An Urban's Rural View

Commentators are still buzzing over something unusual that started happening in financial markets a few weeks ago.

The anomaly is a sharp increase in yields on long bonds combined with a significant fall in the value of the dollar. You can see it in the illustration accompanying this article charting the 30-year Treasury bonds yield and the U.S. Dollar Index.

To understand why this is unusual, imagine you're an Asian or European investor.

An increase in the interest rates available from relatively safe 10- and 30-year U.S. Treasury paper would typically tempt you to buy. With a yield close to 5% in the last several weeks, the 30-year bond would be especially tempting. And you'd be paying less for it; bond prices and yields move inversely.

To buy U.S. debt, you and your fellow foreign investors would typically exchange your local currency for dollars. This would tend to push the dollar's value higher.

That the dollar instead fell while yields were rising suggests those higher yields didn't tempt you. Rather than buying, some big foreign investors were U.S. debt sellers.

Are foreigners now seeing the U.S. as a riskier place to invest? The longer this unusual concurrence of higher bond yields and a weaker dollar continues, the more likely that seems.

Commentators are all gloom and doom. The Economist has written about a possible "dollar crisis." JPMorgan Chase CEO Jamie Dimon predicts "a crack in the bond market." In a new book, Ray Dalio, long thought to be one of the smartest men on Wall Street, sees the U.S. on the verge of an economic "heart attack."

Many of us tune out such talk; after all, there have been many such forecasts in the past. Yet the long bond-dollar anomaly suggests this time really may be different. It's certainly an issue worth another look.

There's a fair consensus that the reason for the foreign investors' reassessment is U.S. policy changes. Start with tariffs.

The dollar had been strong when President Donald Trump was elected -- "All Bow Before the Almighty US Dollar" was the headline on a DTN piece of mine last December (https://www.dtnpf.com/…) -- and it strengthened further through mid-January (https://www.dtnpf.com/…). The greenback began its downward trend once investors realized he was serious about big tariffs, which investors see portending slower economic growth and higher inflation.

But for the first two months of Trump's presidency, the yield on the 30-year bond was declining with the dollar. It's risen in recent weeks as it became clear that the U.S. government's debt burden will continue to mount even with Republicans controlling the White House and Congress.

That the dollar hasn't risen with the yield suggests foreign investors aren't as willing to brush off Washington's fiscal profligacy as they were in the past. They want to be paid more for the risk of being Uncle Sam's creditors.

If that is indeed what's happening, it would be a big deal for financial markets. It's worth at least asking the big questions. Is a dollar crisis possible? Could the dollar be dethroned as the world's reserve currency?

Foreign investors will play a large role in answering these questions. They own more than $8.5 trillion of U.S. government debt, or more than a quarter of the total. Their sales, unlike those of U.S. investors who turn bearish on long bonds, drag the dollar down with them.

A bond-market crash isn't inevitable, to be sure. There are no signs of panic in the market. Investors are just saying it will take higher rates to tempt them to buy. When Treasuries command the desired rates, the buying will put upward pressure on the dollar.

The problem is those higher rates will also exacerbate the government's debt problem. Interest payments are already nearing $1 trillion a year and climbing. It's easy to imagine a snowball effect: As the debt burden increases, investors' concerns increase, causing them to demand still higher rates. Or they bail on U.S. bonds, taking the dollar down with them.

Again, we're talking possibilities, not inevitabilities. But the risk of possibilities becoming realities is rising.

One thing the U.S. still has going for it is that investors' options are limited. As long as the U.S. dollar continues to be the world's reserve currency, foreigners will need dollars; as long as the U.S. has the deepest capital markets, dollar assets will be an obvious parking place.

At the moment, there's no currency that can take the dollar's place. The yuan would be an obvious candidate, but China's capital controls make a reserve yuan impossible.

The euro is another obvious candidate, but the European Union's financial-assets market is too shallow for the euro to play the reserve role.

Though the dollar is likely to remain the reserve currency for a while, foreign investors will likely seek safety in diversification. The dollar's status will continue to be at risk of erosion as long as the U.S. government's debt continues to metastasize.

Dollar weakness benefits U.S. exporting industries like agriculture. They may not have as much appetite for it if it's served with a side of financial-system chaos.

Urban Lehner can be reached at urbanize@gmail.com

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