How tariff policy unpredictability is rippling through U.S. Treasury bonds

By Atul Bhatia, CFA

Investors in 30-year Treasury bonds don’t ask for much. They’re buying what is typically the highest volatility slice of an asset class that historically tends to underperform equities over multidecade time horizons. On a risk-return basis, that’s not a great combination.

What makes it viable is that some of the major buyers of the long bond, as the 30-year Treasury is known, are foreign institutions, life insurers, and other folks who have long-dated liabilities and just want to have an asset that will offset that obligation.

For these investors, the long bond’s drawbacks aren’t that meaningful. Accounting rules generally let them look through the volatility, unless there is a real default concern, and the underperformance relative to equities is seen as acceptable, since these are institutions that want to exist in perpetuity. Empirically and theoretically, there may be better return options than the 30-year bond, but when the stakes are the survival of the investing institution, the focus is on return of capital ahead of return on capital.

With that focus on stability, the difficulty of making major policy moves in the U.S. governmental system has always been a strength of the long bond. There are two chambers of Congress, plus the White House, and the courts, any of whom can slow down or reverse big moves – it’s a lot of folks to lobby or to sue. That tends to make federal policy somewhat stable. Large changes to entitlement spending or health care would take a bruising congressional battle followed by years or even a decade of court fights. Slow, predictable, and with time to adapt portfolios.

One of the striking aspects of the Trump administration’s tariffs is how much was accomplished without resorting to congressional action. Existing legal authority, including emergency economic powers, gave the president the ability to essentially cut off trade with China, one of the U.S.’s largest trading partners, and use taxes to drive private companies’ decisions on capital allocation while potentially transforming how the U.S. government funds itself. All of this, with a razor-thin congressional majority.

We don’t think the concern is necessarily with the policy moves – after all, they were relatively short-lived. But it opened a window into how much authority has been ceded to the president and how much can be accomplished by a single individual. We think the question long bond investors have to ask themselves is how well they can predict future American politics, particularly seven elections in advance.

For people who thought they would have years of notice before a major economic change and that Congress had the “power of the purse,” recent months have likely been an eye-opener in terms of what is possible under the current interpretation of the existing U.S. legal framework.

Too much work for too little pay

While we would argue – vehemently – that U.S. Treasury bond default risk is extraordinarily low and likely to remain so, long bond investors have to be worried about other possible policy changes beyond default. Taxing foreign holders of U.S. government bonds is one obvious example. Currency policy is another.

Overseas bondholders could do a lot of heavy lifting to analyze the details of presidential emergency powers, break down demographic and voting trends in the electoral college, and game plan out the likely policy shifts for the next three decades. But that’s a lot of work for the slim relative yield advantage presented by the long bond, and we question whether foreign investors in particular will continue to look to the U.S. long bond ahead of the long-term debt of their own countries.

It’s important to be clear that 30-year Treasury yields have been higher in both absolute and relative terms in the past and that we are not suggesting that the long bond will completely disconnect from the yield curve. That’s not the scenario we envision.

Instead, we think investors should potentially be prepared for sustained, elevated risk premiums around long-term debt and they should not necessarily expect long-term bond prices to respond as aggressively and positively to economic slowdowns as they have in past business cycles.

Dollar daze

Adding to the long bond’s woes, we believe, are the prospects for the U.S. dollar. While most bondholders hedge their currency risk, those moves can be expensive, and a currency with strong prospects can make long-term debt look more appealing.

In our view, though, the dollar is another asset that will have to adjust to new realities. Whether we date it from the dollar leaving the gold standard, China joining the World Trade Organization, or some point in between, the dollar has been the world’s trading currency for decades. That reliance on U.S. currency comes in part from its availability, and that availability is fueled by persistent trade deficits. It is by exporting more to the U.S. than they import that foreign investors acquire dollars.

What seems clear to us is that the current trading order of U.S. consumers buying up global surplus production is on the downswing. It is a political focus for U.S. leadership and, possibly more importantly, overseas politicians are now forced to recognise the risks associated with having their economic stability depend on the U.S.’s willingness to keep trade flowing. In a world where trade is more balanced, we think global investors will have both less desire for and access to dollars as a savings vehicle. The result is another headwind for long-term U.S. debt.

Long story short

Investors in most types of long-term debt, like U.S. municipal bonds and multinational corporates, tend to get a hefty yield pick-up for extending maturity. Treasury bonds, by comparison, have been an anomaly, particularly of late, in giving investors in multidecade debt about the same yield as an overnight loan. As we look at the impact of recent policy moves, we think that atypical relationship between yield and maturity in the Treasury market is likely to fade.

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