Measures of financial stress are easing this morning after an absolutely wild night in global markets. The dollar is consolidating its losses after enduring something resembling a “flash crash” as Asian markets opened yesterday evening, the S&P 500 is recovering from a circa-3-percent move, and ten-year Treasury yields are stabilising near 4.8 percent after rising by the most in a week since the late eighties.
The trade war between the United States and China is still escalating. On Wednesday, President Trump said he was imposing a 125-percent tariff on imports from China, and the White House yesterday clarified that this would come on top of the 20-percent “fentanyl” levy imposed earlier this year. The Chinese Ministry of Finance this morning responded with its own 125-percent duties on American goods, saying “Given that American goods are no longer marketable in China under the current tariff rates, if the US further raises tariffs on Chinese exports, China will disregard such measures”. In a separate statement, the Commerce Ministry said that tariffs had reached meaningless levels, saying that the US was becoming a “joke in the history of the world economy”.
The impact hasn’t yet shown up in inflation data. According to numbers released by the Bureau of Labor Statistics this morning, producer prices fell last month as energy benchmarks and services costs dropped, offsetting a small rise in goods prices. Data published yesterday showed consumer price growth slowing significantly faster than expected in March, with annual core inflation falling to its weakest pace since early 2021, just before the post-Covid surge got underway.
Input prices are likely to rise substantially in the months ahead, but overall US inflation could actually go down. Costs for manufactured goods imports are vulnerable to tariff-driven increases, yet oil prices are down spectacularly, and domestic inputs and services—which make up the vast bulk of overall consumer spending and contribute the largest share to the Federal Reserve’s preferred inflation basket—might see declines as the economy slows and demand falls. With risks tilted to the downside, the central bank is widely expected to accelerate the pace of rate cuts this year.
This might not allay foreign exchange market concerns, given that a structural reappraisal of the dollar’s role in the global financial system appears to have gotten underway. In a major break with historical patterns, the greenback has fallen in recent weeks—even as stock markets have plunged and Treasury yields have spiked higher—suggesting that investors are beginning to question the dollar’s dominance in global trade, investment, and borrowing flows.
A number of factors could be at play.
China may be selling its Treasury holdings. There’s no clear evidence to suggest that this might be case—and there may never be, given China’s tendency to obscure its holdings—but the country remains the world’s second-largest foreign owner of US government debt securities, and rumours have repeatedly washed across markets suggesting that it could put pressure on American policymakers through the interest rate channel. We’re sceptical, given that such a move would also inflict pain on China itself, that selling pressure has been mostly concentrated in the long end of the Treasury curve, and that other trades are unwinding at the same time—but it nonetheless remains a possibility that should be kept under consideration.
A loss of confidence in American institutional stability could be at fault. Amid ongoing turmoil across the federal agencies responsible for key aspects of the US economy, threats to the Fed’s independence, soaring policy uncertainty levels, and a clear lack of commitment to fiscal restraint, credit default swaps—which measure the cost of insuring against a government default—have soared to heights typically seen during debt ceiling crises, and are well beyond levels seen in other advanced economies.
But we think markets are also taking a longer view. If the Trump administration succeeds in reducing US trade deficits, surplus countries won’t have the need to recycle large pools of excess savings into American financial markets. If cross-border shipping volumes fall overall, the dollar’s role in intermediating trade deals and denominating debt transactions could also fade. Investors may be reallocating assets in recognition of these changes. Some American policymakers may even welcome a deterioration in the greenback’s dominance: but they should be careful what they wish for, given that the developments now underway could easily increase the cost of borrowing for the United States, add to long-term drag on the economy, and raise the prospect of a true emerging market-style currency crisis in the future.
