It is well known that the US runs a large trade deficit and that the rest of the world buys a lot of US dollar-denominated assets. While the two are closely linked, the distribution of benefits and costs is often debated.
Whether the US dollar’s role as the reserve currency is a benefit or a burden to America has been an interesting academic debate for years, but trade policy is now front and centre. Shifts in trade policy have implications for both global capital flows and the US dollar.
In the 1960s, the French finance minister, Valéry Giscard d’Estaing, described the US as having an “exorbitant privilege” as the dollar’s reserve status let the US run persistent deficits without typical financial constraint. Recently, attention has shifted to the drawbacks for the US.
The main argument here is that inflows into the US push up the US dollar such that it makes the US less competitive, particularly in manufacturing.
A link is often made between the decline of manufacturing in the US and the rise of populist politics. Globalisation and the role of the dollar in the financial system are often confused, but the view that globalisation has created relative winners and losers is less controversial.
Trade policy
Trade policy has been a key priority for the new US administration.
We have seen various tariff increases, pauses and negotiations. As of mid-May, the effective tariff rate on US imports is 15%. This is meaningfully higher than the 3% rate at the start of the year. JP Morgan estimates this is akin to a $475 billion tax hike on US households and businesses, which equates to 1.6% of GDP.
Consensus was that US tariffs would harm the rest of the world more than the US. The US dollar was expected to appreciate, as US importers would need to buy less foreign currency if they import fewer goods. The US equity market is seen as more defensive than other, more cyclical markets.
Lastly, a trade war dampens economic activity, which tends to be good for US Treasury bonds.
As the trade war escalated, US equities fell more than global equities, the dollar depreciated, and US Treasury yields rose. This is a highly unusual combination, and as BCA Research noted, one that had not happened to the same degree since 1978, a period when the world lost confidence in the US due to policy missteps.
This raises the question: Are we at the start of a major capital flow rebalancing?
Throughout the 1990s, there were a number of currency crises in emerging markets. Countries with US dollar-denominated debt and a lack of foreign exchange reserves suffered when a shock saw money flow out of the country. This led to a focus on countries building up their reserves by buying US treasuries.
Over the last decade, the private sector outside of the US has accumulated a lot of US assets, both listed and unlisted. Many international pension funds have reduced their home bias and added to global equities, which meant capital flows into the US. Sovereign wealth funds, and even central banks, have bought US equities.
The growth of private markets has also been concentrated in the US. In fixed income, higher interest rates in the US have attracted money from abroad. A deep and liquid market has made this possible. Recent years have seen the US dollar tend to appreciate during market stress. This had been beneficial for global investors, but can no longer be relied upon.
Mixed messages
The US administration has given mixed messages around their dollar policy.
Treasury Secretary Scott Bessent has reiterated a strong dollar policy, and Trump has threatened countries moving away from the dollar. He has also denied reports around threats to Fed independence. His economic advisers, however, have been more vocal about the downsides of US dollar strength.
With US ‘exceptionalism’, a distinction needs to be made between equities, bonds and the currency.
Europe has struggled to recover from the euro crisis in 2012, but Germany is stepping up with infrastructure and defence spending. Japan has escaped two decades of deflation. Bond and equity markets in both countries now offer more interesting opportunities for investors.
US equities generate a higher return on capital than global companies and earnings are less cyclical. The US has benefited from having a lot of technology companies with structural growth.
For the outperformance of global equities to be sustainable, returns on equities will need to rise. We have already seen this with European banks.
The risk-reward trade-off for global investors buying unhedged US bonds has worsened.
While the evidence that global investors are selling US bonds is mixed, the sharp rally in the Taiwanese dollar suggests there are risks for investors who are under-hedged in US dollar assets.
Historically, a weaker dollar has eased global financial conditions, but this time, upward pressure on global bond yields is a risk.
A global rebalancing, with better investment opportunities outside the US and a weaker dollar, is generally a healthy development. However, a reduction in global trade may lead to lower capital flows, and the unintended consequences of this are worth watching.
Nicholas Rilley, CFA, is an investment manager and strategy analyst at Butterfield Asset Management.
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The bank accepts no liability for errors or actions taken on the basis of this information.
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