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Paul J. Davies
US President Donald Trump’s sudden turn towards declaring near-victory in the war on Iran shows he has at least one eye on the blowback from his global tariff debacle almost a year ago. A shocking and ill-considered action? Check. Disruption of trade? Check. Inflationary consequences? Check. A sharp spike in financial volatility and widespread market disruption? Check. The key difference is that backing out of a trade war is significantly simpler than retreating from a real one.
Last April, when Trump’s hyper-aggressive global tariffs triggered a meltdown in stocks and bonds, Treasury Secretary Scott Bessent and business leaders including Jamie Dimon, chief executive of JPMorgan Chase & Co, intervened to convince the president to scrap most of those taxes within a few days. Extricating the US from a Middle Eastern war with obscure aims against a complex, stubborn opponent won’t be nearly so easy. Aside from the lives on the line and the potential for wider economic woes, the rapid spread of chaos across markets is one more reason why Trump’s adventurism looks misguided.
The breakpoint last year was the sharp sell-off in US Treasury bonds with 10-year yields leaping to 4.5 per cent from 4 per cent. This week, it was oil prices shooting to almost $US120 ($169) a barrel on Sunday, sparking fears about the inflationary effects of an extended war. In both instances, the aftershocks spread rapidly through other markets. Measures of volatility in stocks, bonds and currencies jumped late last week, putting investors on edge. But with oil prices easing back to about $US90 on Tuesday, other markets calmed down too. Investors were already hoping to see a quick resolution before Trump signalled his desire to climb down in speeches on Monday evening. But markets aren’t out of the woods yet.
“Many asset classes are now tracking oil almost tick for tick, so for markets, this is what matters above all else right now,” said Jim Reid, strategist at Deutsche Bank. “All the headlines have to be interpreted in light of what they will do for the price of oil.”
The structure of modern finance can quickly turn dramas into crises, and last year’s moves following the global tariff announcement were just the latest example. The widespread use of borrowed money and derivatives mean that sudden changes in sentiment can spark self-perpetuating spirals as investors react to measures of how much value they are at risk of losing.
For many big investors, bigger price moves up or down – in whatever asset – feed directly into their models, which tell them to trade in the direction the market is already moving. They sell when prices are falling and vice versa. This common approach to risk management among various kinds of systematically managed funds is one reason why trouble in one market can quickly appear in others too.
The big multi-strategy firms that dominate the hedge fund world and the proprietary trading arms of electronic market makers can be a direct source of contagion across markets when losses in one area provoke them to cut risks in another. The more borrowed money these funds use to turbocharge their bets, the more sensitive they are to rising volatility and value-at-risk models. That’s why sudden changes of direction can have such a big impact. Three big firms – Balyasny Asset Management, Millennium Management and Point72 Asset Management – all suffered losses last week, according to Bloomberg News.
In recent years, these kinds of funds have become the most important traders in the US and UK government bond markets, while they also play a key role in many others. Public debt prices are the bedrock of finance, so when multi-strategy hedge funds sneeze, every investor is at risk of catching a cold.
Ordinary mum-and-dad investors also use more leverage nowadays through the options bets that have become popular on platforms such as Robinhood Markets, and through other levered products like some exchange-traded funds. They too can add to mayhem through their buying and selling, and the hedging done by the dealers who service this activity.
Sometimes storms of volatility can appear out of almost nowhere. US sharemarkets had a brief wild ride in early August 2024 after a long spell of volatility being suppressed by steady systematic flows into similar investing strategies. An unexpected Japanese interest rate increase and some slightly disappointing US earnings were all it took to spark a sharp spike in volatility and a 6 per cent drop in the S&P 500 over three days. This reversed almost as quickly after enough vulnerable bets had been unwound.
But things typically get most troubling when government bond markets either cause a blow-up or get sucked in by problems elsewhere. The threat that trading Treasuries was about to become dysfunctional helped kill the White House’s tariffs in April. And Britain’s gilt market seizing up was a major factor in pushing former prime minister Liz Truss out of office in late 2022.
The main gauges of fear in markets seemed to calm down once oil prices fell back below $US100 a barrel. But the VIX index of volatility in the S&P 500 is at its highest since the weeks after Trump’s global tariff day.
The same dynamics of volatility and leverage in reverse can help markets bounce back as quickly as they stumbled. Another spike in oil prices risks setting off a fresh conflagration – and the intractability of a complicated war with Iran means it will be much harder to extinguish.
Bloomberg
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