remained orderly thus far. The market's reaction to rate cuts in this context is also uncertain and may not be interpreted positively.
In recent weeks, investment grade bonds have performed well relative to equities and riskier fixed income assets. Interest rates have driven positive returns this year, while credit spreads have widened. Spreads widened from around 70 basis points late last year to as high as 118 basis points following the tariff pause. Since 2015, the average spread over Treasuries has been 120 basis points. Given improved credit quality, shortened duration, and enhanced liquidity, spreads should ideally be lower than historical averages.
Looking ahead, higher yields present more value in corporate credit, allowing greater alpha harvesting potential. In the event of a recession, spreads could widen further, typically reaching 150-200 basis points over Treasuries. Corporate issuers' strong fundamentals and reasonable leverage levels suggest resilience. Markets can rapidly recover based on headlines, and current economic data shows no immediate signs of recession. The tariff pause offers hope to avoid worst-case scenarios.
Prior to new tariff policies, there was optimism regarding US economic prospects and strong demand for investment grade US bonds. Tight valuations offered less cushion against a recession or risk-off event, leading to reduced exposure to emerging markets and overall credit. Despite this, interest rates are expected to eventually decline. The market currently predicts three rate cuts in 2025, possibly a fourth. An economic slowdown could lower intermediate rates.
An active management strategy is crucial in navigating varying risk environments effectively. Technical factors will likely continue driving market dislocations in spreads and sectors. For instance, institutions underperforming in equities may sell bonds indiscriminately to maintain their bond-to-stock ratios, creating opportunities for active managers. Meanwhile, investment grade bonds continue to fulfill their role by providing high income, acting as portfolio ballast, and remaining liquid.
