An American Emerging Market crisis?

It seemed that foreigners were losing confidence in the USD and Treasury assets as a safe-haven.

We have evidence of this shift from Japanese data. The Financial Times cited data showing that Japanese investors were net sellers of $17.5 billion in foreign fixed-income securities from March 30 to April 5, with a “substantial portion” being U.S. Treasury and Agency paper, as per one rates strategist.
 

The same week, Japanese investors were buying foreign equities and funds. In other words, they were dumping foreign bonds and buying foreign stocks.
 

 

What equity market did the funds go? It wasn’t into the U.S. The latest BoA Global Fund Manager Survey showed a stampede out of U.S. equities.
 

 

The data shows that Japanese investors were large sellers of foreign long-dated debt, which was mostly USD paper, and accumulating large foreign equities. In effect, they were shorting the USD by taking on USD-denominated liabilities while acquiring non-U.S. equity assets.
 

It was the U.S. capital flight trade. U.S. stocks, bonds and the USD weakened, while gold rallied to an all-time high. The pattern is new to the U.S. but familiar in emerging markets that are becoming submerging markets. The WSJ succinctly summarized the panic with the headline “Dow Headed for Worst April Since 1932 as Investors Send ‘No Confidence’ Signal”.

The damage can be seen in factor returns. Even as the S&P 500 skidded, the trade war factor has been in a steady uptrend. Inflation expectations recently staged an upside breakout but pulled back, which combined with the strength in the trade war factor is a stagflation signal. The relative performance of non-USD sovereign bonds to the 7–10-year Treasury ETF is a sign of a loss of confidence in the USD.
 

 

 

A Stampede into Gold

The rush out of the USD can be seen in the surge in gold prices, which reached all-time highs in all major currencies, including the Swiss franc, which is regarded as a “hard currency”.
 

 

Most notably, China has been accumulating gold in its reserves.
 

 

 

The Fever Breaks

I have been bullish on gold (see 2025 High Conviction Idea: Gold), but the latest buying frenzy seems to be too much and too fast. If we use gold as a real-time proxy for USD sentiment, a reversal was overdue.
From a sentiment perspective, investors finally caught on to the strength in the shiny metal and fund flows have gone parabolic.
 

 

Gold prices are highly extended from a technical perspective and due for a pullback.
 

 

The reversal occurred last week when the gold ETF traced out a bearish outside reversal on high volume, which is a signal of a downside reversal.
 

 

The fever has broken, and if the inverse relationship between gold and the USD continues, the USD panic is over in the short run. The pullback in gold isn’t surprising, as we are approaching a period of negative seasonality. From a technical perspective, it’s perfectly reasonable to expect some sideways consolidation in the coming weeks before prices resume their bull trend.
 

 

 

The Prognosis

What’s the longer-term prognosis for the USD?

Fears of an emerging market balance of payment crisis for the USD are overblown. While the recent panic is reminiscent of EM BoP crises, there are some important differences. A typical EM BoP crisis occurs when much of the borrowing is in foreign currency. A loss of confidence leads to a bank run on that country’s foreign currency reserves, which forces up yields to incentivize capital to stay in that country. But U.S. debt is denominated in USD, and the U.S. has an unlimited printing press to print currency.

For now, the USD remains the premier medium of exchange in international trade and there are few candidates that can replace its role as a global reserve currency. Other major currencies with sufficient liquidity are flawed in different ways. The euro is highly liquid, but the eurozone runs a current account surplus, which means that there isn’t enough euro-denominated paper sloshing around the global financial system for reserve managers to hold as the pre-eminent reserve currency. Similarly, China runs an enormous currency account surplus and suffers from the same liquidity problem. Gold bugs like to mention the metal, but liquidity is a severe constraint. If the U.S., which is one of the largest holders of gold in its official reserves, were to monetize its gold holdings at market values, it would amount to about US$900 billion, which isn’t enough to finance a single year’s fiscal deficit.
 

 

That said, much of the future trajectory of the USD and global economy depends on the U.S. appetite for currency depreciation and its trade war. Should foreigners lose confidence in USD assets, the Fed could step in and become the bond buyer of last resort. Such a policy would have two important implications. First, a falling USD translates into higher inflation as import prices rise. As well, Fed intervention would likely resolve in a steeper yield curve as short rates fall from Fed intervention while long rates rise as investors demand a higher premium for holding long-dated paper.

When combined with Trump’s high tariff rates, which puts upward pressure on domestic prices, and a potential loss of confidence in the USD, stagflation and a recession are highly likely outcomes.

Despite all the flip flops and announcements, the effective weighted average tariff rate is still very high by historical standards. Supply chain bottlenecks will start to appear by the summer months and lead to severe disruptions in both economic activity and employment. Axios reported that the CEOs of the three biggest retailers — Walmart, Target and Home Depot — warned Trump about the consequences of his actions: “The big box CEOs flat out told him [Trump] the prices aren’t going up, they’re steady right now, but they will go up. And this wasn’t about food. But he was told that shelves will be empty.”

 

Torston Slok at Apollo pointed out that it takes an average of 18 months to hammer out a trade agreement because of the complex issues involved. Trump’s timeline of agreements with 90 countries in 90 days is simply unrealistic and prone to disappointment. Slok stated in an CNBC interview that in the absence of a change in policy, the probability of a recession is 90%.
 

 

Treasury Sectary Bessent told a closed-door meeting of investors that the China tariff stand-off was unsustainable and both sides needed to de-escalate. The WSJ reported last week that Trump is considering halving the tariffs on China to de-escalate the trade0 war. While the markets welcomed this news with a relief rally, it nevertheless puts the U.S. in a worse negotiating position. It’s still burdened with a historically high effective tariff rate, reduced negotiating leverage, along with the prospect of stagflation and escalating inflationary expectations.

Putting it all together, confidence in the USD and Treasury assets is being eroded. As well, the U.S. faces stagflation and elevated recession risk in the next 12–18 months. While investors usually hedge slow growth outcomes by holding USD and Treasuries, they would be better served by holding high-quality non-USD sovereign bonds and gold.