Lower Trade → Higher Yields → A Weaker Dollar
The U.S. has long benefitted from a virtuous cycle: it runs a trade deficit, and in return, trade-surplus countries recycle export proceeds by purchasing U.S. Treasury securities and dollar-denominated assets. This dynamic has helped suppress yields and stabilize the dollar for decades.
Tariffs, however, disrupt this balance.
Foreign central banks, particularly those in trade-surplus economies, accumulate reserves through net exports and channel those dollars into U.S. Treasuries. Today, foreign investors hold ~25% of Treasury debt, and another 25% of government-sponsored entities (GSE) debt from agencies like Fannie Mae and Freddie Mac. This foreign demand has historically helped maintain low borrowing costs across the U.S. economy, from mortgages and credit cards to municipal bonds and corporate credit.
But if trade volumes shrink, so too does the reserve accumulation that underpins this capital recycling. And with that, demand for Treasuries weakens, causing yields to rise.
Moreover, sovereign wealth funds in countries like Norway, Saudi Arabia, and Singapore invest trade surpluses in broader dollar assets (e.g., equities, private markets, and real estate). A reduction in trade flows implies reduced sovereign fund inflows, further pressuring the dollar and long-dated U.S. assets.
We're already seeing the impact: the dollar has depreciated over 10% year-to-date against other major currencies.
Policy Volatility May Fade, But the Yield Shock Stays
Much of the market’s reaction has centered on the unpredictability of trade policy, with shifting tariff schedules, exemptions, and contradictory statements. While this uncertainty is disruptive, we believe the structural impact on U.S. capital flows poses the bigger threat.
The U.S. currently faces a $2 trillion fiscal deficit and must refinance about $9 trillion in maturing debt this year. That puts total gross issuance needs at ~$11 trillion, one of the largest debt supply waves in history.
Even if trade policy stabilizes, the Treasury must roll over bonds issued during lower-rate periods at today’s higher yields. We estimate this rollover alone will add $150 billion to $200 billion in annual interest expense, or 0.65%–0.80% of GDP. If Treasury yields continue rising due to diminished foreign demand or credit risk repricing, this cost escalates.
Additionally, larger deficits and weaker demand could lead to rating downgrades, pushing institutional investors to demand higher premiums for U.S. debt further embedding a high-yield regime.
Currency Depreciation Risks U.S. Capital Formation
A weakening dollar is also a drag on capital investment. In emerging markets – which offer ample case studies for the current scenario in the US – sustained currency depreciation typically coincides with reduced foreign direct investment (FDI) and capital formation. Long-term investors prioritize currency stability when evaluating projects that require multi-decade payback periods, tilting away from jurisdictions without a stable currency base.
The U.S. needs to invest roughly 17%–20% of GDP annually in capital formation just to maintain production capacity. At the low end of that range, capital investment merely replaces depreciated assets. A weaker dollar, combined with elevated funding costs, jeopardizes that threshold risking a drag on productivity and future growth.
Strategy: Stay Defensive, Stay Patient
We continue to recommend a conservative positioning strategy. This includes:
- Elevated cash allocations
- Very short-term fixed income instruments
- Equity exposure concentrated in defensive sectors, especially those with:
- Strong free cash flow
- Low exposure to global trade
- Insulation from rate sensitivity (e.g., P&C insurance, utilities)
Despite the recent pullback, the S&P 500 still trades above 19x forward earnings, which we view as elevated given macro headwinds. Select opportunities are emerging (e.g., GOOGL looks attractive on earnings and growth metrics), but pure beta exposure remains risky until policy clarity improves, and valuations reset.
