Big, Beautiful Bond Volatility
In May, the S&P 500 and Nasdaq Composite marked their best month in two years posting returns of 6.3% and 9.7% respectively, while the U.S. Aggregate Bond Index generated its first negative monthly return of the year. The sharp rebound in U.S. equity markets in the month of May can largely be attributed to eased concerns over tariffs. U.S. trade policy saw several meaningful shifts, with the most significant development being a 90-day de-escalation between the U.S. and China. Both countries agreed to lower tariffs by 115% from their recent peaks while continuing a 10% baseline tariff during the suspension period. Stocks got an additional boost last week after the U.S. Court of International Trade blocked the majority of the new U.S. tariffs. The U.S. Court of Appeals for the Federal Circuit later granted a stay on the decision, however, allowing the tariffs to stay in place until a final verdict is reached, setting up for a definitive ruling from the U.S. Supreme Court.
While equity investors have applauded the easing of tariffs and shift to tax cuts, bond markets have started to react. The U.S. bond market in May saw increased volatility, with Treasury yields fluctuating amid concerns over inflationary pressures, geopolitical uncertainties, and U.S. debt sustainability. The 10-year yield peaked at 4.6% before retreating to 4.4%, while the 30-year yield reached 5.1%, the highest level since 2023. Investors now want more compensation for the risk of holding longer-term bonds (term premium), as policy developments like the budget bill bring attention to unsustainable debt dynamics. Higher inflation, and consequently higher policy rates, along with any rise in term premium boosts debt servicing costs. In addition to that, tariffs as a tool in trade policy introduces a push/pull in yields between slowing growth expectations (lower yields), inflationary pressures (higher yields), and potential of higher federal revenue (lower yields). So, bonds are likely to stay volatile given how quickly these factors continue to evolve. This is not unique to U.S. however, with long-term yields rising around the globe. In Japan for example, 30-year bond yields hit a record high in May. Japan’s central bank has trimmed purchases as part of its policy normalization, while many investors are questioning how long the Japanese markets can withstand higher rates given the country’s debt/GDP ratio of over 260%. Rising bond yields may present an even greater hazard to the global economy than the trade war.
Another casualty of the trade war has been the U.S. dollar, which has declined over 10% from it’s recent high in January as investors reduce expectations for U.S. economic growth and the “de-dollarization” theme plays out. According to Goldman Sachs, central banks are buying roughly $8.5 billion of gold each month, highlighting a mounting concern amongst some countries about overexposure to the dollar.
Economic growth has held up well so far this year, supported by solid consumer spending and a resilient labor market, but there are indications of potential weakness on the horizon. Yesterday’s ADP employment survey, while notoriously volatile, came in well below expectations with just 37,000 jobs added to private payrolls (vs. an estimate of 114,000). Consumer surveys show general pessimism with concerns about rising prices due to tariffs and cuts in federal spending, with the threat of tepid economic growth with rising inflation dragging on consumer sentiment. The Bureau of Economic Analysis (BEA) reported that its core personal consumption expenditures index (PCE) – the Fed’s preferred measure of inflation – rose 2.5% year-over-year in April, down from 2.7% in March. While encouraging that the data is trending down, the reading remains firmly above the Fed’s long-term target of 2%, and many market participants expect the lagged effect of tariffs to drive hotter inflation in the coming months.
Moving forward, continued trade, economic, and geopolitical uncertainty will dominate price action. Markets are likely to stay volatile, particularly over the next 40 days that remain on President Trump’s 90-day pause. The Federal Reserve is on hold as uncertainty about inflation has forced them into a holding pattern. With the S&P 500 trading at over 23 times forward earnings, equity markets may be looking past the risk of policy error. Tomorrow’s employment report for May will provide critical evidence in the direction of the U.S. economy.
Ryan Babeuf, CFA
Market Strategist
Ryan.Babeuf@EdgeWealth.com
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