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Markets are giving Donald Trump a pass, a thumbs-up, even. His on-off tariff threats against strategic friends and neighbours this week did unsettle stocks and fluff up the dollar, but investors largely held their nerve. Perhaps they are waiting to see if his action matches his words. Much of the alarm had dissipated even before Trump agreed to delays with Mexico and Canada.
This is not the only scene of radical uncertainty that investors are choosing to ignore. At the same time (it has been a long week), a clique of Elon Musk acolytes has been rootling around the arms of government, looking to slash costs, even gaining access to the Treasury department’s core plumbing system. Treasury secretary Scott Bessent has sought to reassure the public this is “not some roving band” and a judge has reined in the system access for the Musk staffers. But while fiscal hawks may cheer the prospect of heavy budget cuts, Democrats in Congress are outraged at the apparent absence of checks, balances and norms. Again, though, the message from markets is: Carry on. We’re cool with this.
Declining to take the president at his word may be good for short-term market stability. But that is not to say it carries no cost. In government bonds, the US wears a shiny shield of exorbitant privilege. Being home to the planet’s dominant reserve currency provides wriggle room around norms that other large economies do not enjoy. This will not evaporate overnight. But shifts in demand for Treasuries since Trump’s re-election in November do show some cracks in the armour. This market has been posing a puzzle for several months. The Federal Reserve has cut interest rates hard since September, but bond prices have continued to fall. As a result, borrowing costs for Uncle Sam and everyone else have stayed elevated. This is quite weird.
Yes, inflation is still niggly and yes, the US economy is still in good shape, denting demand for bonds. Fiscal sustainability concerns might also be playing a role. But another explanation, set forward last month by Rashad Ahmed, an economist at the US Office of the Comptroller of the Currency, and Alessandro Rebucci, a professor at Johns Hopkins University, is potentially more unsettling.
In a report released in mid-January, the researchers dug in to demand for Treasuries among official reserve managers — the big, conservative, slow-moving beasts of bond markets that look after pools of national wealth around the world. Drawing on weekly data from the New York Fed, which covers around two-thirds of these holdings, they note a reduction in reserves after election day, to the tune of about $78bn from election day to January 8, only around a third of which has returned since. This may, they wrote, “reflect waning foreign official demand for dollar-denominated safe assets, possibly driven by geopolitical concerns including fear of sanctions and asset freezes”.
It was, of course, Trump’s predecessor Joe Biden who used tools like that to the most dramatic effect in recent years, as part of his move to punish Russia for its full-scale invasion of Ukraine in 2022. This shone a light on the reality that the US can use its reserve currency status as a weapon. Normally that might not be a problem. If you don’t want your assets frozen, don’t start a war of aggression. It’s not that hard to avoid. Now, though, it is tricky to predict how a much more mercurial and adversarial president might wield this power.
Cynics have warned for decades that the US could lose the backing of reserve managers, and for decades they have been largely wrong. Where else can these funds go? Despite Trump’s unpredictability and challenge to US institutions, Ajay Rajadhyaksha at Barclays says he sees “zero” chance of the US losing its reserve currency status, in part because of that lack of decent alternatives. Only direct interference in even “a sliver” of the Treasury infrastructure that handles bond payments would convince him otherwise. Team Musk, take note.
But two points from Ahmed and Rebucci’s analysis stick out. One is that some of these reserve managers do not appear to be seeking an alternative bond market. Many are opting for gold, especially in trading outside US hours. The other is that we don’t need a nightmare (and highly unlikely) scenario of global reserve managers dumping their Treasuries to make life more difficult for the US. Instead, it takes only a small reduction in the dollar slice of global reserves to hit prices and keep borrowing costs unusually high, the researchers said. This is especially so when potentially inflationary tariff policies scare other buyers off from stepping in.
We are not yet close to a serious credibility problem for US institutions. But ending the age when investors of all kinds could place their full faith in the word of the US president and his Treasury secretary does not come for free. The new president has been back in the Oval Office for less than a month, and he is demolishing norms that long-term bond investors have always said they hold dear. They already appear nervous. The coming months will provide a live high-stakes experiment in how far he can push them.
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