- A rebalancing of the economic system would require a rebalance of assets.
- Trump’s tariffs and associated uncertainties have increased urgency amongst investors to reduce USD.
- This rebalancing would likely take time amidst considerable constraints.
- USTs could trade like a risky asset until rebalancing is done.
- Asia rates may decouple from USD rates.
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A rethink / rebalancing of the global monetary regime is underway. The existing global economic system had worked well for decades. This system can be traced back to 1971 when the USD was de-pegged from gold. Even through the stagflation period of the 1970s and the erosion of US economic clout in relative terms in the ensuing decades, the USD was the reserve currency of choice. The role of the USD took a serious hit in the Global Financial Crisis (GFC) of 2008/09 and that triggered the creation of crypto currencies. However, even as confidence in the US got dented, crises in the Eurozone (2011) and China (2015/16) meant that there is no alternative to the USD. That has since changed. As China’s economic clout grew and Trump seeks to rework the global economic system (tariff wars), the global financial system must also be rejigged. Below, we lay out some of the considerations from an interest rates perspective for the medium term.
How are reserves going to be rebalanced?
There are good reasons for diversifying reserves away from the USD (USD make up some 57% of global FX reserves). For some economies, fear of the USD being weaponized is the key cause. For others, recent actions from the US (especially from the tariff policies) have eroded the confidence of investors in USD assets. The upshot is that many investors are probably thinking about reallocation if they are not already in the midst of doing so.
That said, there are constraints. Reserves should be put in assets which can retain value (store of value) and they must also be in large / liquid markets. US Treasuries fit the bill. Up until recently, USTs have been the go-to asset during times of risk aversion and investors generally had confidence in the US economy and its institutions. Size wise, there are some USD 26tn of USTs outstanding. Comparatively, there are about USD 10tn in European general government securities, USD 9tn in JGBs and USD 10.5tn in China government securities outstanding. Simplistically, just considering these four blocs, USD reserves should only make up about 46% of total FX reserves. However, in reality, the amount of debt available for the public to buy is even more constrained. Importantly, only the US runs a large current account deficit. By the balance of payments identity, this means that there will be a lot of USTs left for the rest of the world to purchase. Comparatively, if an economy runs a balanced or surplus current account, government debt can easily be absorbed by their respective domestic sectors. Note that this dynamic did not even take into account that fact that the Fed, ECB, BOJ and PBoC all hold considerable amounts of government bonds. Constraints on eligible assets for reserves are binding for the short term and could be the key reason why gold has been outperforming. There have been 200k tons of gold mined thus far and this amounts to about USD 21tn at current gold prices. However, not all of that gold is tradable in the financial markets.
Given time, the constraints could ease but that would probably require the Eurozone and China to step up domestic demand with their respective governments leading the charge. We have seen some encouraging signs of Europe willing to raise infrastructure and defence spending. Similarly, the Chinese authorities are stepping up on fiscal stimulus amidst intense economic and trade war pressures. These dynamics would likely require an extended period to play out. Accordingly, an optimal reallocation of reserves will likely not be possible for several years.
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