After Liz Truss’s ill-fated mini-Budget blew up the bond market three years ago, the former prime minister was forced into an embarrassing climbdown.
As well as sacking her chancellor Kwasi Kwarteng, she also quickly unwound her package of unfunded tax cuts to keep the markets at bay.
However, despite the radical reversal, borrowing costs did not return to their old levels and Britain was left paying what was unkindly dubbed a “moron premium”.
The US is now at risk of suffering a similar fate.
Once seen as the bedrock of the global financial system, America has transformed into an unreliable economic partner under Donald Trump’s erratic White House administration.
And that comes at a cost, as we saw earlier this week when investors dumped US debt over fears that the president’s trade war would trigger a financial crisis.
Although US bond yields fell in the wake of Trump’s tariffs climbdown on Wednesday, Orla Garvey, at money manager Federated Hermes, notes how they have since been climbing once again.
This shows that the “premium on US treasuries remains high”, says Garvey, referring to the extra interest investors demand in return for taking the risk to lend over time.
This should be of increasing concern for Trump, who admitted that he paused his global tariffs blitz in response to people “getting a little bit afraid”.
“It was almost certainly moves in the bond market, rather than equity markets, that forced the change in stance by the US,” says Neil Shearing, at Capital Economics. “It is the bond market that sets borrowing costs for the government.
“There were some signs that market functioning was starting to become impaired. It scared them, spooked the US Treasury and prompted the change of heart.”
The problem is that Trump cannot simply announce a partial freeze on tariffs and expect investors in the bond market, such as the pension funds, wealth managers and foreign states, to forget that he ever declared a global trade war.
Nor will they simply disregard the escalating spat between the US and China with the two countries announcing a barrage of tit-for-tat tariffs.
There is also concern about where funding for US treasuries comes from.
One major source is China. As the world’s second-largest economy exports much more to the US than it buys in return, it must find something to do with all the dollars it receives for its goods.
Traditionally, China has used this cash to buy up US treasury bonds, bankrolling America’s government in the process.
However, given that Trump has now imposed a new 145pc tariff on goods from China, which has hit back with a 125pc levy of its own, trade between the two countries is poised to plunge.
Mohit Kumar, an economist at investment bank Jefferies, says this will cut off a key source of revenues for the US.
“Trump policy aims at reducing trade deficits,” he says. “However, if trade deficits reduce, it is not obvious that the rest of the world will continue to fund US fiscal deficits. Some of the damage from the trade wars will be permanent.
“The US will be seen as an unreliable partner, leading to countries trying to reduce trade ties with the US and increase trade ties with each other. Even on the geopolitical front, Europe will see the US as an unreliable ally, leading to increased focus on self-reliance.”
He recommends investors put their money into Europe and Asia instead, indicating that the US will have to pay more interest to attract global investors. This is an expensive proposition given its $36 trillion (£28 trillion) national debt pile.
The longer Trump has to pay the “moron premium”, the longer the US economy will suffer.
Credit: Reuters
Shearing notes that American mortgages, which are typically fixed for their entire length, not just the first two or five years as in the UK, are closely linked to the 30-year government bond, so a higher rate there directly feeds through to families.
This is likely to last for years.
Bilal Hafeez, at Macro Hive, says the US built this economic system over decades to its benefit. Suddenly, investors are questioning whether there is political risk within US assets.
“This is a generational change,” says Hafeez. “It takes a long time to build up a credible, rules-based system, which the US has effectively been underwriting since the Second World War.
“The US was always the one which said, ‘these are the rules of the road, we will always stabilise the global financial system’ – and as a result, the US was able to attract huge financial flows.
“Now that is all gone. It could cause a recession in the US. It also means longer-term growth will fall as well.
“It has had higher productivity than the Europeans, the Japanese, and part of that is because the US is the central node in this global system. What is happening now will start to chip away at that.”
There are knock-on effects for other countries too, because when borrowing costs rise in the US, they tend to jump elsewhere.
James McAlevey, at BNP Paribas Asset Management, says higher costs are bad news for not only Trump’s administration, where any economic downturn could easily send its budget deficit of 6pc of GDP up to 8pc, but also stretched European economies, including France and the UK.
“The US is not the only country with fiscal frailties,” he says. “We are in a situation where loads of developed markets’ fiscal authorities are sitting with deficits that are wider than they should be at this point in the economic cycle, having done nothing to repair those whilst growth has been a bit more favourable post-Covid.”
The threat of global fiscal pressures has now been compounded by a breakdown in trust across markets, says Stephen Thomas, professor of finance at Bayes Business School.
“Trump repeats complete falsehoods, which permeate people’s confidence and trust in everything which comes out of that administration, which leads then to the bond market,” he says.
“All this builds up to reduce our trust in economic data, in the politicians, and ultimately, the bond market is based upon trust.
“Whether you call it a ‘moron premium’ as with Liz Truss, or you might call it a half-truth premium or a falsehood premium – it is what has been triggered now with these tariffs.”
