Tariff War Shock and US Treasury Convenience Yields

 The April 2025 Tariff War was a significant economic shock triggered by the United States government's decision to levy the highest import duties in a century. This unanticipated move led to a rapid escalation of reciprocal tariffs between the U.S. and China, creating a global "convulsion" in financial markets. In the context of the Tariff War Shock, the sources focus on the erosion of the "safe-asset" status of long-term U.S. Treasuries and the resulting impact on their convenience yield.

The Erosion of the Convenience Yield

The convenience yield represents the "service flow" benefits investors receive from holding Treasuries, such as liquidity, safety, and their use as collateral. The sources highlight several critical developments regarding this yield during the 2025 shock:

• Long-End Deterioration: While the convenience yield for short-term Treasuries (2-year and 5-year) actually increased or remained stable, the convenience yield for 10-year nominal Treasuries dropped substantially. This was measured through the TIPS-Treasury premium, which reveals that the price gap usually favoring nominal Treasuries over "synthetic" versions narrowed or reversed for long-term bonds.
• Decomposition of the Yield: By breaking down Treasury yields into a frictionless risk-free rate, credit spread, and convenience yield, researchers found that the loss of the hedging property in long bonds was primarily driven by the erosion of this convenience yield component.
• Rotation to the Short End: The relative stability of short-term Treasury convenience yields suggests a "flight to quality" rotation where investors abandoned long-term debt in favor of shorter-term maturities.

The "Tariff War Shock" and Stock-Bond Covariance

The sources explain that the Tariff War Shock fundamentally changed how Treasuries interact with the stock market. Historically, Treasuries act as a hedge (negative covariance), meaning their value rises when stocks fall.

• Reversal of Hedging Property: In early April 2025, the stock-bond covariance reversed sharply into positive territory for long-term bonds. On April 11, the stock-bond correlation reached as high as 0.5, a stark contrast to the -1 correlation seen just days earlier on April 3.
• Bonds as "Risk" Assets: This shift meant that long-term bonds began acting like "risk" assets rather than safe havens, losing their ability to hedge against aggregate economic risks.

Drivers and Substitutes for Safe Assets

The sources identify several mechanisms driving these market shifts, including stagflation risk, the withdrawal of traditional safe-asset investors, and the unwinding of cash-futures basis trades.

Furthermore, the role of traditional safe havens shifted:

• Gold as a Substitute: Gold emerged as a primary alternative for investors seeking safety, showing a positive covariance with stocks on days when bonds failed to act as a hedge.
• U.S. Dollar Failure: Unlike previous crises (such as the Global Financial Crisis or COVID-19), the U.S. Dollar (DXY index) did not convincingly act as a safe haven during this period.

Future Risks and Fiscal Rollover

The sources warn that a sustained standoff could lead to a permanent erosion of the convenience yield for long-term bonds. This creates a fiscal rollover risk, as the U.S. Treasury might be forced to supply more short-term T-bills to meet investor demand, potentially destabilizing the government's ability to manage debt in a high-uncertainty environment.

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    The April 2025 Tariff War—triggered by the United States levying the highest import duties in a century and subsequent Chinese retaliation—led to a significant erosion of the convenience yield for long-term U.S. Treasuries,. This erosion is central to understanding how the "safe-asset" status of Treasuries was compromised during the shock, fundamentally altering their role as a hedge against aggregate economic risks,.

The Nature and Measurement of Convenience Yield

The sources define convenience yield as the "service flow" benefits investors receive from holding Treasuries, specifically those related to liquidity, safety, or use as collateral. To track the erosion of this yield during the 2025 shock, researchers primarily used the TIPS-Treasury premium, which is calculated as the TIPS yield plus the inflation swap minus the nominal Treasury yield.

• Long-End Deterioration: During the tariff war, the convenience yield for 10-year nominal Treasuries dropped substantially. This was further evidenced by the 30-year Overnight Indexed Swap (OIS) spread, which dropped by over 10 basis points following the tariff news.
• Short-End Resilience: In contrast, the convenience yield for 2-year and 5-year Treasuries actually increased during the same period,.

Convenience Yield as a Driver of Risk

A critical insight from the sources is that the erosion of the convenience yield was the primary driver behind the loss of the "hedging property" in long-term bonds. By decomposing Treasury yields into a frictionless risk-free rate, a credit spread (CDS), and a convenience yield premium, the sources illustrate a striking divergence:

• Positive Covariance: For 10-year bonds, innovations in the convenience yield began to co-move positively with the stock market, meaning the yield premium shrank exactly when stocks were falling,. This turned long-term bonds into "risk assets" rather than safe havens.
• Flight to Quality Rotation: The improvement in short-term convenience yields suggests a rotation within the Treasury market, where investors abandoned long-term debt in favor of shorter-term maturities to hedge against rising stagflation risks and potential recession,.

Market Mechanisms and Substitutes

The sources identify several mechanisms that likely contributed to this erosion, including the withdrawal of safe-asset investors, the unwinding of cash-futures basis trades, and a general shift in global risk perceptions,.

• Gold as a Substitute: As the convenience yield of long bonds eroded, gold emerged as a substitute for flight-to-safety investors, showing a negative covariance with stocks on days when the bond hedge failed,.
• USD Disconnect: Unlike previous crises, the U.S. Dollar (DXY index) did not convincingly act as a safe haven during this period, reinforcing the idea that the 2025 shock was fundamentally different from past events like the Global Financial Crisis.

Long-term Consequences: Fiscal Rollover Risk

The sources warn that a sustained erosion of long-term convenience yields could lead to fiscal rollover risk. If investors continue to prefer short-term "T-bills" over long-term bonds, the U.S. Treasury may be forced to load its supply at the short end of the maturity curve, creating a precarious debt-management situation in a high-uncertainty environment.

In the context of the April 2025 Tariff War, the sources utilize yield decomposition to explain why U.S. Treasuries—traditionally considered the world's premier safe asset—suddenly lost their ability to hedge against stock market risks.

The sources break down the nominal Treasury yield into three distinct components to pinpoint the exact source of market instability:

1. A "Frictionless" Risk-free Rate: The underlying rate of return without market imperfections.
2. A Credit Spread (CDS): The component reflecting the risk of U.S. government default.
3. A Convenience Yield (Premium): The "service flow" benefits investors receive from the liquidity, safety, and collateral value of Treasuries.

Decomposition of the 10-Year "Risk" Asset

The decomposition reveals that the dramatic increase in stock-bond covariance for long-term bonds (10-year) was not driven by changes in the risk-free rate or credit risk, but specifically by the erosion of the convenience yield.

• Positive Covariance as Risk: For the 10-year bond, innovations in the convenience yield began to move in the same direction as the stock market (positive covariance). This meant that at the exact moment stocks were crashing due to the tariff war, the "safety premium" of long-term bonds was also shrinking, causing bond prices to fall alongside stocks.
• CDS as a Surprise Hedge: Interestingly, the decomposition shows that the 10-year CDS premium actually maintained a hedging property during the shock. This underscores that the loss of the "safe-haven" status was almost entirely due to the collapse of the convenience yield rather than a sudden fear of U.S. default.

Decomposition of the Short-End "Safe" Asset

Conversely, the decomposition explains why shorter-term Treasuries (2-year and 5-year) managed to retain their hedging properties. The sources attribute this to two primary factors:

• Expectation of Recession: A reduction in expected risk-free rates, which is consistent with investors pricing in a higher risk of a U.S. or global recession following the tariff escalations.
• Flight to Quality Rotation: An improvement in the short-term convenience yield. This indicates that investors did not abandon Treasuries entirely; instead, they performed an internal "rotation," fleeing risky long-term debt for the perceived safety of shorter maturities.

Historical Context and Mechanisms

The sources note that this erosion is consistent with a historically negative relationship between the convenience yield and stock-bond covariance. When the convenience yield is high, bonds typically act as a strong hedge (negative covariance); when it erodes, as it did in April 2025, bonds become risk assets.

The primary mechanisms driving these changes in the yield components included stagflation risk, the withdrawal of traditional safe-asset investors, and the unwinding of cash-futures basis trades.

During the April 2025 Tariff War, the traditional "safe-haven" status of long-term U.S. Treasuries was severely compromised as their convenience yield eroded. As long-term bonds lost their ability to hedge against aggregate economic risks, investors actively sought safe-asset substitutes, primarily rotating into gold and shorter-term Treasuries, while notably avoiding the U.S. Dollar.

Gold as a Primary Substitute

The sources identify gold as a clear beneficiary of the "flight-to-safety" capital that abandoned long-term Treasuries during the shock.

• Inverse Hedging Relationship: Intraday data shows that on days when Treasuries failed as a hedge (showing positive covariance with stocks), gold stepped in as a substitute, exhibiting a negative covariance with the stock market.
• Target of Safety-Seeking Capital: The pattern of frequent shifts between Treasuries and gold suggests that investors viewed gold as a viable alternative for preserving value when the "specialness" or convenience yield of long-term bonds vanished.

Internal Rotation to Short-Term Treasuries

Rather than abandoning the Treasury market entirely, many investors performed a "flight to quality" rotation within the term structure, moving from the long end to the short end.

• Resilient Convenience Yield: While the convenience yield for 10-year nominal Treasuries "dropped substantially," the yield for 2-year and 5-year Treasuries actually increased or remained stable.
• Hedging Property Retention: Short-term Treasuries maintained their hedging property due to two factors: a reduction in expected risk-free rates (pricing in a potential recession) and an improved convenience yield.
• Fiscal Rollover Risk: The sources warn that if this substitution becomes permanent, the U.S. Treasury may be forced to supply more short-term T-bills to meet demand, creating significant fiscal rollover risks in an uncertain environment.

The Failure of the U.S. Dollar (DXY)

In a departure from historical norms, the U.S. Dollar did not act as a convincing safe-asset substitute during the April 2025 shock.

• Historical Divergence: Unlike the Global Financial Crisis or the COVID-19 pandemic, where the dollar was a clear safe haven, the DXY index did not show the same substitution pattern as gold.
• "This Time is Different": The sources cite research indicating that the dollar's failure to capture flight-to-safety flows highlights the unique nature of the tariff-driven convulsion compared to prior financial crises.

Underlying Drivers of Substitution

The sources attribute the need for these substitutes to a combination of factors triggered by the tariff war, including:

• Stagflation Risk: The prospect of simultaneous high inflation and low growth made long-term nominal bonds unattractive.
• Investor Withdrawal: Traditional "safe-asset investors" withdrew from the long end of the market.
• Basis Trade Unwinding: The unwinding of cash-futures basis trades further destabilized long-term bond pricing.

The sources identify several key underlying mechanisms that drove the erosion of the U.S. Treasury convenience yield and the loss of its safe-asset hedging property during the April 2025 Tariff War shock. While the situation is still evolving, the researchers highlight four primary contributors to these developments: stagflation risk, the withdrawal of safe-asset investors, a rotation toward shorter-term assets, and the unwinding of cash-futures basis trades,.

1. Stagflation Risk

The tariff war, characterized by the highest import duties in a century and aggressive Chinese retaliation, created a significant stagflation risk—a combination of stagnant economic growth and rising inflation,. This risk environment is particularly damaging to long-term nominal Treasuries:

• Recessionary Pricing: At the short end (2-year and 5-year), the hedging property was maintained partly due to a reduction in expected risk-free rates, as investors priced in a higher risk of a U.S. or global recession.
• Hedging Failure: At the long end (10-year), however, the inflationary pressure from tariffs likely overwhelmed the recessionary "safety" bid, causing long bonds to behave more like risk assets that moved in tandem with the declining stock market,.

2. Withdrawal of Safe-Asset Investors and Basis Trade Unwinding

The sources suggest that the "specialness" or "exorbitant privilege" of long-term Treasuries was undermined by changes in market participation and technical factors:

• Investor Retreat: Traditional safe-asset investors began to withdraw from the long end of the Treasury curve as its convenience yield—the premium paid for liquidity and safety—dropped substantially,.
• Basis Trade Unwinding: The unwinding of cash-futures basis trades appears to have contributed to the market convulsion,. These technical trades involve high leverage and depend on stable Treasury pricing; their rapid unwinding can lead to significant price pressure and a further drop in the convenience yield.

3. Flight-to-Quality Rotation

A critical mechanism documented in the sources is a divergence in the term structure of convenience yields, driven by a rotation of capital:

• Internal Rotation: Investors did not abandon Treasuries entirely but shifted "quality" expectations to the short end. This led to an improvement in the short-term convenience yield (2-year and 5-year) while the 10-year yield premium eroded.
• Gold as a Substitute: Beyond Treasuries, gold emerged as a primary substitute for flight-to-safety investors. Intraday data shows that on days when 10-year bonds failed as a hedge, gold often showed negative covariance with stocks, capturing the capital fleeing from long-term debt.

4. Yield Component Dynamics

Using yield decomposition, the sources pinpoint that the mechanism driving the stock-bond covariance into positive territory was specifically the innovation in the convenience yield component for 10-year bonds,.

• The CDS Paradox: Surprisingly, the U.S. credit spread (CDS) maintained a hedging property during the crisis. This indicates that the instability was not caused by a fear of immediate government default, but by the collapse of the convenience flows (liquidity and safety benefits) that investors normally associate with long-term debt,.

Future Risks: Fiscal Rollover

The researchers warn that if these mechanisms lead to a sustained standoff, the U.S. Treasury may face fiscal rollover risk. If the convenience yield remains concentrated at the short end, the government may be forced to supply more short-term T-bills, making the national debt more difficult to manage in a high-uncertainty environment.