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Q2 GDP Set to Soar—Thanks to This Trade Twist

Posted on June 9, 2025 by Sage Advisory

With uncertainty swirling around potential tariff actions — particularly the scope and timing of April’s proposed measures — US importers have accelerated their orders to get ahead of possible disruptions. That pull-forward has distorted economic optics, amplifying trade’s contribution even as domestic demand has remained relatively stable.

Imports as a share of GDP rose sharply in Q1 to historic levels, suggesting that the drag on growth was more about timing than fundamentals. In the GDP accounting framework, imports are subtracted from total output because they represent spending on goods and services not produced domestically. When imports rise sharply without a corresponding increase in exports or domestic production, they create a negative contribution to GDP — even if underlying demand remains strong. Conversely, a decline in imports can mechanically boost GDP by reducing that drag, even if it’s driven by inventory normalization or weaker consumption. This makes trade flows a frequent source of noise in quarterly growth figures, often obscuring true economic activity.

Source: Sage, BEA

That surge now appears to be reversing. The ISM Manufacturing Index’s imports component has slipped below Covid-era contraction territory, a signal that import activity is cooling as firms digest elevated inventory levels built earlier in the year.

Source: Sage, ISM

This reversal is already feeding into real-time growth tracking. The Atlanta Fed’s GDPNow model projects a healthy rebound in Q2 GDP, with net exports swinging from a significant drag to a meaningful tailwind, with total GDP growth for Q2 expected to print near 4%. A front-loaded import spike subtracts from one quarter’s GDP, followed by an import pullback that boosts the next.

Source: Sage, Atlanta Fed

But beyond quarterly arithmetic, importers’ willingness to act preemptively introduces a latent cushion into the economy — inventory buffers and forward positioning that can absorb supply chain stress before it filters into consumer prices. In the near term, this could delay inflationary pass-through, lowering the urgency of a policy response.

While the underlying growth dynamic remains weaker than in 2024, the likely Q2 rebound should ease fears of an imminent recession. If tariff risk remains live or escalates, this pattern is likely to repeat: episodic hoarding, inventory payback, and supply chain volatility that blunts business confidence and weighs on capital formation. None of this suggests a hard landing. But it does imply that the expansion will remain vulnerable to exogenous shocks and structurally constrained by policy uncertainty.

In short, the growth trend remains positive, but fragile. Import behavior in Q1 wasn’t a signal of strength or weakness — it was a hedge. And the more firms feel the need to hedge against policy, the harder it becomes to sustain real momentum.

Disclosures: This is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Although the statements of fact, information, charts, analysis and data in this report have been obtained from, and are based upon, sources Sage believes to be reliable, we do not guarantee their accuracy, and the underlying information, data, figures and publicly available information has not been verified or audited for accuracy or completeness by Sage. Additionally, we do not represent that the information, data, analysis and charts are accurate or complete, and as such should not be relied upon as such. All results included in this report constitute Sage’s opinions as of the date of this report and are subject to change without notice due to various factors, such as market conditions. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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A Reality Check on GSE Privatization

Posted on June 4, 2025June 4, 2025 by Sage Advisory

Recently, there has been a renewed push from policymakers in Washington to explore the privatization of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Given the importance of implied or direct government backing of the mortgage market and its benefits to the private sector, there appears to be little net benefit to fully privatizing the GSEs.

Fannie Mae and Freddie Mac play a central role in the US housing finance system. These GSEs were created to stabilize the mortgage market and promote homeownership and access to credit, particularly for low- and moderate-income households. The 2008 financial crisis marked a turning point when the GSEs were placed into federal conservatorship; however, in the years since, they have returned to profitability and repaid the Treasury in excess of the original bailout amount. Their continued operation under conservatorship has allowed for tighter oversight and risk-based pricing, which has helped protect taxpayers from future losses.

Households have also benefited from these GSEs. By providing liquidity and standardization in the secondary mortgage market, GSEs have helped keep mortgage rates lower than they might otherwise be — especially during periods of market stress, such as the Covid-19 pandemic. Their support for 30-year fixed-rate mortgages, in particular, has offered long-term affordability and stability for homeowners. Innovations in credit risk transfer and capital frameworks have further reduced systemic risk while maintaining broad access to mortgage financing.

Privatizing Fannie Mae and Freddie Mac would represent a fundamental shift in the US housing finance system. We see the major implications as follows:

Higher Mortgage Rates: Privatized GSEs would lead to tighter credit standards and higher mortgage rates, as investors in agency mortgage-backed securities (MBS) demand higher yields to compensate for the reintroduction of mortgage credit risk. Current market data supports this concern; non-agency mortgage rates generally charge higher yields than loans underwritten to GSE lending standards. This could reduce access to affordable home financing, especially for first-time buyers and underserved communities.
Increase Home Price Volatility: The housing market could experience increased volatility in the absence of a government-backed stabilizing force. During economic downturns, the GSEs have historically played a countercyclical role by continuing to provide liquidity when private capital retreats. Privatization could weaken this function unless alternative mechanisms — such as a government mortgage insurance fund or a public utility model — are put in place.
Protracted Timeline: The timeline to disentangle the GSEs from the Treasury would be lengthy and potentially problematic. The process depends on the political will and regulatory changes involved. Privatization will require coordination between the Federal Housing Finance Agency (FHFA), the Treasury, and potentially Congress for legislative approval. Coordinated action across multiple layers of the federal government would likely span multiple presidential terms.
Recapitalization: While privatization would result in funds potentially flowing to the US Treasury via the equity sale of the GSEs, a significant amount would be required to recapitalize the now-private entities. The GSEs have been allowed to retain earnings since 2019 to begin rebuilding capital buffers. However, under current capital requirements set by the FHFA, both Fannie and Freddie would need to accumulate roughly $250 billion dollars in capital to meet the thresholds required for safe operation outside of conservatorship. This process alone could take 5 to 7 years through organic earnings growth.
Government Backstop Could Remain: Privatization could, in theory, transfer risk from taxpayers to private shareholders and creditors. However, without a clear and credible resolution framework, taxpayers may still assume some level of government support in a crisis, potentially limiting the fiscal benefits. Moreover, if privatized entities were to face financial distress, the government might still feel compelled to intervene, similar to 2008.

The push to privatize Fannie Mae and Freddie Mac may generate headlines, but in reality, the implications are clear: the risks tied to full privatization outweigh the potential rewards. The GSEs have played a key role in keeping mortgage markets liquid and stable, especially during downturns. Their current conservatorship model has allowed for tighter oversight and steady returns without exposing taxpayers to undue risk. Privatization could lead to higher mortgage rates, tighter credit, and more market volatility. The long and uncertain path to privatization combined with the likelihood of continued government involvement in a crisis also add to the complexities around privatization.

For now, the more compelling investment thesis lies in monitoring how the GSEs evolve within the current framework, rather than positioning for a full exit from government control. We maintain a constructive view on agency MBS, given the continued support from the GSEs and the structural benefits they provide to the housing finance system.

MBS Opportunities Amid Quiet Housing Market

Posted on June 2, 2025June 2, 2025 by Sage Advisory

The US housing market remains in a state of inertia. Despite the arrival of the spring selling season, both new and existing home sales continue to underwhelm. In April, existing home sales fell to an annualized pace of 4 million units — down 2% from a year earlier and well below the pre-pandemic average of over 5 million. New home sales, while slightly more resilient, have also plateaued as affordability pressures mount.

Source: Sage, National Association of Realtors

Mortgage rates are a key factor. As of late May, the average 30-year fixed mortgage rate remains near 6.84%, a level that has persisted for months. These elevated rates have created a lock-in effect: homeowners with sub-4% mortgages are reluctant to sell, while buyers face higher monthly payments and tighter credit conditions.

Source: Sage, Bankrate.com

The result is a market with limited inventory and muted activity. Even though active listings have increased year-over-year, total inventory remains 16% below pre-pandemic levels. Home prices, meanwhile, are showing signs of softening. Zillow now expects national home values to decline by 1.4% in 2025 — a modest but notable shift after years of rapid appreciation.

Sentiment reflects this cooling. A Q1 2025 Realtor.com survey found that nearly two-thirds of prospective buyers expect a recession within the next year. While some see that as a potential buying opportunity, many remain cautious — concerned about job stability, credit access, and the risk of overpaying in a market that feels increasingly uncertain.

Even as the housing market remains subdued, agency mortgage-backed securities (MBS) have emerged as a bright spot, drawing investor attention due to their evolving risk profile and attractive valuations.

Agency MBS are bonds backed by pools of residential mortgages and issued by government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac, and Ginnie Mae. These securities are considered to carry minimal credit risk due to their implicit or explicit government backing. However, they are still subject to other forms of risk — primarily interest rate risk and prepayment risk.

In a typical environment, prepayment risk is a major consideration. When interest rates decline, homeowners often refinance at lower rates, causing MBS to prepay earlier than expected. As a result, investors receive their principal sooner and are typically forced to reinvest at lower yields. But in today’s high-rate environment, refinancing activity has slowed dramatically. This has reduced prepayment volatility and made the cash flows from agency MBS more predictable.

At the same time, spreads on agency MBS remain elevated. This is partly due to a shift in demand dynamics. The Federal Reserve, once a major buyer of MBS during its quantitative easing programs, has been reducing its balance sheet. Commercial banks — another traditional source of demand — have also pulled back following the regional banking stress of 2023. With fewer natural buyers in the market, spreads have widened relative to historical norms, and are even considered cheap relative to corporate bonds in an environment of higher earnings uncertainty.

Adding another layer of complexity is the renewed discussion around the potential privatization of government-sponsored enterprises (GSEs) under the Trump administration. President Trump has recently stated that he is giving “very serious consideration” to taking Fannie Mae and Freddie Mac public. While this idea has surfaced before, past efforts to privatize the GSEs have faced significant legal, political, and logistical hurdles. The conservatorship structure, in place since 2008, has proven difficult to unwind, and many in the housing and financial sectors remain skeptical that a full privatization can be executed without disrupting the mortgage market.

Nonetheless, President Trump has emphasized that any move toward privatization would retain the implicit government guarantee that underpins the stability of agency MBS. That assurance may help temper market volatility, but the path forward remains uncertain.

Source: Sage, Bloomberg

In a fixed income landscape where high-quality yield is increasingly scarce, agency MBS stand out for their relative value. Despite carrying no credit risk, current coupon MBS are trading at spreads well above historical averages — offering a meaningful pickup over comparable-duration Treasuries. Importantly, these elevated spreads are not being driven by deteriorating fundamentals. Prepayment risk has diminished in the current rate environment, and the underlying credit quality remains strong due to the government-sponsored nature of the issuers. In a market starved for high-quality yield, agency MBS offer a rare combination of stability, attractive spreads, and reduced volatility — making them a compelling option for income-focused investors navigating today’s uncertain environment.

Refreshing the Fed’s Policy Framework

Posted on May 19, 2025 by Sage Advisory

Federal Reserve Chair Jerome Powell delivered the opening remarks at last week’s Thomas Laubach Research Conference, focusing on the Federal Open Market Committee’s (FOMC) review of its Monetary Policy Framework. The Fed is committed to conducting a public review every five years to ensure the framework remains responsive to changing economic conditions. The last assessment was in 2020, during the Covid-19 pandemic, and the review that is taking place now is expected to result in updates that could shift how the Fed responds to economic and financial developments.

The Consensus Statement

The Federal Reserve’s dual mandate — promoting maximum employment and maintaining stable prices — was established by Congress in 1977 in response to the economic challenges of the 1970s. While the mandate guided monetary policy, it lacked specific metrics for evaluating progress. In 2012, the Fed introduced the Statement on Longer-Run Goals and Monetary Policy Strategy, known as the “consensus statement,” to clarify how it would pursue its objectives.

In response to low interest rates, low inflation, and low unemployment post-Great Financial Crisis (GFC), the Fed began a review of its policy framework in 2019, which ended in 2020. A key outcome was the adoption of flexible average inflation targeting (FAIT), which allowed inflation to exceed the 2% target after periods of undershooting, to better anchor expectations.

The 2020 review also changed how the Fed evaluates labor market conditions. Instead of responding to both upward and downward movements from maximum employment, the Fed began focusing on “shortfalls” from full employment — signaling a more patient stance.

As the chief concern at the time was persistent disinflation, the modifications in 2020 resulted in less reactive policy shifts that were asymmetrically dovish. The economic environment changed soon after these adjustments. The Covid-19 pandemic triggered a surge in inflation, and while the Fed responded, it underestimated the persistence of inflationary pressures.

From the GFC to the Post-Pandemic Era

Today, the Fed faces different challenges. Real interest rates are higher, inflation volatility has increased, and supply-side disruptions are more frequent. Powell recently addressed this shift:

“Higher real rates may also reflect the possibility that inflation could be more volatile going forward than in the inter-crisis period of the 2010s. We may be entering a period of more frequent, and potentially more persistent, supply shocks — a difficult challenge for the economy and for central banks.”

Source: Sage, Federal Reserve, BEA

The Fed appears ready to revise its framework again. According to Powell, FOMC participants have shown interest in reexamining the language around employment shortfalls and reassessing average inflation targeting. The Fed is also considering changes to how it communicates forecasts and uncertainty.

Refreshing the Policy Framework and Communications

As the Fed reviews its policy framework, several areas may change. The experience of the past few years — marked by a pandemic, inflation, and a delayed tightening cycle — has highlighted the need for a framework better suited to managing supply shocks and inflation volatility. One likely adjustment is to how the Fed approaches average inflation targeting. While FAIT was designed to address inflation undershooting, its application during a period of rising inflation revealed limitations. The language around employment shortfalls may also be reconsidered. The 2019 focus on shortfalls was appropriate in a low-inflation environment, but in today’s context, a more balanced approach may be necessary to avoid the perception of excessive tolerance for inflation in pursuit of labor market goals.

Future iterations of the framework may place less emphasis on past deviations from inflation or employment targets and instead prioritize a more responsive stance. This could lead to quicker policy adjustments and, as a result, greater variability in interest rate outcomes — introducing more volatility into rate markets.

The Fed is also evaluating how it communicates policy. As outlined in Ben Bernanke’s recent Brookings proposal, clearer and more structured messaging could enhance policy effectiveness. One suggestion is a quarterly “Monetary Policy Report Summary,” which would provide a plain-language explanation of the FOMC’s outlook, policy rationale, and associated risks. Importantly, it would also include alternative scenarios to help the public understand how the Fed might respond if its base case proves incorrect. Additionally, given the market’s focus on the “dot plot” as a signal of future rate paths, the Fed may consider revising how it presents its projections for the federal funds rate.

A shift toward a more flexible and less formulaic policy approach could increase uncertainty around the timing and magnitude of rate changes. This may lead to more frequent repricing across financial markets, particularly in interest rates and risk-sensitive assets. While this could present challenges, it also creates opportunities for investors who can interpret evolving policy signals and adjust their positioning accordingly.

Inflation Expectations Hold Firm Amid Tariff Noise

Posted on May 13, 2025May 13, 2025 by Sage Advisory

Despite the announcement of new tariffs, long-term inflation expectations—as measured by the 5y5y inflation rate—have remained stable. This rate, which reflects expected average inflation over a five-year period starting five years from now, is a key indicator of market sentiment on long-term inflation and is typically derived from TIPS or inflation swap markets.

From April 2 to May 12, the 5y5y rate stayed flat, even though tariffs are expected to raise costs. Since the November election, the rate has actually declined by 10 basis points to 2.26%.

Source: Sage, Bloomberg

Several factors help explain why long-term inflation expectations have remained stable despite the announcement of new tariffs. First, market uncertainty around the implementation of tariffs likely played a role. Investors may have anticipated that the proposed tariffs would be delayed or softened, a view that was validated when the US and China agreed to a 90-day postponement following in-person negotiations. This delay signaled a potential de-escalation in trade tensions, mitigating the perceived inflationary risk.

Moreover, the nature of tariffs themselves may limit their impact on long-term inflation expectations. Tariffs are generally seen as a one-time shock to prices, influencing short-term inflation more than the long-term trajectory. As such, markets may have discounted their relevance to the broader inflation outlook.

Additionally, concerns about the broader economic impact of tariffs may have further dampened inflation expectations. Tariffs can compress corporate profit margins and weaken aggregate demand, both of which are deflationary forces. Rather than fueling inflation, these effects could signal slower economic growth, which tends to suppress price pressures over time.

Another important factor is the behavior of energy markets, which are closely tied to inflation expectations. Oil prices have declined amid increased supply from OPEC+, contributing to a more subdued inflation outlook. Since energy is a key input cost across the economy, falling oil and gasoline prices can exert downward pressure on inflation expectations.

Source: Sage, Variant Perception, Bloomberg

Finally, confidence in the Federal Reserve’s credibility appears to be anchoring long-term inflation expectations. Despite recent economic volatility, the 5y5y inflation rate has remained close to the Fed’s 2% target. This suggests that markets still trust the Fed’s ability to maintain price stability over the long run, even in the face of fiscal and geopolitical uncertainty.

Source: Sage, Bloomberg

While tariffs typically signal upward pressure on prices, markets appear unconvinced that recent trade developments will meaningfully alter the long-term inflation landscape. The resilience of the 5y5y inflation rate underscores investor confidence in the Federal Reserve’s ability to anchor inflation expectations and reflects broader forces — like global energy prices and demand outlooks — that continue to exert a stronger influence on long-term inflation sentiment than short-term policy shifts.

The Two-Faced Economy: Strong Data Amid Shaky Sentiment

Posted on May 6, 2025 by Sage Advisory

The current geopolitical climate has injected an extra dose of unpredictability for economic participants, as investment and consumption decisions for everyone have been clouded by trade wars and fiscal policy. Sentiment on the economy is understandably depressed, weighed down by uncertainty; however, real economic data remains expansionary, and should be able to withstand geopolitical stress and tariff concerns over the next few months.

Labor market data last week was solid, with payrolls growing by 177,000 jobs in April, handily beating expectations. The unemployment rate remained near a healthy 4.2% rate, and while it is too early for tariff uncertainty to affect employment, it is clear that the economy is on sound footing.

Source: Sage, Bureau of Labor Statistics

Consumer sentiment on the outlook for jobs, however, is a different story. The most recent Conference Board Consumer Confidence Survey results indicated that 32% of respondents expect there to be fewer jobs in 6 months, which is the highest reading since the Great Financial Crisis.

Source: Sage, The Conference Board

Dynamics around inflation are similar, as the recent core PCE (personal consumption expenditures, excluding food and energy) release continued to show a moderating pace of inflation, with core PCE up 2.6% on an annualized basis.

Source: Sage, The Bureau of Economic Analysis

Consumer sentiment, however, reflects a deep concern for the future path of inflation. Survey measures of expected inflation have ticked higher in recent months.

Source: Sage, The Conference Board, FRB Atlanta

It is evident that uncertainty is weighing on sentiment, but the effects on underlying economic activity have yet to be seen. This is natural, as the impact of tariffs, whatever they end up being, will take months to materialize in the hard economic data readings.

How does this affect markets and, in particular, interest rates? We believe the FOMC will continue to display patience in resuming rate cuts until the second half of this year, if inflation and growth continue to decelerate. The variance of outcomes for the economy will be wide, as tariffs, tax cuts, and fiscal deficit developments will all serve as catalysts for the economy and markets through the summertime.

The Ripple Effects of the US/China Trade Embargo

Posted on April 29, 2025 by Sage Advisory

In an interview last week, Treasury Secretary Scott Bessent characterized the trade situation with China as “unsustainable,” pointing to possible relief through negotiations with Chinese officials. The current level of tariffs of 145% on Chinese goods and 125% on US goods going into China amounts to a trade embargo between the two countries. We are starting to see signs of weakness in US/China trade via shipping data that could eventually flow through to the US consumer if this trade embargo were to continue over the coming months.

The port of Los Angeles, which accounts for 17% of all US imports and is a key destination for Chinese goods, has not seen volumes diminish recently; however, data from IMF PortWatch shows that there was a period of huge volume in the first quarter prior to the inauguration, which could illustrate shippers’ desire to front-load imports ahead of Trump taking office. A report in the Financial Times says that port officials are expecting shipping volumes to slow: “scheduled arrivals in the week starting May 4 [are expected] to be a third lower than a year before. . . . Bookings for standard 20-foot shipping containers from China to the US were 45 percent lower than a year earlier by mid-April.”

Source: IMF PortWatch, Sage

Rates for containers from Shanghai to LA have dropped significantly from elevated levels in 2024 and earlier this year as the demand for shipping has slowed for this key shipping route.

Source: Drewry, Sage

Container ship counts have also dropped sharply in April in concert with tariff uncertainty.

Source: Bloomberg, Sage

Forward-looking indicators are also signaling a sharp slowdown. Tariff uncertainty is clearly weighing on shippers as cancellations have increased and bookings have slowed. Blank capacity, which refers to a cancelled voyage or a skipped port call, has been increasing, indicating reduced shipping activity. Sea Intelligence reports a sharp increase in cancelled sailings over the coming weeks. The chart below illustrates the percentage of scheduled blank capacity relative to the planned capacity on the Asia-North America East Coast route. This data covers the period from March 24 to May 12, with each line representing which week of this year sailings were scheduled (weeks 12 through 16). The chart shows that the proportion of scheduled blank capacity has been increasing week by week, with a notable rise in May.

Source: Sea Intelligence, Sage

Bookings have also plummeted. Bookings of imports to the US fell 12.15% week-over-week and 22.37% year-over-year for the week of April 14^th, after strong Q1 activity. Bookings from China to the US declined 22.14% week-over-week and are down 44.49% year-over-year, having fallen by 40% in the three weeks following Liberation Day.

Source: Vizion, Sage

While tariffs have had a noticeable effect on shipping activity, particularly between the US and China, one positive readthrough is that imports jumped in the second half of 2024 and in the first quarter of this year in anticipation of damaging tariffs, which could delay the effects of the current US/China trade embargo on consumer prices and inventory levels. However, the longer this dynamic continues, the higher the probability of a supply shock and its subsequent effects on corporate margins and consumer prices. “Unsustainable” may have been the right characterization of the current state of trade between the US and China, which could continue to weigh on economic activity this year.

Balancing Treasury Market Stability and Systemic Risk

Posted on April 21, 2025April 28, 2025 by Sage Advisory

In an interview last week Treasury Secretary Scott Bessent, who has been vocal about his desire to lower the 10-year rate, mentioned what he sees as the Treasury’s toolkit for doing so. One of those measures was the lowering of the supplementary leverage ratio (SLR) for banks, which he described as something that will “allow banks to buy more Treasuries without a big capital charge . . . I expect we will have created a new buyer for Treasury securities.”

The SLR is a binding capital requirement intended to limit excessive balance sheet expansion among large banking institutions. It was introduced as part of the Basel III post-crisis regulatory reforms and implemented in the US beginning in 2014. Unlike risk-weighted capital ratios, which adjust capital requirements based on asset riskiness, the SLR applies uniformly across asset types — treating US Treasuries, reserves, and loans equally, with the goal being to limit banks’ balance sheets from growing too large and limiting systemic risk in a crisis. For US global systemically important banks (GSIBs), the minimum SLR requirement is 5%, meaning they must hold 5% of common equity capital relative to their total leverage exposure. The largest US banks typically maintain an SLR well above the required level, although SLRs have trended lower toward the 5% minimum in recent years.

Source: Sage, Bloomberg

In response to the significant balance sheet expansion driven by monetary and fiscal interventions, the Federal Reserve announced in April 2020 a temporary exclusion of US Treasury securities from the SLR denominator for bank holding companies. This action was intended to mitigate binding capital constraints arising from a rapid influx of low-risk assets, particularly as banks absorbed deposits and acted as intermediaries in strained Treasury markets.

The exclusion expired in March 2021. Although regulatory agencies indicated they would review the long-term calibration of the SLR, no structural changes have been implemented.

The mechanics of the SLR have direct implications for Treasury market functioning. When Treasuries and reserves are included in the leverage exposure measure, increases in these positions consume balance sheet capacity. As a result, banks may be disincentivized from engaging in market-making or absorbing large Treasury flows, particularly during periods of supply shocks or liquidity stress, especially as the banking sector’s holdings of Treasuries have grown significantly in recent years.

Source: Federal Reserve

A reintroduction of SLR relief, either through a renewed exemption of Treasuries and reserves or as a recalibration of the leverage exposure definition, would likely produce several market effects:

Banks would have greater capacity to hold US government securities, potentially reducing auction tail risk and compressing term premia.

Market liquidity would improve. Reduced balance sheet frictions would enable more active market-making and better absorption of issuance. Also, banks would be more willing to provide financing in the repo market against Treasury collateral, reducing the likelihood of funding stress in short-term markets.

The main trade-off from the loosening of regulatory burden for Treasuries would be its potential negative effect on the broader objective of systemic resilience. The SLR was designed to provide a capital floor regardless of portfolio composition. Minimizing this requirement could risk reintroducing moral hazard, particularly in a financial system where perceived safe assets dominate balance sheets. A regulatory decision to relax the SLR would create more capacity for Treasury purchases, but they do not necessarily compel banks to buy Treasuries. Additionally, the Federal Reserve would have to loosen this requirement, which may prolong the process as it requires Treasury/Fed coordination.

Bond Trauma

Posted on April 14, 2025April 28, 2025 by Sage Advisory

There are decades where nothing happens, and then there are weeks where decades happen. Last week, the tariff stress that shocked equity markets spread across fixed income and foreign exchange markets, threatening financial stability and resulting in a delay of reciprocal tariffs from the US as well as a shift in tone from both White House officials and Fed speakers.

Following the tariff announcements on April 2, the chorus calling for recession grew, seeing an initial classic “flight to quality” pattern that is expected in negative economic growth shock episodes. Last week, market stress morphed into something worse, as rates traded sharply higher and the USD uncharacteristically weaker, as a system-wide deleveraging took place, particularly in leveraged positions. Falling equities, rising yields, wider spreads, and higher transaction costs are all indicative signs of a classic liquidity squeeze.

Source: Sage, Bloomberg

Some corners of the market displayed stress that pointed to deterioration in the functioning of the US Treasury. Swap spreads measure the difference between the interest rate on a swap and the yield on a Treasury bond with the same maturity. When the spread is wider, it means Treasury bonds are more valuable compared to swaps, and when the spread is narrower, swaps are more valuable. Since the supply and demand for Treasury bonds significantly influence these spreads, changes in swap spreads can indicate the market’s expectations for Treasury bond supply and demand.

The market had anticipated a favorable supply and demand for Treasuries following the February 5th Treasury Refunding Announcement, which led to higher spreads and leveraged investors favoring cash Treasuries over swaps. However, last week’s liquidity squeeze caused swap spreads to drop sharply. This was due to expectations of increased Treasury supply from widening deficits during a recession and a lack of buyers for Treasury debt, especially if the US aggressively reduces its trade deficit. We believe that the dysfunction in the Treasury market significantly contributed to the delay of reciprocal tariffs on April 9th. Ultimately, these disruptions should stabilize as liquidity conditions improve, particularly since Fed officials have indicated their readiness to intervene and maintain financial stability.

Source: Sage, Bloomberg

While the liquidity issues plaguing the markets can be alleviated by Fed intervention or incrementally improving headlines, the structural shift to aggressively collapse the US trade deficit with its trading partners could have wide ranging long-term implications. In particular, the aggressiveness of the tariff rollout threatens weakening the dollar’s global reserve status. After sanctions on Russia following the Ukraine invasion led to the development of a financial network outside of the US dollar system, the current tariff battle represents another phase of economic warfare. This could further encourage a shift away from dollar-based trade.

The US bond market depends heavily on foreign investors. Any significant move away from the dollar would reduce the ability to finance the US’s twin deficits (fiscal and trade). While other markets may not be as deep or liquid as the dollar-denominated bond market, there hasn’t been a compelling reason for foreign investors to look for non-dollar investment options until recently. US policymakers should be cautious not to create such a reason. It’s important to remember that capital will always flow to where there is demand.

Source: Sage, IMF, Bloomberg

The Path Forward After the Tariff Shock

Posted on April 7, 2025April 28, 2025 by Sage Advisory

Last week President Trump announced tariffs on nearly all US trading partners, a move that far exceeded the most pessimistic expectations of market participants. The substantial amount and the haphazard manner of the announcement caught markets off guard. While tariffs were anticipated due to presidential campaign rhetoric and Trump’s intense focus on addressing the US trade deficit, the actual announcements were more aggressive than anticipated and markets reacted accordingly. The tariffs, calculated as a percentage of the 2024 trade deficits with the US, resulted in an effective rate of approximately 22.5% across the board, a significant increase from the 2.5% rate in 2024.

Source: US International Trade Commission, Yale Budget Lab

While the historically high tariff rate is intended to be a starting point for negotiations and is expected to decrease, the high initial rate means that the final negotiated levies will likely be higher than anticipated. These tariffs are set to be implemented almost immediately, giving little time for partners to negotiate before they take effect. Given that bilateral negotiations with affected trading partners could take months, the elevated tariffs could remain in place for an extended period. Additionally, the risk of retaliation and escalation from trading partners is significant, as evidenced by China imposing retaliatory tariffs less than 24 hours after the Liberation Day tariffs were announced.

Markets reacted sharply to the unexpected announcement, with the US equity market experiencing its largest two-day decline since 1940. This led to a flight to quality, resulting in a rally in rates and widening spreads.

Treasury yields dropped sharply after the announcement. Tariffs typically lead to higher prices for companies and consumers, but the immediate market reaction was to anticipate a near-term drop in aggregate demand and a slowdown. Inflation expectations decreased, with the TIPS breakeven inflation rate falling by 14 basis points, indicating the market’s expectation of a negative growth shock in the near-term. The FOMC is now expected to cut rates by at least 100 basis points this year. In his remarks on April 4^th, Jerome Powell indicated it was too early to gauge the appropriate monetary policy stance, while expressing concern about both rising prices and falling growth.

Source: Sage, Bloomberg

Credit spreads widened from their historically tight levels, with investment grade corporates increasing by 16 basis points to 1.09%, and high-yield bonds rising by 93 basis points to 4.27% over treasuries. Although credit markets are experiencing their worst repricing since 2024, spreads are still not at crisis or recessionary levels and remain on the lower end of historic averages. While there is potential for spreads to widen further, especially with tariffs posing a real threat to economic expansion, we believe fixed income inflows should remain strong. “Yield buyers” are likely to take advantage of the high yields amid high equity volatility and substantial money market assets facing lower forward yields. Any sharp increases in yield should result in solid demand, particularly in IG bonds.

Source: Sage, Bloomberg

Shrinking economic activity and heightened geopolitical concerns should see fixed income remain well supported. In recent weeks, fears of slowing growth compounded by the negative shocks from potential tariffs and federal job and spending cuts resulted in a shift in the stock/bond correlation structure, which saw high-quality fixed income serve as a diversifier to risky assets after years of moving in tandem with equities. Since the last update in early March, correlations have continued to fall precipitously and are now on par with the negative growth scare in the fall of 2024. We expect this relationship to continue to revert as the risk of a deeper slowdown grows.

Source: Sage, Bloomberg

The path forward contains more questions than answers at this point. Could the current wave of tariffs push the economy into a recession? Despite the negative market and public reactions, even if tariffs don’t directly cause a recession, market stress could undermine confidence, leading to a deeper slowdown — a phenomenon George Soros famously termed “reflexivity.” It’s too early to make a definitive call, as economic data still indicate solid expansion, with recent job figures exceeding expectations. Additionally, the US private sector is healthy, with household balance sheets much cleaner than in prior debt crises. However, the decline in confidence indicators and the buildup in investment balances in recent years warrant caution.

Tariffs will result in inflation across the global economy, as it is effectively a tax on production. Broadly rising prices results in lower demand and a deeper slowdown in a “stagflationary” dynamic. In that scenario, the Fed will face a dilemma in its monetary policy calibration on whether to raise rates to combat rising prices or lower them to stimulate demand. We believe the Fed will continue to lean toward a dovish approach, prioritizing the demand side of the equation (lower consumption and employment) over the supply side (tariffs), which, despite tariffs being significantly high, they represent a one-time shock to prices.

Lastly, the political factor remains the largest unknown. What is the administration’s “pain tolerance” for the economy and markets and its appetite for negotiation? Also, the other major leg of Trump’s economic agenda, which is the renewal of the 2017 tax cuts along with any spending cuts, will play a big role in the trajectory of the economy and certainly market sentiment. We mentioned in a prior post that we believe tariffs will be a key fixture in trade negotiations, as a tool to extract better trade terms. Unfortunately, the delicate balance of negotiations versus a damaging trade war seems to have tipped in favor of the latter.