When you think you’re drinking whisky, but it’s actually cologne

Ever since Trump arrived in the Oval Office, we have been lurching from one upheaval to the next. The latest incident – which, judging by the videos released by the White House, I am not yet sure has been properly assessed – has thrown the markets into turmoil, fuelling mistrust and discrediting Europe’s closest ally in the eyes of most global investors, a situation which, at least for now, has left us in a state of shock. But what has happened? Is Trump a strategist with a mind superior to Kasparov’s, or a visionary at the helm of the world’s largest economy? I shall leave it to the reader to form an opinion on this matter; I shall merely explain what has happened – which, unfortunately, does not mean it will not happen again.

12 March 202 Reading time: 5 minutes 45 seconds

After a long time without writing this column, I’ve made a point of finding the time to do so and to explain what so many people have been asking me about over the last few days: whether what happened with Trump was a benevolent concession by a great leader or a full-blown capitulation.

To understand this, I need to explain something that can sometimes be a bit tricky to grasp, but just read the following carefully and you’ll get the hang of it, because it’s much simpler than it might seem. Let’s get started.

The largest operators on the world’s stock exchanges – and particularly in New York – are funds known as ‘hedge funds’. In Spain, the CNMV refers to them as ‘Fondos de Inversión Libre’ (FIL). In other words, these are funds that face very few restrictions when it comes to choosing where to invest their assets. These funds typically hold positions in equities and fixed-income securities. From now on, I will refer to shares and bonds – whether sovereign or corporate.

However, almost all of these ‘hedge funds’ share one characteristic that sets them apart from other funds, namely that they are heavily in debt – which, technically speaking, means they are highly leveraged. What does this mean? I shall explain it with an example:

Let’s imagine a ‘hedge fund’ whose portfolio consists solely of shares and bonds (they may hold property, unlisted companies, etc., but ours does not). Our fund, therefore, holds only these two types of assets.

Our “HedgeFund” has assets totalling 100 million dollars; in other words, investors have invested that amount in it. With those 100 million

invested in company shares and bonds (public and private debt), goes to the bank and asks for a loan of 80 million, to invest in the same assets as the 100 M he already has. If the bank grants the loan – which it most likely will – his investable assets will now total 180 million.

But of course, the bank wants collateral and tells him that, in exchange for lending him 80 million, it wants 120 million as collateral – out of the new total of 180 million. Some might say to me, and quite rightly so, that the bank is asking for something it has itself provided to serve as collateral – that is, the 80 million (as is the case with mortgages). However strange this may seem to the uninitiated, it is very common.

“These days, hedge funds are the biggest players on the world’s stock markets, moving vast sums of money”

From the bank’s point of view, it secures a loan of 80 M with collateral worth 120 M. The difference compared with mortgages is that the bank requires the fund’s net asset value not to fall below 120 M. This could happen because the total value of the shares and/or bonds, which was initially 180 M, could fall below the required 120 M.

Furthermore, the fund is not concerned because it has a ‘value decline buffer’ of 60 million (180 M of the new net assets – 120 M of the guarantee).

“The stock market volatility of recent days has wiped out around 20 per cent of Americans’ savings”

What could possibly go wrong?

Well, just one thing: that the share price would plummet and the fund’s net asset value would fall below those 120 million.

If this happens, the fund will need to raise liquidity either to increase its collateral or to repay part of the loan.

Now the fund manager has a decision to make: what should I sell – the shares that are plummeting and have lost 20 per cent of their value, or the bonds that are more or less holding steady? I think we’d all make the same decision: the bonds.

Let’s take a step back and look at another perspective – that of the Government.

A state has only one source of revenue: taxes. It makes no difference to me whether they are direct or indirect, or whether they are levied on goods or services. At the end of the day, it’s a tax. On the other hand, it has various types of expenditure, which I’ll kindly group into five categories: public sector wages; pensions and benefits; miscellaneous current expenditure; and capital expenditure. And no, I haven’t forgotten the fifth one. I’ve put it last precisely because it’s the only one you can’t change: interest on public debt.

Public debt is nothing more and nothing less than the sum of previous years’ public deficits that have not been covered by surpluses. The US, like Spain, has not experienced a surplus for many years, which is why the debt is only set to grow. Its public debt currently stands at approximately 37 trillion USD (37 trillion in the Anglo-Saxon notation) and, over the next four years, approximately 9.2 of the 33 will fall due.

“One of the few things our economy has in common with the US economy is the massive public debt; the difference lies in the solvency ratios.”

Either they cut spending so much that they are able to pay off those 9 trillion – something not even Trump believes is possible – or they try to lower the interest rate at which the debt must be refinanced, because if they don’t, they will either increase the deficit or be forced to cut spending (this is necessary for the country, but in this instance, we do not need to address it).

Let’s take another break. This is the last one, really – we’re nearly at the end.

If you bought a bond (the total amount of government debt issued is the sum of all bonds in circulation) worth 100,000 USD, with a 10-year maturity and a 5 per cent annual interest rate, you will receive USD 5,000 in interest each year for the next 5 years, and at the end of the 10th year you will be repaid your USD 100,000. But imagine that in the 5th year you need to sell the bond on the market because you have an unexpected expense.

You will not necessarily receive the 100,000 USD that you invested. You will receive a higher, equal or lower amount, depending on the yield of that same bond at that same time. If, at that time, a ten-year bond like yours is trading at 6 per cent, you will receive less than USD 100,000, because why would anyone buy a bond paying 5 per cent when there is another identical one on the market paying 6 per cent? And the same applies the other way round.

“Contrary to what many people believe, the stock market is not a zero-sum game”

What is in the issuing government’s interest? Well, whenever it comes to rolling over bonds that it will be unable to redeem – because it has a deficit rather than a surplus – the interest rate on that bond is lower than the rate at which it was issued.

And what determines whether a bond is priced at one level or another? Well, the law of supply and demand. If there are a lot of people who want my bond, I’ll be able to issue it at a lower interest rate; conversely, if fewer people want it, the interest rate will be higher.

Right, now let’s bring all of the above together.

Trump’s statements have sparked not just uncertainty about the future, but a certainty that they will trigger a recession. The reason for this is that companies will sell less, make fewer profits and unemployment will rise.

And what is a share price on the stock market, if not a discount on expected profits? The conclusion was, and remains, clear: the stock markets are crashing.This did not seem to bother Trump, who weathered the storm until the following happened: leveraged funds (the ones I mentioned at the start) were forced to sell positions to cover their collateral and, naturally, sold the only stable asset in their portfolios: bonds. And the sell-off was massive, because the stock market crash was so severe.

You didn’t need to be a genius to realise this.

Scott Bressent, Secretary of the Treasury and former CEO of a hedge fund, upon seeing this, jumped on a plane and flew to Florida to see if Trump, whilst travelling from hole to hole in his golf buggy, would get the message.

And finally, as the numbers go in order, what was to be expected happened here: the US bond

As a benchmark, the Treasury’s 10-year government bond yield rose from 3.87 per cent to 4.53 per cent in less than a week, signalling a rise in borrowing costs that the US would find impossible to bear at a time of major debt roll-over. And it certainly took this on board and backed down.

That’s what happened – nothing more, nothing less.

So why has Trump given in? Because the financial markets interpreted these tariff measures as a sign of an impending recession, which led to a fall in

the losses I was incurring in leveraged investment funds (those hedge funds I mentioned) which forced them to provide further collateral to the banks, which they did not have.

The funds did what they could, selling their most stable assets: US government bonds. An oversupply of bonds made them less attractive to buyers of bonds that needed to be refinanced, and therefore more expensive for the Government.

The aim of reducing the cost of debt had not only proved fruitless, but quite the opposite, at a time when a huge amount of debt needs to be refinanced.

But this does not stop at hedge funds. A deep-seated mistrust has taken hold across the financial markets, which are no longer convinced that the US dollar – and therefore US government bonds – constitute a safe-haven asset. If financial market participants, apart from hedge funds, lose confidence in the US dollar and its bonds as safe-haven assets, and the US Treasury has to refinance its public debt at increasingly higher costs, this would weaken the US economy, creating a vicious spiral that could drag down all Western economies.

Arrogance is cured with a good slap. The problem isn’t the face of the person who received the slap; the problem is the state of the arm of the person who delivered it, which in this case has resulted in a sprained shoulder – let’s see how long it takes to heal.