Investment in an age of uncertainty

As the global order in trade and capital flows is upended, investments in everything from equities to fixed-income securities have started to reflect a level of risk that was hard to imagine even six months ago.

The recent downgrade of U.S. debt by Moody’s is a case in point, highlighting the unsustainability of U.S. fiscal policy and the risk facing foreign holders of dollar-denominated assets.

The downgrade also points to the increased possibility of a bond market sell-off as investors lose confidence in the American economy and its institutions.

Global investors, who for 80 years helped finance the U.S. economy, are increasingly questioning the soundness of the dollar and dollar-based assets.

The result, as the economists Olivier Blanchard and Ángel Ubide have written, is a global flight from the American dollar.

The first to fall—the U.S. dollar

The benefit of a floating exchange rate is its ability to quickly absorb shocks to the economy. Theoretically, a depreciation of the dollar makes it cheaper for foreign investors to buy U.S. goods and financial assets, reinvigorating the U.S. economy and ameliorating the damage of the shock.

But with the U.S. Dollar Index having dropped by more than 10% from its Jan. 13 peak to June 20, that recovery has yet to happen.

This is not the first time that a domestic shock reduced the demand for the dollar. In 2017−18 and again in 2020−21, the dollar declined as the U.S. experienced heightened uncertainty. 

In both cases, the dollar recovered as the American economy showed its resilience.

But that has yet to happen this time around, which begs a question: Where else can investors park their money, if not in the dollar?

The next step in the reordering of the global financial system would most likely be the creation of a deep and liquid market of euro bonds, as we have argued. Creating this new market would not happen overnight, but it would provide investors with an alternative safe asset.

In the meantime, investors have been grappling with heightened volatility, particularly in equity markets. 

Uncertainty in the bond market

At the beginning of the year, the bond market was righting itself as inflation remained subdued and the economy chugged along.

Five months later, the yield curve is digesting a ratings downgrade by Moody’s as the American fiscal authority finds itself paying a higher risk premium to get investors to purchase long-dated U.S. debt.

All of this has resulted in a 10-year Treasury note trading as high as 4.6% in May and a 30-year bond as high as nearly 5.1%.

Yet at the short end of the curve, 2-year Treasury securities dropped 35 basis points to 3.9% as of June 20, after trading at 4.25% to start the year. That pricing by investors implies only one or two cuts in the Federal Reserve policy rate and a large degree of caution on the part of market participants.

That view is not about to change, especially if the Fed is confronted with rising inflation and a stagnant economy.

The downgrade of U.S. debt by Moody’s is further evidence of the unsustainability of U.S. fiscal policy.

In addition, the recent discussion in financial circles to exchange current Treasurys for nonmarketable perpetual bonds has investors questioning the safety of their purchases. The long end of the curve is clearer on where it stands.

The yields on long-duration bonds have increased, implying that investors have already pared their holdings, as new investors require more compensation for holding long-term debt.

That is, investors are pricing in a higher risk of default as the economy struggles through tariffs and as higher inflation decreases the real return on long-duration investments. 

The rising uncertainty in today’s economy can be seen in the spread among economists’ forecasts for 30-year bonds. 

While the forward market sees 30-year yields remaining near  5%, forecasts among economists range from 3.75% to as high as 5.4% later this year.

There are similar wide ranges in forecasts for other Treasury maturities and for corporate debt.

The higher forecasts can be attributed to the Fed having to respond to inflation, while the lower forecasts most likely reflect an economy damaged by the tariffs.

Either way, the underlying reason for higher yields at the long end of the curve is the loss of confidence in U.S. policy. This is not a question of a couple of basis points or when the Fed will begin to cut its policy rate; rather, the question is whether this is the start of a long-term bond market sell-off.

The takeaway

The haphazard implementation of tariffs and the decline of the U.S. as a magnet for global investment have not gone unnoticed by our trading partners.

The wide spread of forecasts for bond yields indicates the uncertainty facing investors and the business community. The result is a decline in U.S. assets, beginning with the dollar.  

Investors should prepare for an extended period of dollar weakness, inflation and higher interest rates, which will be driven by economic policy.