The twin sell-off that signals a break with the past

US government bonds and the US dollar very rarely decline at the same time. But they did last week. And it was a simultaneous sell-off that ranks as the fourth most violent of the past 40 years.

There are competing explanations for the double drop and some technical factors at play.

But by our reckoning, a move of this magnitude marks a clear repudiation of President Trump’s flagship policy initiative, and serves as a warning that the haven status of US Treasuries and the dollar can no longer be taken for granted. In other words, it’s a watershed moment for investors.

We have for some time argued that the steady erosion of US soft power - in everything from foreign policy to multilateral cooperation - would at some point lead to a material increase in the US’s cost of capital. The policies pursued by this administration simply bring forward the day of reckoning.

Import tariffs that aim to reduce US trading partners’ dollar surpluses naturally reduce demand for the dollar and Treasuries while the government’s weaponisation of the greenback and the US financial system – coupled with policy flip-flops – further diminish the country’s investment appeal. 

The epicentre of uncertainty

Of course, the US is used to bending the world to its will.

For decades, US exceptionalism -- or the uniquely dominant role the country has occupied in geopolitics, the economy and financial system -- allowed it to push the boundaries of economic orthodoxy. In the most recent decade, it has been able to maintain a huge twin deficit – fiscal and current account – allowing the economy to run hot.

But the policies it is now pursuing are of a different order of magnitude altogether. As we argue in our upcoming Secular Outlook - where we detail our asset class return forecasts for the next five years - the US has evolved from being a source of global stability into an epicentre of uncertainty.

For any country, credibility is the main asset it has. When that breaks, it is extremely difficult to repair. As such, it is unrealistic to expect global capital to continue rushing into the US at the present pace. 

The UK offers some useful lessons. In 2022, the then Prime Minister Liz Truss’s policy of steep, unfunded tax cuts caused a panic in gilt markets, damage which is still visible today. In this past week of market turmoil, UK gilts experienced significantly more volatility than their developed peers, with the 30-year yield hitting its highest level since 1998.

Watch out for the premium

As investors reprice the risk of US capital, the term premium – a component of US Treasury yields – has climbed to the highest in over a decade.

This is the additional compensation investors require to hold a long-term bond over and above the expected rate of economic growth and inflation. Calculating it is a complex task as it encompasses several different factors ranging from market sentiment and monetary policy to political uncertainty.

Based on some widely-used models, our calculations show that the premium could rise at least another 25 basis points from the current level.

Debt mountain

The US’s situation is all the more precarious because of its unusually high public borrowing needs.  

The Treasury is expected to issue USD2 trillion of new debt and roll over USD8 trillion of maturing notes to finance the fiscal deficit this year.

Worryingly, the net issuance of Treasuries has so far failed to keep pace with the worsening fiscal balance (see chart). The hole will need to be plugged over the remainder of the year, resulting in some USD500 billion of net new borrowing at a time when funding costs will be higher than they are now. 

The additional supply of debt will likely target more the medium to longer term maturity than short-term T-bills, which already represent more than a fifth ofthe total marketable debt.

But thanks to President Trump’s planned tax cuts and with tax receipts likely to fall as the economy slows, we expect further deterioration in the fiscal balance.

Recent Treasury auctions have been weak, or at best lukewarm, sending another warning signal for investors.

If higher supply results in higher yields, the US’s debt dynamics will become even worse.

The Congressional Budget Office estimates that an increase of 0.1 percentage point in yields each year will lead to an cumulative increase in deficit of USD350 billion from their baseline projection for the 2026-2035 period.

No big bang; slow degradation

For all this, it would be wrong to assume the US will lose its haven status overnight. The process is likely to unfold over a long period, not least because there aren't any assets that currently rival the liquidity of the dollar and US government bonds.

The US currency and Treasuries will remain anchor investments in global portfolios – and there will be many times in future when it might make sense to hold overweight positions in both.

However, over the medium to long-term, investors will find it makes more sense to seek out alternatives and gradually diversify part of their portfolios away from US assets.

German Bunds and gold are likely to be benefit most from this re-allocation, but other assets including emerging market local government bonds and high quality credit should also see inflows.

It is worth noting that yields on German government bonds have remained stable even as the panic swept the US market in April. Bunds enjoyed their greatest weekly relative outperformance over US Treasuries since 1989. This shows government bond investors are becoming more discerning.

Gold, meanwhile, has seen its price hit a new record of USD3,100 an ounce. We expect the rally to continue as emerging market central banks allocate more of their reserves to the precious metal.

Also gaining at the US Treasury market’s expense will be emerging market sovereign bonds.  In their favour, emerging nations possess stable fiscal positions, growing economies and the capacity to cut interest rates further.

Crucially, for bond investors, emerging countries are the only group of nations where inflation is still surprising to the downside. This makes local currency government debt, particularly in Latin America, an attractive proposition. What is more, widening growth differentials in favour of emerging over developed economies should benefit high quality emerging market corporate credit.

Of course, it is certain that Trump’s tariff policies will evolve in the coming weeks. Yet whatever the eventual outcome of the trade negotiations taking place, we think the damage to the economy and US assets has already been done. Trump has given bond investors every incentive to consider alternatives to Treasuries and the dollar. There is no going back from here.