These unusual market moves show trust in the dollar may be breaking
2 days ago
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Graph: USD/EUR exchange rate and US 10-year Treasury yield
Something strange is happening in the US.
As investors batten down the hatches over fears of a tariff-fuelled financial crisis, a rare split has opened up between the dollar and the yields that America’s government pays on its debts.
While somewhat technical, this essentially means that the Green Back is plunging at the same time as US borrowing costs are rising.
Already, this trend has panicked investors, who note that the two key financial metrics usually do the opposite by moving in tandem.
Worse still, stock markets have also taken a pummelling since Donald Trump’s trade war unleashed a wave of economic turmoil.
Combined, the falling dollar and rising yields reflect the shifting fiscal landscape in America, where the US President’s tariff blitz has put the country’s safe haven status at risk.
Christian Keller at Barclays notes how far the US has fallen since Trump ramped up his trade war earlier this month.
“A parallel sell-off in equity, rates and the currency is typical for emerging markets, but not for the world’s core safe-haven markets,” he says.
Investors had become used to the idea that the US was the best place for their money in good times or bad, giving America the “exorbitant privilege” of controlling the world’s reserve currency.
It meant lower borrowing costs and easy access to a flood of foreign money to invest in the States, making the country richer and helping its economy to grow faster.
But suddenly, investors are turning their backs on the US, ditching the dollar and other assets all at once.
It represents a stunning reversal of usual patterns of behaviour, breaking what had come to be seen as something close to a basic rule of global finance.
The result is that the dollar and bond yields, which by and large tend to move in tandem, have sharply diverged.
Even after the President suspended his most aggressive tariffs on almost all countries apart from China, markets have failed to comply.
Since April 2, which Trump called “liberation day”, the dollar has fallen more than 4pc and the yield on 10-year US bonds has risen from 4.2pc to 4.5pc.
Keller says the moves are a remarkable break with history.
“The dollar’s depreciation in response to US tariff increases – the opposite of economic textbook doctrine – and the US Treasury sell-off in parallel to equity losses – the opposite of safe-haven behaviour – have cast a broader light on the overall dynamics triggered by Trump’s tariff policy,” he says.
As tariffs harm imports, textbook economics would dictate that the dollar strengthens. Similarly, the expectation of a recession should push down interest rates, including bond yields.
“US Treasury yields rose as a consequence of foreign holders demanding a higher term premium to compensate for concerns about Treasuries as a care-free safe-haven instrument,” says Keller.
Gerard Lyons, economist at Netwealth, notes that America’s dominance in the past 25 years arose in part from a lack of alternatives.
For example, the replacement of Germany’s Deutsche Mark with the euro abolished one safe haven, while Japan is no longer seen as the sound market it once was.
Also, several of the props that had supported bonds in recent years have been kicked away.
Quantitative easing (QE), which drove the Federal Reserve’s asset purchases to a peak of nearly $9 trillion (£6.9 trillion), has long vanished as the central bank runs down its balance sheet.
When the policy was core to the central bank’s operations after the financial crisis, new waves of QE would push the dollar down at the same time as squashing yields, pushing down borrowing costs in the process.
The dominance of American stocks has also influenced the performance of the dollar, as the so-called Magnificent Seven tech companies have sucked cash into the US. But that too has been shaken by the trade war.
Meanwhile, America’s trade deficit stems from businesses and households in the United States buying goods from abroad.
Currently, more than one-fifth of America’s government’s $36 trillion debt is financed by overseas buyers.
If Trump succeeds in crushing the US’s trade deficit, he will also cut off the flow of dollars which find their way back into America’s bond market.
Crucially, there are limits to the steps that the authorities can take to restore faith in the US economy.
For example, Jerome Powell at the Federal Reserve could buy bonds to shore up markets.
But it is hard for him to fire up QE once again over fears that it could reignite inflation alongside tariffs.
What’s more is that the Fed can do nothing to limit the impact of Trump’s erratic decision-making, says Krishna Guha at Evercore ISI, who described the recent sell-off as “almost unprecedented”.
“By backstopping liquidity, the Fed can limit prices overshooting,” he says. “But it cannot stop capital outflows driven by a loss of confidence in US economic policymaking.”
Ultimately, the reserve currency status that gives America such power globally is based on trust. And once that trust is called into question, it risks becoming a self-fulfilling prophecy.
Holger Schmieding at Berenberg Bank warns of a “Liz Trump moment” in America, referring to the former prime minister whose mini-Budget sparked market chaos.
“Unconventional policies that gamble with a country’s public finances and its growth outlook can cause bond investors to question the assumption that government debt is risk-free,” he says.
“The breakdown in the relationship between US Treasury yields and the dollar highlights the concerns of investors about Donald Trump’s policy agenda.”
“The trade war damage can expedite the deterioration in the US fiscal position.
“Huge uncertainty will cause a retrenchment in investment and consumption, driving a sharp slowdown in the US economy.”
He predicts further falls in the dollar and increasing yields, with the stunning divergence in those crucial economic indicators poised to worsen.
“These developments are so important to watch because they indicate a potential paradigm shift in how the US is seen as a destination for capital flows overall,” says Keller at Barclays.
“This is triggered not only by the extreme tariff policies, but also the associated concepts regarding charging the rest of the world for the provision of the dollar as the reserve currency.
“As tariff and foreign policy proposals became increasingly radical, these ideas started to look less remote as well. This, in turn, requires the rest of the world to reconsider the US as an investment destination.”
