The Truth Behind the "US Debt Collapse": 4 Suggestions in the Liquidity Crisis

Is US debt still safe?

Last week, many investors in global fixed-income products were shocked. How could a week wipe out two months of returns? It’s important to know that this type of product has always been stable, but making money is not easy. This truly reflects the old saying that describes fixed-income products – "making money is slow, losing money is fast."

Moreover, this time the culprit is what has always been considered a safe-haven asset—the US Treasury bonds.

What's even scarier is that there are many rumors—

The understanding king is at odds with the whole world, and everyone no longer wants US debt.

We are going to fight a financial war with the ugly country, and the ultimate weapon is the US bonds in our hands.

Understanding King wants to collect interest tax from the governments of countries investing in national bonds globally, and now everyone is selling...

It seems quite similar to that, last week the U.S. experienced a "triple whammy" in stocks, bonds, and currencies, a situation that previously only occurred during financial crises in emerging markets. In addition to the significant drop in long-term government bonds, the U.S. dollar index fell by 3% last week, and the S&P 500 dropped by 9.08% the week before.

If that's the case, then there will be chaos in the world. The status of U.S. Treasuries and U.S. stocks is completely different. Almost all foreign currency wealth management products and QDII bond products hold U.S. Treasuries to some extent. The lower the risk of the product, the higher the proportion of U.S. Treasuries. Therefore, many people in the "New Wealth Thinking" circle of Steel Big have asked me: What should we do if the wealth management product has not matured and cannot be redeemed.

An important conclusion that I want to clearly state at the beginning is: at least for now, such a thing will not happen; US Treasury bonds are still a safe asset.

Of course, these claims are not unfounded. The current trading logic of U.S. Treasuries has shifted from traditional safe-haven assets to concerns over an increase in U.S. national credit risk, leading to a sell-off of some Treasuries. This reflects a lack of trust among global (including domestic U.S.) investors in the overall U.S. policy, shaking the status of the U.S. dollar and Treasuries as risk-free assets.

Currently, it is not serious enough to the point of a collapse, so this article will discuss two important issues:

Question 1: Who is selling during this U.S. Treasury crisis?

Question 2: Why is there no need to worry about the safety of investment products centered around U.S. Treasury bonds for the time being?

First, we need to know that a significant drop in long-term U.S. Treasuries with maturities of over 10 years has occurred in every financial crisis.

Safe-Haven Assets in Times of Crisis

Bond investment seems very simple, but it actually has a high threshold, and the deeper you go, the more you need a foundation in economics. However, for ordinary investors, at the beginning, you only need to clarify a pair of counterintuitive concepts:

Bond prices rise, and yields fall, allowing investors to profit.

Bond prices fall, yields rise, and investors lose money.

The main reason is that the maturity price of bonds is fixed, and an increase means that the yield to maturity decreases.

In articles analyzing bonds, some places use "yield to maturity" while others use "bond price"; the direction of these two is completely opposite. If you really can't understand, just memorize this answer for now, and you'll gradually understand it later.

Once you understand the "counterintuitive" relationship of bonds, you can return to the main topic.

Government bonds are generally considered safe-haven assets, as they are guaranteed by the credit of the state. Therefore, when risks arise, the first phenomenon that occurs is "the yield on bonds declines, and bond prices rise." There are two main reasons for this:

On one hand, macro risks often lead to economic recessions, reducing the demand for funds in the market, lowering interest rates, and at the same time, the central bank will lower policy rates to stimulate the economy.

On the other hand, the risk of bonds is lower than that of stocks. When stocks plunge, capital will flow from the stock market to the bond market, driving up bond prices and lowering the yield to maturity.

In the past two years, the yield on 10-year government bonds in our country has fallen from over 3% to a low of 1.59%, which reflects the first logic.

The same is true for sudden crises in the short to medium term. At the beginning of 2020, during the initial outbreak of the pandemic, global government bond yields saw a sudden and significant drop, with China's 10-year government bond yield falling from 3.2% to 2.4%, and the United States dropping to as low as 0.5%.

But the above mainly refers to recession and ordinary crises. When a crisis reaches a certain level, it becomes different afterwards.

For example, during the outbreak of the pandemic in 2020, the 10-year U.S. Treasury bond saw a significant increase in buying from late February when the crisis began until early March when the crisis rapidly worsened. Driven by both the economic recession and a surge in market risk aversion, investors flocked to buy U.S. Treasuries, causing yields to fall sharply, first dipping below 0.5%, setting a historic low—this all aligns with traditional investment logic.

However, by the second week of March, as some investors took profits and market expectations for policy stimulus increased, the 10-year U.S. Treasury yield experienced a strong rebound, rising by about 40 basis points during the week, leading to exacerbated losses for investors who had sought refuge here – similar to the situation that occurred last week.

In fact, most safe-haven assets have this characteristic.

The most typical safe-haven asset is gold. When the crisis began in 2020, it also rose continuously just like this time, but started to fall for 10 consecutive days from March 9, dropping from $1680 to $1473. Many people avoided the decline in U.S. stocks, but instead fell victim to what seemed like a safe asset, gold.

The Japanese yen is also a traditional safe-haven asset. At the beginning of the crisis in 2020, investors sought safe-haven assets, driving up the value of the yen, with the USD/JPY rising significantly from 111.83 on February 21 to 103.08. However, thereafter, a tightening of dollar liquidity led to a "dollar shortage," and the yen rapidly depreciated to 111.71.

The US dollar itself is not immune to the fate of large fluctuations. The US Dollar Index first dropped from 99.9 to 94.63 on March 9, then rose to 103 on March 20. However, after the Federal Reserve provided ample dollar liquidity through unlimited QE on the 23rd, it fell sharply for four days to 98.34.

Assets with safe-haven properties are not absolutely secure during a crisis; the main issue is still liquidity shocks. For example, the direct reason for the drop in U.S. Treasury bonds last week was the forced liquidation of "basis trades," which has occurred in past crises.

Basis Trading and Liquidity Crisis

The so-called "basis trading" involves holding a long position in U.S. Treasuries while shorting the futures of Treasury bonds that are trading at a premium, earning this portion of risk-free profit.

For example, on April 14 at around 7 o'clock, the yield on the U.S. 10-year Treasury bond was 4.44% (spot price), but the trading yield on the 2505 futures contract was 4.406% (futures price). Due to the carrying cost, the futures yield is generally always less than the spot yield (i.e., the futures price is higher than the spot price), and this excess is called the "basis."

But by the delivery date, the prices of futures and spot will converge. This process can either lead to a decline in spot yield or an increase in futures yield. Regardless of the direction, as long as the basis returns to zero, "basis trading" is guaranteed to be profitable.

Specifically, basis trading is divided into three steps: first, purchase government bonds (equivalent to shorting the spot yield of government bonds), while pledging these government bonds to financial institutions to finance the shorting of futures prices (i.e., going long on government bond futures yields), earning the risk-free profit from the spread.

However, the basis is very small, and high leverage must be opened to obtain sufficient returns. In addition, it is basically a risk-free return, so the basis trading of government bonds generally uses a leverage of more than 50 times.

Basis trading is usually risk-free in a normal market, but it may not be the case during a financial crisis.

Financial crises usually begin with a decline in stock prices. Many funds are leveraged, and when prices drop to a certain level, margin calls must be made. Investors then need to sell off other investment types they hold. At this time, government bonds are generally rising and yielding profits, often becoming the first choice for investors.

If the crisis escalates and more people sell government bonds, the price of government bonds will experience a rapid decline, leading to a situation where the basis is lower than the repurchase rate, turning guaranteed profits into steady losses, which further intensifies the selling pressure. This could lead to a divergence between futures prices and spot prices. At this time, both the futures and repurchase markets will require additional collateral. If hedge funds cannot meet the requirements, the lenders will seize the pledged government bonds and sell them in the market, causing a further increase in bond yields, creating a feedback loop.

The reason basis trading can "guarantee profits" during normal times is that financial institutions bear the cost of liquidity to finance interest. Once a crisis occurs, this cost amplifies sharply, and naturally, this trading becomes unviable.

Therefore, the size of the liquidity shock can be assessed by the difference between the implied repo rate and the federal funds rate. Last Thursday, after the announcement by the understanding king to postpone the reciprocal tariffs for 90 days, the CTD implied repo rate was only 20-30 basis points higher than OIS, far below the extreme level of over 200 basis points in 2020, and still within a controllable range.

Additionally, the spread between the 2-year and 10-year government bonds can also be judged, as the 2-year government bond is equivalent to cash, essentially having no leverage, and is primarily held by foreign governments. Last week, the 2-year bond remained basically unchanged, and the widening of the term spread also indicates that the main reason for the decline in long-term bonds is the liquidity shock caused by ordinary trading institutions.

If it is just a liquidity shock, the Federal Reserve has many tools at its disposal and can fully alleviate the overall liquidity pressure by relaxing bank leverage restrictions. The Federal Reserve will not make the same mistake twice in the same place. In 2020, the Federal Reserve even personally stepped in to purchase high-grade U.S. Treasury bond ETFs for liquidity.

However, the market's concerns are not unfounded; the real crisis is not the decline of long-term bonds, but the "triple kill" of stocks, bonds, and exchange rates—has this "triple kill" happened before?

Taking the stock market crash of 2020 as an example, the crisis began on March 21. In the first two weeks, both the U.S. stock market and the U.S. dollar fell, while U.S. Treasury bonds rose; in the third and fourth weeks, the 10-year Treasury bonds and the S&P 500 both fell, but the U.S. dollar index rose; by the last week, the U.S. dollar and U.S. Treasury bonds both fell, while the U.S. stock market began to rebound.

One of the three will always rise, reflecting liquidity shocks. Funds hide and seek during a crisis, but they have not left the dollar system.

Especially as both the US dollar and US Treasuries, these two safe-haven assets, have fallen together, this has only happened four times in history, totaling seven days. Typically, this occurs after a significant easing of liquidity crises, where safe-haven assets flow into risk assets, but this time it is completely inconsistent.

The "stock-bond-foreign exchange" triple kill only indicates one thing - capital is leaving the dollar system, as evidenced by the surging gold, euro, and yen last week. This is why former Treasury Secretary Yellen described this tariff policy as "mad self-harm."

Many self-media outlets are starting to speculate whether this time will mark the beginning of countries around the world moving away from dollar assets, leading to the collapse of the dollar empire.

But still, that being said, the proportion of foreign capital sell-off is not high. According to the latest Federal Reserve custody data, from April 2 to 9, foreign holdings of U.S. Treasury bonds only decreased by $3.6 billion, and the average duration of official sector holdings is only 5 years, so the selling pressure may be limited.

In fact, there was only a "three kills" on April 10, and U.S. bonds began to fall on the 7th, and U.S. stocks have stopped falling on the same day, from the perspective of the week, U.S. stocks actually rose 5.7% last week, and there were no "three kills", reflecting more of the characteristics of the liquidity crisis.

So my answer is still very clear, maybe one day in the future, but the conditions are not yet mature, and the reason is still the tariff war, the trade imbalance.

Can the Renminbi Replace the US Dollar?

Many netizens like to use "war thinking" to think about financial issues, but in the financial market, everyone faces a common enemy - risk.

China holds more than 700 billion US dollars in US bonds, last year in the context of a boom in the financial market, sold for a year, only sold more than 50 billion, less than 7%, if China "attacked" US bonds, such as a large number of US bonds sold in the short term, it will inevitably trigger the sell-off of global investors, which will indeed cause the collapse of US bonds, but in fact they can't sell much, all of them are smashing their own goods, these are the wealth accumulated by foreign trade enterprises for many years.

Moreover, China's holdings of U.S. Treasury bonds are less than 2%, and a large amount of U.S. debt is in the hands of global investors. The collapse of U.S. Treasury bonds would mean a collapse of the global financial market, leading to a 20-year regression of the global economy. For every 1% decline in global economic growth, the number of people living in poverty would increase by 100 million, and the number of deaths would rise by 1 million. This is no different from starting a war.

The actual situation is more complicated than imagined. If China does not undergo significant structural changes in its economy in the future, it will be very difficult to reduce its proportion of U.S. Treasury holdings.

This is mainly because in international trade, the currency used for settlement is usually decided by the buyer. If China's position as a global manufacturing hub does not change, the surplus will certainly bring in a large amount of US dollars. After enterprises sell foreign exchange to the central bank, the central bank cannot just hold on to it. Because the US dollar has been depreciating, buying US Treasury bonds yields more than 4% interest, while buying Japanese bonds only yields 1%. The issuance of bonds from other countries is simply insufficient.

Of course, you can also buy gold, but if everyone buys gold, the price will skyrocket. It is still a non-interest-bearing asset. U.S. Treasuries have high interest rates to hedge against volatility, while the fluctuations in gold are purely losses.

Also, where do you keep the gold after buying it? If you want to bring it back, the deficit country may not have that much, and if it can't be brought back, it means your wealth is essentially in the hands of another country.

The root cause lies in the surplus US dollars from international trade, with the global demand heavily favoring the United States, forcing everyone to buy US Treasury bonds. China has already reduced its holdings of US Treasury bonds as much as possible.

This is similar to debt in reality; a massive debt often occurs when the debtor wants to go bankrupt, but the creditor does not want it to collapse. We are naturally the maintainers of international order; this is not a matter of image, but of interests.

Is it possible to unite with other countries to use other currencies in international trade?

Of course, it is possible. Our country has been working hard, but the root of the problem lies in the fact that we are a producing country, and our production capacity is prepared for the global market, which inevitably leads to a surplus. If we settle in RMB, the amount of RMB spent will certainly be less than the amount received, but only we can issue RMB. The country is currently using "currency swaps" to solve this problem, but the amount is far from sufficient. Moreover, the currencies of the countries we are interested in may not be willing to exchange, and the countries that are willing to exchange have currencies that we do not find appealing. This is a paradox.

The issue lies in consumption; only when you become a consumer and buy things from other countries will trade balance occur, allowing the renminbi to potentially go abroad.

In the past, people often said that when Americans printed some money, they brought all the real goods home and made a big profit. In reality, if such a good thing existed, this tariff war wouldn’t have happened. Everything comes with a price: the government’s fiscal deficit, excessive consumer debt among the public, widening wealth gaps, and the decline of the manufacturing industry are all costs of the dollar's status as the international reserve currency.

So the status of an international reserve currency is a result, not a wish or an effort goal. This time, the euro has appreciated the most, but are Europeans happy? Not really, because the EU has a large trade surplus with the US, and export competitiveness has declined. If the renminbi starts to appreciate, our GDP could soon surpass that of the US, which would make the onlookers happy, but export businesses would be crying. Only when the dollar appreciates do ordinary Americans not feel too bad relatively, because they are importers and consumers, and prices become cheaper.

If the Renminbi wants to become a global reserve currency, we must become a consumer country. Once we become a consumer country, it is equivalent to replicating the path that the United States is currently on. Are we willing to do that?

The issue is now clear. The United States is unwilling to be just a consumer, so we also need to increase our domestic demand market and adapt accordingly. The day they realize that manufacturing cannot return, and prices are uncontrollable, they will lower tariffs again, and we can do business properly. We need to enhance the adaptability of our economic structure; the mindset of financial warfare is merely wishful thinking and not a solution to the problem.

Recent Configuration Suggestions: 4 Tips

Finally, let's discuss a few practical viewpoints on financial investment:

First of all, the crisis of long-term bonds has not passed. Since the market has already seen that bonds are the "Achilles' heel" of the understanding king, this area may be repeatedly attacked in the future, causing the volatility of bonds—mainly long-term bonds—to increase, but it will not break through the upper limit and will not spiral out of control, because there are too many tools in the Federal Reserve's toolbox.

Since the market has already seen that bonds are the "soft spot" for the wise king, this area may be repeatedly attacked in the future, causing increased volatility in bonds—mainly long-term bonds—but it will not break through the upper limit and will not lead to a crisis out of control, because there are too many tools in the Federal Reserve's toolbox.

Secondly, looking at the dollar credit mainly involves examining short-term debt. The fluctuations in long-term debt are caused by its speculative nature, while short-term debt is more affected by the real-world "gravity," has less investment nature, less leverage, and is relatively stable. During the stock market crash in March 2020, only short-term debt showed relatively stable fluctuations among all "safe-haven funds."

Again, gold is not absolutely safe. Gold is currently the only safe-haven asset (short-term U.S. bonds count as half), and funds have all flowed in this direction, leading to a large-scale entry of speculative capital. However, the very essence of a safe asset is safety, and when it rises too quickly, it becomes inherently unsafe. During the Chongqing bombing in the War of Resistance, not many people left on the streets were killed by the bombs, while over ten thousand who hid in air-raid shelters suffocated to death due to lack of oxygen. Being 'suffocated' by safe assets is a typical phenomenon of liquidity crisis.

In the end, the center of the storm is temporarily safe. This time, the market protection is part of a political mobilization, and the state team does not hide it; they are just doing it for the market to see, similar to when a bank run occurs, putting cash on the counter for open withdrawals, to establish confidence among global investors.

Of course, not all A-shares, just a small portion of index stocks.