Time to Prepare for Volatility to Return

Zeitgeist: “How did you go bankrupt? Two ways. Gradually, then suddenly.”

Heard on the floor: “still a big risk that they will crash equities to save bonds”.

Deficits don’t matter until they do – you can keep funding and rolling and raising debt ceilings until you cannot do it any longer. We may be approaching that point. Moody’s is a rather tardy canary but its downgrade of US credit rating has focused attention and shaken some out of what in my view has been a rather complacent mindset.

After the rollercoaster of April, an uneasy calm has returned to financial markets. The VIX completed its quickest ever round trip from panic to calm. But bond markets are on the march, and we may be due a renewed bout of volatility. 

• Tariff risk: tariff risk has not gone away. Treasury Secretary Scott Bessent suggested over the weekend that some Liberation Day tariffs could be reimposed, which has hurt risk sentiment on Monday morning and reminded investors that it’s an armistice and not a peace treaty on the trade war front. We are past peak pessimism (April lows) and past the peak optimism (China trade deal announcement last Monday). So, from here it likely gets choppy again.

• US fiscal position remains precarious: We have seen a structural shift in the market’s willingness to fund America’s twin deficits. Now Moody’s downgraded America’s credit rating, citing the unsustainability of growing budget deficit and US national debt. The US lost its triple-A rating years ago – Moody's has been slow to catch on. But it shows that there are growing worries about the fiscal situation in the US.

• Ok we have been here before – we've talked about unsustainable debt for years. So what’s different now? One is tax changes (see below), while tariffs and economic policy has led to a reassessment by foreign investors large and small about their willingness to buy US assets. Also, just the number – deficits don’t matter until they do.

• Big, beautiful tax bill: adding to the perception problem regarding US debt is Trump’s sweeping tax cut bill, which cleared a key Congressional committee on Sunday. This will add between $3 trillion and $5 trillion to the nation's $36.2 trillion in debt over the next decade. A problem that the market has about this is that there is only really scope for one big fiscal shift this term and so whatever gets passed is going to stick.

• Recession risks have not gone away. Many big investors have said they think it’s still likely and the stock market will retest the lows.

• Bond markets are stressed: Stress in the bond market is elevated and this may start to bleed into equity markets. The US 30yr Treasury yield has binned 5% and not showing much signs of cooling off, while the 10yr has chalked up 4.55%. Japan’s 30yr yield is at its highest in decades, while gilts are at 4.7% on the 10yr and 5.5% on the 30yr...no one wants duration in this market and the worry for the White House has always been “losing control of the long end”.

• Fed is already active: QuiEtly does it... The Fed bought $8.8bn in 30-year bonds in a single day and $43.8bn in total last week. Stealth QE suggests policymakers are already taking action here.

• VIX ticks up: Volatility eased further on Friday, with the VIX closing down 3.3% at 17.24—its lowest since early April. Cue Monday and we’re pushing 20 again.

Bottom line: Moody’s downgrading US debt matters little to the big picture – the US is not about to default.But it underscores market angst, and this is showing up in the bond market. Moreover, markets are clearly perturbed by ongoing trade uncerainty, economic policy uncertainty and the potential to lock in sweeping tax cuts in the US, undermining the fiscal position further. The question now is what policy moves can be engineered to tame yields, which could be a worry for equity markets.