Given today’s commodity market carnage, I’d like to look at economic signals emanating from U.S. Dollar Assets.
Treasury bonds used to be boring. Apply a 2 % inflation expectation, a real growth rate estimate to arrive at estimate for a fair yield. For kicks, you could add in some term premium and do a little Fed watching.
Those days are likely over.
Considering selling pressure in Japanese Government Bonds (JGB) to fears of overseas investors potentially divesting their U.S. Treasury holdings. In the background, we see gold spiking and the dollar falling.
The recent rise in Japanese Gov’t Bond (JGB) yields took place largely for domestic reasons, but has a global impact. Investors have a choice of where to lend money and as Japanese yields go up, it puts pressure on other borrowers.
Since the U.S. remains by far the world’s largest debtor, it is going to be one of the most impacted by the need to pay more to attract and retain capital. This is particularly true for JGB yields, as Japan is the single largest foreign holder of U.S. government debt.
The Japanese bond move also has a psychological impact on Treasury investors. Japan’s debt-to-GDP ratio almost doubles that of the U.S. was taken by some to mean that U.S. debt would not impact Treasury yields.
The comparison is particularly troubling for U.S. investors since the drivers for the recent JGB move were concerns over large debt loads, expansionary fiscal policy, and underlying inflation pressures.
This concern will likely cause reverberation for U.S. bonds.
Higher Japanese yields set up a competitor for investment capital, making it more expensive for the U.S. to fund its deficit spending. At the same time, it raises the idea that we could see a rapid repricing of U.S. debt.
Unlike the situation with Japan, the divestment issue is more of a distraction than a real influence on U.S. bond pricing. It’s highly unlikely to occur on a large scale.
The end result would likely be a moderate increase in yields to a still manageable level. This is not to say that it would be a seamless transition. It would almost certainly be extremely volatile in the short run.
In the case of the U.S., the idea of divestment is much more hype than substance.
The biggest threat to Treasuries does not come from abroad but from U.S. fiscal policy. While that threat is manageable for most Treasury bonds, 30-year maturities are another matter. While the U.S. economy is expanding at an above-average pace, the U.S. budget deficit is hovering near 6% of GDP, an amount that historically was associated with recessions.
No one would argue that this is a sustainable budget, including the politicians that passed it. It’s unclear how, or when, U.S. finances will get back on track, but it seems that it will take an external event to force budgetary sanity on the country.
Put simply, if the U.S. government cannot put its fiscal house in order when there is single-party control of government and a strong economic expansion, when will it?
Tariffs and inbound investments could assist at the margin, but nothing in the data or projections suggests they will meaningfully alter the debt trajectory. This lack of fiscal sanity, creates multiple headwinds for longer-maturity Treasuries.
Another risk is the potential for growing deficits over time. Rational investors could choose to focus their holdings on shorter-maturity Treasuries.
Since January 2025, the dollar is down nearly 10 % against a roughly trade-weighted basket of major currencies. Given the ubiquity of the dollar in global finance, that simple reality has a way of altering the return perspective on many asset classes. The S&P 500, for instance, turned in a robust 18 % return in that time; measured in euros, however, it barely cleared a 3 % gain.
Small deficits are usually a boon for a country’s currency since it contributes to growth and gives room to keep interest rates a touch higher.
Concerns that debt service costs could rise soon are likely playing a role in the dollar’s weakness.
Even though the Fed has cut short-term interest rates by 1.75 % since September 2024, the 10-year government bond yield has risen 50 basis points in that time.
This leaves the U.S. increasingly forced to choose between stability and price. It can use expensive 10-year financing, or it can rely on inexpensive short-term money - with the risk of rapid swings in debt service costs.
Global investors have reduced appetite to hold dollars as a safety asset, their reallocation of those funds is likely to create ongoing headwinds for the greenback.
One should consider taking modest steps in response to the evolving landscape. These include:
- Remain invested in the United States: It’s a huge, productive economy and needs to be in investor portfolios.
- Diversify globally: Non-U.S. equities can offer currency exposure and diversification benefits.
- Shorten up maturities: Caution on the longest maturity bonds in many jurisdictions. Benefits to keeping maturities or high probability call dates within 10 years.
The biggest overhang for longer-term Treasuries and the dollar is the lack of a clear, simple story on why an investor should own them.
Treasuries and dollars were seen as the key to safety. Now, however, we see U.S. debt dynamics and an apparent lack of interest in returning to a sustainable fiscal path as major overhangs for longer-term Treasuries.
The dollar is still the default trade currency and continues to benefit from a lack of obvious replacements.
Global bond markets, precious metals, and currencies are sending us a signal on sustainability. I think we should all listen carefully.
If you have any questions or comments, please do not hesitate to let me know.