US President Donald Trump’s “big, beautiful” tax bill was passed by the House of Representatives last Thursday and is headed to the Senate for approval.
If it becomes law, the bill will cut taxes and increase spending. While this could provide a near-term boost to the economy, it is expected to increase the federal deficit over the medium-term. Estimates suggest the legislation could add more than $3 trillion to the deficit over the next decade.
The bond market is already showing signs of concern. Yields on 30-year US Treasury bonds climbed to 5.161 per cent – their highest level since 2023 – triggering a selloff. Adding to market jitters are lingering concerns about stubborn inflation and the diminished odds of a Fed rate cut. Ongoing uncertainty around trade has further eroded investor confidence.
“The combination of gaping deficits throughout the forecast horizon, potential fiscal stimulus, and sticky inflation isn’t friendly for the bond market,” wrote Benjamin Reitzes, Canadian rates and macro strategist at BMO Capital Markets, last Wednesday. “If at least one of those three drivers doesn’t change, look for the uptrend in yields to continue.”
While deficits are nothing new, bond investors are increasingly concerned the current policy of tax cuts and trade protectionism will lead to more bonds being issued than the market can absorb. This concern was evident at last week’s 20-year bond auction, where investors demanded higher yields to compensate for the increase in risk.
Recently, deficits have not rattled markets. The prevailing view is that the fiscal situation remains anchored as long as the rate of economic growth outpaces interest rates. Even though deficits and debt are rising, the debt-to-GDP ratio is not growing. However, ongoing policy uncertainty around tariffs raises concerns that this anchor will no longer hold.
Long-dated debt has been selling off globally in recent weeks amid these fears. In Japan, concern has been heightened following a decrease in bond purchases by the central bank, the largest holder of government debt. Weak demand at last week’s 20-year JGB auction underscored the market’s diminishing capacity to absorb new debt issuance to finance the government’s fiscal deficit. The focus of the market right now is at the super-long end of the yield curve, with speculation that the government could shorten the duration of its debt and limit 40-year bond issuance if absorption concerns persist.
Developments in the Japanese bond market have implications for US Treasuries. After years of ultra-low interest rates, Japanese investors have become major holders of US Treasury bonds, with $1.13 trillion in holdings as of March. As Japanese yields rise, there is potential for a gradual shift of capital back to the domestic market. Meanwhile, Chinese holdings of US Treasuries have already declined.
The UK has now surpassed China as the second largest non-US holder of Treasuries, with $779 billion in holdings. However, UK-based accounts are typically custodial, which is a common proxy for hedge fund activity. Hedge funds also use jurisdictions like the Cayman Islands and the Bahamas for custody services.
It remains unclear whether China is actively unwinding its US Treasury holdings or simply shifting them into custodial accounts in jurisdictions like Belgium or Luxembourg.
In the background, debate continues over the diminished role of traditional broker-dealers in facilitating Treasury trades and the increasing involvement of hedge funds as marginal buyers and intermediaries.
One policy proposal is to ease certain capital rules imposed on US banks after the financial crisis. Specifically, there have been recommendations to cut the supplementary leverage ratio (SLR), which stipulates how much capital banks must maintain as a percentage of their assets. The proposal would exempt Treasuries from the SLR calculation, effectively lowering capital requirements and potentially spurring banks to buy more Treasuries.
The most significant impact of this proposed rule change would be to exempt Treasury repos from the SLR calculation. This would allow dealers to expand their financing of hedge fund trades, particularly the Treasury cash-futures basis trade.
Hedge funds finance Treasury bond purchases by borrowing from dealers and simultaneously selling futures contracts to hedge the interest rate risk of the bonds. This basis trade has become a key mechanism for intermediating interest rate risk in the bond market. The availability of repo financing is key to both the scale and profitability of the trade. For the US Treasury, the concern is that this proposal could fuel leveraged hedge fund trades and create greater risk to the Treasury market in the event of a market-wide unwind.
Monitoring US Treasury auctions, foreign bond holdings, and potential changes to the SLR will provide key insights into how the US bond market is responding to fiscal and monetary policy – and the implications for the Canadian market.
Housing Affordability Watch
CMI monitors the latest developments and offers insights on solutions to Canada’s housing affordability crisis
Moody’s recent downgrade of the US credit rating highlights growing concerns about the country’s fiscal health. With rising pressure on long-term interest rates, this shift has important implications for Canada – particularly as the federal government pushes forward with its housing agenda. Could old financing tactics be making a comeback?
Find out more in our latest Housing Affordability Watch here: Government Debt and Housing Finance – It’s Complicated
Independent Opinion
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