The Safe Haven Status of US Debt

Trump’s lurch toward protectionism and the resultant divorce of the world’s two largest economies and geopolitical foes are the proximate causes of this potential rupture. But at the structural level, it has to do with “plumbing,” specifically with how money is moved through the infrastructure of global financial markets. In times of looming economic crisis and market turmoil, investors run from volatile risky assets like shares and stocks into “safe haven” assets. These include gold, certain highly regarded investment funds (such as Invesco’s “QQQ” index fund) and, above all, government debt securities.

The largest and most sophisticated market for government debt is the market for US bonds. With $28.6 trillion outstanding globally, the Treasury market is the lifeblood of balance sheets globally because bonds act as the preferred safe assets in a world where trade is largely invoiced and debt denominated in dollars. The price of a bond moves inversely with its yield, which for the debt issuer represents the interest rate and for the debt holder the realised return (as a percentage of the current price).

So, when investors seeking safety from volatility rush into Treasuries, pushing up their price, we expect yields to fall across the maturity spectrum. This is the ordinary business of financial markets in times of stress. It is also a key aspect of what has been termed the “exorbitant privilege” associated with American economic exceptionalism and the dollar’s global key currency status: the ability to “fund” the federal government by issuing pieces of paper that the normal metabolic functioning of the market requires people to hold (as collateral for funding, etc.) and of which they consequently cannot get enough.

Is Something “Unwinding” in the Global Treasury Market?

What we have instead witnessed is a dramatic rise in yields, especially on the ultrasafe ten-year Treasury, which rose above 4.5 percent by the end of last week. The last time yields rose as fast as they did last week, within three days, was in early 1982, when they reached 14 percent; those yields are significantly higher than today’s, but trend and momentum are what matter. They matter because they recall, in the minds of savers and investors, earlier episodes in which an exogenous shock led to a panic-driven unwinding that had far-reaching consequences.

These events sparked tense memories of March 2020, when the world’s most important market convulsed like never before due to the exogenous shock of the pandemic. Liquidity conditions (the ease at which securities can be bought and sold) deteriorated as large actors, such as hedge funds and the managers of foreign exchange reserves, unloaded Treasuries. To prevent such disorderly selling, the market usually relies on large banks (such a JPMorgan Chase) who act as “market makers” (creating both demand and supply as broker dealers of Treasuries) to stabilize the system. Yet even these large banks were overwhelmed and themselves caught up in the panic.

A major contributing factor to these safe-haven disorders, both the one in March 2020 and the current one, is a relatively new feature of financial markets: the “basis trade.” This goes back to changes in the banking sector enacted in the aftermath of the 2008 financial crisis. In an effort to make banks safer, regulators required more callable capital on bank balance sheets to stave off potential losses. In practice this means holding safe assets like treasuries.

While this did render banks safer, it also limited space on their balance sheets, and, with it, their ability to provide loans to clients looking to leverage their investments. To compensate for the loss in potential fees, the enterprising broker-dealer banks came up with the basis trade. This allowed large investors like hedge funds and other investment managers to bet on the small price differences between actual Treasury securities and the market for the associated Treasury “futures” contracts, through the “cash” market (the “repo” or repurchase agreement market in which Treasuries act as collateral for short-term loans). These funds finance their purchases overnight on the vast wholesale money market. And, because the returns were small, these bets were highly leveraged, meaning that the value of debt was high relative to that of assets.

For the large broker-dealer banks, the upside of the Treasury cash-futures basis trade was the ability to use otherwise idle parts of their balance sheets more efficiently by “renting” them out to their more sophisticated clients. It also rendered the bond market more liquid, as there was more demand for cash Treasuries when the market was stressed. This suited central banks prior to the pandemic when they were slowly tapering their own bond-buying programs, in the process removing demand from the market.

But the “use-it-or-lose it” obsession with maximizing gains created a new systemic vulnerability. When, in March 2020, the banks needed as much of their balance sheets as possible to manage their risk, the hedge funds and other institutional investors who were “long” Treasuries and engaged in the basis trade suddenly could no longer roll over (refund overnight) their position and therefore liquidated them en masse — into a market where the largest de-risking buyers had limited balance sheet capacity.

Due to the global nature of the COVID shock, the managers of dollar-denominated foreign-exchange reserves, in search of dollar liquidity, were also rushing to shed Treasuries on a large scale. For many, the search for buyers was in vain. The market failed to clear, worsening the sell off of other assets to meet liquidity needs. Thus, a trade that otherwise kept the world’s largest market more stable ended up destabilizing it. Nonetheless the practice persisted and grew. By 2024, the basis trade market was valued at around $800 billion.

Last week’s convulsions were partly due to a similar unwinding of the basis trade, with widespread disorderly liquidation creating a hole in the market. Initially, the largest sellers were Japanese banks, pension funds, and foreign exchange reserves managers. By no means was this the first panic-inducing sell-off of US bonds by Japanese investors, the largest holder of Treasuries since 1985. According to an account related in Steven Solomon’s seminal account of the power of central bankers, The Confidence Game, the unloading of Treasuries by Japanese traders was chiefly responsible for various bond crashes and the “Black Monday” stock market crash of 1987.

This sell-off was amplified by the unwinding of another obscure but crucial part of the dollar system, the market for so-called FX (foreign exchange) swaps. These are over-the-counter derivative contracts taken out by investors who need to invest in dollar-denominated assets but would like to do so without further foreign-exchange risk. They therefore fund these investments by “swapping” their currency for dollars but also committing to swap dollars back; by fixing the price of the swap, they avoid the uncertainty of a shift in the exchange rate while using their currency for investment in dollar assets.

The size of this market is astonishing, with the stock of outstanding dollar obligations to pay totaling around $80 trillion. Japanese institutional investors, such as pension funds, hedge funds, and life insurance companies, play an outsize role in it.

A Possible Dollar Crisis

The sell-off of Treasuries and unwinding of FX swaps contributed to another unexpected development: a large slide in the value of the dollar. There have been previous times of dollar weakness, particularly in the era before 1995 when Robert E. Rubin became secretary of the Treasury. But the current slide is inconsistent with how a dash into safe dollar assets plays out during crises, when the dollar strengthens.

What’s more, it is not consistent with the foreign-exchange effect of tariff policies as described in economics textbooks. When a country unilaterally introduces tariffs in imported goods, its currency tends to strengthen. This is because an increase in the price of imports dampens the demand of domestic households and firms for those same goods. These are usually priced in foreign currencies, for which the domestic currency is exchanged. Absent retaliation, tariffs cause the demand for other currencies to fall while demand for the domestic currency remains unchanged. In relative terms, then, unilateral trade levies should appreciate the currency of the country imposing them.

This has not happened. Since the Trump administration’s sweeping “reciprocal tariffs” were announced (and then erratically modified and clarified in subsequent days), the dollar has slid against virtually all other major currencies — an unheard-of event, compounded by the fact that (due to demand for safe dollar assets like Treasuries) the dollar generally strengthens during crisis.

This has the potential for a systemic spasm. A sudden loss of liquidity in the bond market and the comprehensive liquidation of the no-longer-deemed-safe assets can have effects that cascade through the entire financial system, from the very top, before spilling into the real economy. Cash may become the only refuge from volatility, credit could seize up, firms may put off investment, unemployment may rise, and the solvency of the federal government could be called into question — with all the social and political implications.

In such a scenario – –as was the case in 2008 and in 2020 – –only the decisive action of central banks, particularly the Federal Reserve Bank, because it is at the apex of the dollar system, can halt the bleeding. The Fed could do this by providing liquidity backstop to markets (by buying or committing to buy bonds in an unlimited fashion) and by easing lending rates. Together, these actions could restore relative order and stave off a larger disaster.

How closely the world flirted with this scenario last week is not yet clear. What is concerning about these events is not necessarily the immediate financial effects but what they signal about the health of the dollar system more generally. There is reason to believe that last week’s panic was about more than the “plumbing” of the financial system.

Wither, American Economic Exceptionalism?

To dislodge a persistent equilibrium something drastic has to happen. Economists have generally believed that in the absence of any viable alternatives (i.e., currencies with deep liquid markets for benchmark safe assets), and due to powerful network effects in trade and finance, the dollar’s role as the world’s reserve currency was, for the time being, unassailable. But Vladimir Lenin’s quip about “decades occurring in weeks” has never rung truer.

For one, the major European economies — chief among them Germany — reacted to the frayed Atlanticist relations by abandoning their fiscal rules and embarking on large debt-financed defense spending programs, thereby opening the door to a greater circulation of equivalent safe assets like German “Bunds,” French “OATs,” and possibly joint European liabilities such as those created during the pandemic under the Next Generation EU funding plan (NGEU). In theory, this would open up the possibility of the euro eventually replacing the dollar in at least some of its current functions.

More importantly, concerns over the breakdown of orderly policymaking, the character of US institutions, democratic backsliding, and the profound economic damage of the new protectionism, seem to have, in the aggregate, provoked a larger shift in attitude toward America’s economy. It was, for instance, reported that Danish and Canadian pension funds (some of the world’s largest investors) were “cooling” on the United States as an institutional, reliable source of growth and economic dynamism, echoing reports from other institutional investors more generally.

The Federal Reserve meanwhile has received a record number of requests from foreign central banks to withdraw and physically repatriate their gold reserves from the Fed’s New York branch. Economic forecasters and market participants are maintaining their bearish stance on the economy, fearing that the United States is already in a deep recession.

The leading concern, however, seems to be the potential for escalating global tensions between the US and its allies, above all with China. No evidence has yet emerged that shows China played a significant role in the Treasury rout by liquidating its own substantial holdings (still valued at $759 billion, despite having fallen in the United States in recent years). But it is now clear that, given the current pressure on the dollar, China’s position as the United States’ second-largest creditor could be brought to bear if the conflict between the two nations escalates further.

This was the scenario predicted by policymakers and macroeconomists prior to 2008: a geopolitical spark would lead to a conflagration on the bond market, with China shedding its vast holdings, the dollar weakening, and the US plunging into a fiscal crisis. While the likes of former Fed chair Ben Bernanke had predicted the wrong crisis then, this scenario doesn’t seem too implausible now.

Along with China’s unrivaled position in the supply and refinement of critical minerals, its predominance in leading manufacturing technologies and its ability to substitute low value-added imports (largely agricultural products) more easily than the United States can substitute theirs (machinery, electronics, and textiles) indicates that it holds all the cards in a potential standoff. And as the depreciation of the dollar proceeds apace, US imports grow expensive and its fiscal position more tenuous, this picture is only set to worsen.

Finally, the United States might lose its true exorbitant privilege: being the destination of choice for millions of talented and hard-working immigrants. Disquieting reports of abducted students, rescinded visas, and detainments at the border have led to new visits to the US plummeting. Many wishing to permanently relocate stateside will also have second thoughts. Such immigrants, however, form the bedrock of American technological innovation, the absence of which would further shift the odds in China’s favor.

But even if this scenario can be avoided, US financial prospects are deteriorating sharply. The divergence of bond yields and the value of the dollar could indicate the emergence of a geopolitical “moron risk” premium. That is, investors are demanding a higher interest rate based on their lack of confidence in the state of US economic policymaking. This bears great resemblance to how in vulnerable and institutionally weak emerging markets (EMs), fiscal deficits, inflation, and a sliding currency usually lead to higher borrowing costs and a greater risk of capital flight and debt crises; the US currently ticks all those boxes.

The effect of this “EM-ification” over time might be the decline (and in certain sectors the cessation of) the investment and portfolio flows that have underwritten much of the exorbitant wealth of the asset-owning class. While some of the undeniably destabilizing side effects of these flows might thereby be alleviated (the dollar is structural overvalued due to demand for dollar assets being high relative to the size of the US economy), this would come as cold comfort for tens of millions of Americans already facing precarious financial circumstances who will be made worse off by unemployment, economic stagnation, and inflation. The global financial system, long a mainstay of US power and privilege, is a dog that has begun to turn on its master.

The Beginning of the End of the American Century

The decline of economic exceptionalism was preceded by a waning of US hegemonic power. The limited success of the sweeping financial sanctions enacted against Russia following the invasion of Ukraine; China’s recalcitrance in response to the arch peremptory “small yard, high fence” doctrine; the resistance of the largest holders of US debt (one of them the chief rival, the other a long-time ally, both set to be hit hard by tariffs); and increasingly hostile financial markets — all seem to indicate that the grip of American power is loosening.

The question that arises is: If indeed its time has come, will we miss this system that combined coercive US hegemony with global trade and financial imbalances? In the long run, the brunt of net imbalances in the global trading system was always borne in the form of austerity by the surplus countries like Germany and China, where the imbalances reflect the weakness of their domestic demand, largely caused by wage repression and high savings

But the overall picture is a relatively positive one, for both sides of the imbalances. For some developing countries (notably in East and Southeast Asia), export-led growth allowed them to convert their hard work of wage restraint and structural reforms into a share of global demand and climb up the global value chain. The result was a dramatic reduction in poverty and rise in living standards. Nowhere has this system produced greater results than in China, whose growth now depends neither on net exports or on imports of US goods.

And while other countries require access to Western capital markets to be part of the global trading system, the possible demise of the dollar system opens up the door to an alternative financial and monetary system: one in which hedge funds don’t use public goods like government debt securities for speculative gain, or in which developing countries are not at the mercy of the arbitrary decisions of the Fed to raise interest rates — the reform of which was often stymied under US leadership.

To parse the broader implications of this shift, it is worth reflecting on the sequence of events that led up to this moment. It started with the first global pandemic of the modern era and a global economic “shutdown” that severely disrupted fragile supply chains; this increased the price of oil and spurred Russian aggression against Ukraine, which produced further commodity and inflationary shocks; these, in turn, aided the creation of a new US industrial policy consensus that over time became increasingly confrontational and militaristic and found its zenith in MAGA 2.0. President Trump is now escalating his futile and self-defeating attempt to arrest industrial decline based on a flawed zero-sum view of global trade and a failure to understand the deeper malaise of the American political economy.

This is how the crisis of US capitalism has become a crisis of US hegemony. We cannot afford to let it become the crisis of globalization. The future of billions depends on constructing a world after America.