Did the U.S. Treasury Bond Auction Trigger a "Stock, Bond, and Currency Slaughter"? Wall Street Fears Much More Than That!

The three major US stock indices suffered their worst sell-off since April, long-term US Treasury yields surged by double-digit basis points in a single day, and the US dollar index plummeted by nearly 50 points in a single day—for Wall Street, Wednesday was undoubtedly another trading day marked by a "triple rout" in stocks, bonds, and the currency. Amidst the sea of red, US Treasuries once again became the "epicenter" of the entire financial market...

Just as we warned yesterday, following the chilly reception of Japan's 20-year bond auction on Tuesday, the weak issuance results of the US 20-year Treasury bond on Wednesday once again cast a shadow over the global market, prompting investors to adopt a defensive stance.

The problem lies in the fact that when sovereign bonds, which are supposed to serve as a safe haven, become the source of heightened market anxiety, this sell-off takes on a more unsettling significance. This is especially true when the "protagonist" is US Treasuries.

(The S&P 500 index plummeted after the 20-year US Treasury auction)

As we introduced the day before,Wednesday's 20-year US Treasury auction was the first long-term bond auction since Moody's stripped the US of its Aaa rating last week. Ultimately, the auction ended with dismal figures that no one wanted to see:The highest accepted yield for this issuance reached 5.047%, the second time in history that the accepted yield exceeded 5%. It was approximately 1.2 basis points higher than the pre-auction yield of 5.035%, representing the largest tail spread in nearly six months. Meanwhile, the bid-to-cover ratio also declined from the six-month average of 2.57 to 2.46.

It was expected that the first US Treasury auction after the loss of all AAA ratings would see weak demand. In fact, the situation is always similar—investors from all corners of the world will buy Treasuries, with the only question being the price. The yield premium demanded by traders on Wednesday was significantly higher than expected, and the market reacted accordingly.

"The bond market is sending warning signals to policymakers that fiscal sustainability issues can no longer be ignored for long," said Priya Misra, a portfolio manager at J.P. Morgan Asset Management. "It's not just the bond market; these concerns are now dampening risk sentiment, looming over the stock market, and also starting to capture the attention of the credit market."

Washington's fiscal profligacy remains the primary source of anxiety for bond investors.Nonpartisan analysts claim that US President Trump's proposed tax cut bill could further exacerbate the $36 trillion federal debt by $2 trillion to $5 trillion over the next decade.

The 20-year US Treasury auction added fuel to the bond market fire, but the fixed-income market had already been simmering with underlying tensions earlier in the week. Tariffs, monetary stimulus, rising debt, lax fiscal discipline, heightened policy risks, stubborn inflation, and soaring inflation expectations—all these factors are unequivocally deterring global investors from extending "duration" or purchasing long-term bonds.

Given that Trump has just launched a reckless global trade war and attempted to overturn the world economic order of the past 80 years, other countries are reassessing their holdings of US dollar assets, and "selling America" has gradually become the dominant theme in global capital markets in recent months.

Is this loss of AAA really different?

In fact, financial markets started the week with a rather mediocre reaction to Moody's decision last week to strip the US of its Aaa credit rating, with some market participants expecting that this action would not cause long-term damage to US asset prices—just as was the case when the US rating was first downgraded in 2011.

However, given the challenging global macroeconomic environment and the deteriorating fiscal situation in the US, this may just be wishful thinking.Many seasoned industry professionals have stated that a key indicator to monitor in the coming months is the so-called "term premium" of US Treasuries.

In August 2011, when S&P Global became the first of the three major rating agencies to downgrade the US AAA rating, it hardly caused much negative reaction, as US Treasuries were still widely regarded as the safest assets in the world. Despite S&P's unprecedented historic decision at the time, demand for US Treasuries actually surged after the downgrade, with yields and term premiums plummeting sharply.

But now, this scenario is unlikely to happen again.

In 2011, the US federal government debt-to-GDP ratio reached 94%, setting a record high at the time, reflecting the government's surge in spending to combat the global financial crisis from 2008 to 2009. However, the federal funds rate was only 0.25%, and the inflation rate was at 3% and on a downward trajectory, dropping to zero a few years later, only returning to 3% during the pandemic in 2020.

Today, the situation is quite different. Moody's data shows that US public debt accounts for about 100% of GDP and is expected to rise further to 134% over the next decade; the official interest rate exceeds 4%. Although the inflation rate has currently pulled back to 2.3%, it is expected to rise again as tariffs drive up prices. Meanwhile, consumers' short-term and long-term inflation expectations have reached their highest levels in decades.

Although the $29 trillion US Treasury bond market remains a cornerstone of the global financial system, the increasing policy risks in the US are prompting other countries worldwide to reconsider their exposure to US assets, including Treasury bonds—a process of "de-dollarization" is underway.

From the perspective of credit market pricing, the industry even seems to anticipate that the US sovereign credit rating will eventually be downgraded by six notches to BBB+ in the future, just above the edge of investment grade (BBB-).

Could the term premium on US Treasuries surge further?

Taking these factors into account, it may not be difficult to conclude that, unlike in 2011, the "term premium" on US Treasuries—the risk premium that investors demand for holding long-term bonds rather than rolling over short-term debt—may rise further after this rating downgrade, especially considering its relatively low starting point.

Indeed, before Moody's downgraded the rating last Friday, the term premium on US Treasuries had already reached its highest level in a decade, currently at 0.75%—or 75 basis points. However, this is still significantly lower than the levels in 2011 and remains low by historical standards.

Historically, the last time the debt or inflation dynamics of "Uncle Sam" were as concerning as they are today, the term premium was much higher.During the stagflation-hit 1970s, the term premium rose to 5%, while in the early 1980s, after the "Volcker shock" recession triggered by the US Fed's adoption of double-digit interest rates to quell double-digit inflation, the term premium was around 4%.

Emanuel Moench, a professor at the Frankfurt School of Finance & Management and co-creator of the New York Fed's "ACM" term premium model, pointed out, "Given the fiscal challenges facing the US, the term premium has risen significantly in the near term and may continue to rise in the future. Some investors are concerned about the possibility of a self-fulfilling debt crisis—where a high debt-to-GDP ratio pushes up interest rates, increases the government's interest burden, and narrows the space for debt resolution through growth, which could further drive up the term premium."

The key question is: Where is the ceiling?History suggests that there is significant room for this premium to rise before the US implements serious fiscal discipline or before market interest rates exert excessive pressure on households, businesses, and the federal government.

Some analysts expect the yield on 10-year US Treasuries to rise by another 50 basis points this year, which would push it to the key level of 5%—a psychological threshold for most investors and also the post-global financial crisis high reached by this "anchor of global asset pricing" in October 2023.

As Moench said, with the current high level of fiscal uncertainty and low policy credibility, U.S. Treasuries are in a "fragile moment." Meanwhile, the global environment is also starting to become fraught with tension—this week, the yield on Japan's 30-year bonds also surged to an all-time high...