April 14 - One of the biggest surprises since Donald Trump’s "Liberation Day" tariff announcement has been the continued weakness of the U.S. dollar, which is raising fears about an emerging market-style crisis brewing in the world’s largest economy. But what we’re likely witnessing is a healthy rebalancing of global capital.
Before the U.S. president announced his "reciprocal tariffs" on April 2, almost all economists expected the dollar to strengthen following the news. Tariffs are inflationary, so, in theory, they should cause bond yields to move higher, reflecting expectations of fewer potential rate cuts by the Federal Reserve.
The dollar’s relative yield pickup versus other currencies should, in turn, have strengthened the greenback in the short run. Only at a later stage, if the trade deficit of the U.S. were to decline, and with it demand for dollars from foreign businesses, should the greenback have weakened.
Meanwhile, these broad-based tariffs should lead to lower growth in the euro zone and other export countries, which should have translated into euro weakness.
Alas, the exact opposite happened. Our model for trade-weighted exchange rate movements related to the tariffs suggested that the dollar should have strengthened by 1% if there were no retaliation or weakened modestly with retaliation, while the euro should have weakened by 1% in the first scenario and by 0.7% in the latter. What has actually occurred? A more than 4% decline in the dollar and a 2.8% jump in the euro.
This could be written off as yet another example of flawed economic modelling were it not for the simultaneous moves in the bond market.
In the U.S. Treasury market, 5-year breakeven inflation rates dropped 20 basis points in reaction to the tariffs, even though, again, tariffs should be inflationary. And 5-year real yields rose despite the fact that tariffs should lead to a drop in economic growth and push real yields lower.
As I write these lines, U.S. bond yields continue to rise, driven almost entirely by rising real yields, as market chatter about the end of U.S. exceptionalism grows louder.
‘LIZ TRUSS MOMENT’
Experienced investors will recognise this pattern. It’s one we typically see in an emerging market crisis when investors lose confidence in a country’s government and its ability to service its debt. The result is capital flight and a rapid sell-off of government bonds as the risk premium increases.
This phenomenon was largely absent in developed markets until September 2022 when then-UK Prime Minister Liz Truss lost the confidence of global investors with her infamous mini-budget.
The result was a rapid increase in gilt yields and capital flight that forced the Bank of England to step in before ultimately compelling the prime minister to abandon her policies. Eventually, the prime minister was ousted herself, famously outlasted by a head of lettuce.
The current weakness in the dollar and the moves in Treasury real yields indicate that Donald Trump could be facing his own Liz Truss moment. International investors may be losing confidence in the dollar and the U.S. as the best place to allocate capital.
Detailed capital flow data is not yet available, but we can get an idea of what may be happening by looking at daily ETF flows. When looking at the net flows from equity ETFs in the U.S. and Europe in the week after the tariffs were announced, it is clear that there were large outflows from U.S.-focused ETFs and hardly any outflows from ETFs investing in Europe. Among U.S. investors, there were even net inflows to "international ETFs" that focus on global equities ex-U.S.
REBALANCING
In short, we may be seeing the end of U.S. exceptionalism in real time. But it is not the end of the U.S. dollar as the world’s reserve currency. What we are witnessing is likely a rebalancing of international investment portfolios, which, over the last decade, have become increasingly concentrated in U.S. assets. For example, the U.S. share of the MSCI World stock market index has risen from 48% in 2010 to 73% today.
In a way, this is reminiscent of what occurred after the tech bubble burst in 2000. Back then, investors gradually reduced their U.S. portfolio allocations in favour of European and Asian investments after the U.S. market share in the MSCI World had risen from 40% to 60% in just five years.
The result was the gradual decline of the valuation discount of European stocks versus their U.S. counterparts, as U.S. markets devalued while European valuations remained largely stable. Unsurprisingly, investors moved money from the U.S. to better-performing markets.
Over the next few years, there may be a similar period of portfolio rebalancing that leads to persistent U.S. underperformance in favour of European and Asian markets. Given how much foreign capital has flooded U.S. markets in recent years, this rebalancing could be painful for Wall Street.
(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank)
Writing by Joachim Klement; Editing by Anna Szymanski and Alison Williams
