Crosscurrents buffet U.S. dollar and Treasury market

By Atul Bhatia, CFA

Treasury bonds used to be boring. Pencil in around two percent inflation, estimate a real growth rate and the result is a decent estimate for a fair yield. If an investor wanted to get fancy, he or she could throw in some term premium and do a little Fed watching.

Those days, it seems, are over. We go from headlines talking about selling pressure in Japanese Government Bonds (JGBs) to fears of overseas investors potentially divesting their U.S. Treasury holdings. In the background, we see gold spiking and the dollar falling. Trying to put all the moving parts together to get a broad perspective on what’s happening looks hideously complex.

And, to a certain extent, we believe it is. There are whole textbooks written on these relationships and the feedback loops involved.

But like most things in economics, however, we’d argue there’s a core simplicity to what we’re seeing. If we strip away the jargon and the rhetoric, certain realities emerge, and what follows is a simplified, but still accurate, view of how we think about the Treasury yield curve in the months and years ahead.

ABCs of JGBs

The recent rise in Japanese yields took place largely for domestic reasons, but it absolutely, in our view, 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, we think it is inevitably going to be one of the most impacted by this 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.

Sure, there are additional complexities. Yields went up in Japan for a reason, so not all the impact is going to translate one-for-one to the U.S. dollar. Hedging costs also play a role in how yields translate between different sovereign issuers. But those are largely quibbles about the magnitude of the impact on the U.S. from the JGB move and not its direction.

The Japanese bond move also has a psychological impact on Treasury investors. Japan has long occupied the role of counter example to folks concerned with the U.S. debt level. The fact that 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.

With the recent JGB selloff, it seems that perhaps there is a limit to the debt that markets will overlook. The comparison is particularly troubling for U.S. investors since the proximate drivers for the recent JGB move were, we believe, concerns over large debt loads, expansionary fiscal policy and underlying inflation pressures. This list has resonance for any U.S. bond observer.

In short, 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 so-called “tail risk” concerns, or the idea that we could see a rapid repricing of U.S. debt.

The divestment catch-22

Unlike the situation with Japan, we think the divestment issue is more of a distraction than a real influence on U.S. bond pricing.

To begin with, we think it’s highly unlikely to occur on a large scale. Divestment is a good threat to have in the background, but once a country sells its holdings, that’s it – the threat is done with and the U.S. would then have a free hand to retaliate. Strategically, it’s not necessarily a great move, in our view.

Even if it were to occur, however, we believe it would largely be a reshuffling of assets versus a long-term, fundamental hit to the United States. What we think would happen would be official and quasi-official investment funds selling U.S. assets as private investors and hedge funds bought the securities. The net result, in our view, would be one class of investor going underweight U.S. risk while another type of investor went overweight. This type of investor reprofiling is not a routine occurrence, but it is not unusual. 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. We believe it would almost certainly be extremely volatile in the short run. But at the end of the day, if people want to own U.S. assets, they will find a way. If official capital divests, private capital will backfill. We’ve seen that story play out dozens of times. Even heavily sanctioned countries can find global capital. In the case of the U.S., we think the idea of divestment is much more hype than substance.

The call is coming from inside the house

We think the simple truth is that the biggest threat to Treasuries does not come from abroad but from U.S. fiscal policy. And while we think that threat is manageable for most Treasury bonds, we have concerns about the 30-year maturity.

Even though the U.S. economy is expanding at an above-average pace, the U.S. budget deficit is hovering near six percent of GDP, an amount that historically was associated with recessions. No one, we believe, 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 increasingly likely 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? These conditions offer a solid backdrop and the lowest friction to pass legislation, and yet no discernible progress has been made on the fiscal front. Tariffs and inbound investments could, in theory, assist at the margin, but nothing in the data or projections suggests they will meaningfully alter the debt trajectory.

This lack of fiscal sanity, we believe, creates multiple headwinds for longer-maturity Treasuries.

One is the issuance of new bonds to fund this spending. Buying a 30-year government bond may not be catching a falling knife, but it’s arguably napping under the Sword of Damocles – not a comfortable spot.

Another risk is the potential for growing deficits over time. Taking away benefits is always unpopular, but adding new ones is relatively easy. Future administrations are likely, we believe, to open the spigots further and add to the deficits, creating more supply and higher inflation risk.

Finally, we think there is the question of potential tail risks as we go into longer maturity bonds. If it’s true that markets, and not politicians or voters, are going to be the catalyst for change, that catalyst is likely going to come in the form of higher yields and lower bond prices. These impacts – and losses – will likely be felt most severely at the 30-year point. Rational investors, we think, could choose to focus their holdings on shorter-maturity Treasuries.

Dollar daze

Since Jan. 2025, the dollar is down nearly 10 percent 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 percent return in that time; measured in euros, however, it barely cleared a three percent gain. Much of what we think of as rising asset prices is really the impact of using a shorter yardstick to measure the value.

We think the dollar’s weakness is related to concerns about the debt but is more generally about the predictability of U.S. policymaking and the apparent absence of any roadmap to fiscal sanity.

In theory, deficits and currency strength are not mutually exclusive. In fact, a small deficit is usually a boon for a country’s currency since it contributes to growth and gives room to keep interest rates a touch higher, both of which currency markets tend to like. But deficits and the resulting debt are like adding salt to a dish. A little bit can elevate the taste, but too much and it’s unpalatable.

The key line is the real interest rate versus the real growth rate. If the country’s economy is growing faster than its cost of funds, the debt is sustainable. If not, the currency will likely face pressure. Unfortunately, there’s no way to know the relevant interest and growth rates since we’re concerned with future events. We do know, however, that the U.S. long-term real growth rate and the current real interest rate are at about the same level.

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 percent since Sept. 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 but predictable 10-year financing, or it can rely on inexpensive short-term money but with the risk of potentially large and rapid swings in debt service costs. So far, the U.S. government has kept to a blended issuance approach, but there is no guarantee that will continue to be its plan.

Safety of security

More than these theoretical concerns, however, we’d argue that risk management is currently driving the currency bus.

Investors like to have assets that they perceive as a safe haven. It’s great to have at least one position in a portfolio that is expected to do well when things turn scary in the world. For a long time, the dollar and the Treasury bond played that role. The best part was that they tended to generate a reasonable amount of income as well – essentially it acted like an insurance policy that simultaneously protected and paid the investor. Nice deal if you can get it.

We believe there is reasonable evidence that global investors may feel less secure in being plugged in to the dollar ecosystem. While it still offers exposure to one of the world’s largest and most vibrant economies, the exposure carries with it a potential pain point that can be exploited. To the extent that 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 reason to believe that the search for safety is a key component of the recent dollar weakness is the concurrent very strong performance of precious metals and currencies such as the Swiss franc.

It’s important to distinguish this type of reprofiling from divestment. The former is likely to be a gradual process driven primarily by traditional risk-return calculations while the latter is done as a means of applying pressure to a government even if it is not economically advisable.

What does this mean for investors?

We think investors 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, in our view.
• Diversify globally: Non-U.S. equities can offer currency exposure and diversification benefits.
• Shorten up maturities: We are generally cautious on the longest maturity bonds in many jurisdictions. We see benefits to keeping maturities or high probability call dates within 10 years.

Simple question, difficult answer

At the end of the day, we think the biggest overhang for longer-term Treasuries and to a lesser extent the dollar is the lack of a clear, simple story on why an investor should own them. Not too long ago, that question would have been considered nonsensical by most investors; 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, but its utility now comes at a higher apparent cost in the form of a potentially exploitable exposure.

Global bond markets, precious metals, and currencies are sending us a signal on sustainability. We think investors should listen.