Trade Wars and the U.S. Dollar
As U.S. trade policy transforms, investors are grappling with the implications for the world’s preeminent reserve currency.
Announced U.S. tariffs aimed at revitalizing domestic manufacturing in the long run could first weaken the U.S. economy and rekindle inflation, casting a shadow over the U.S. investment outlook. As trade barriers rise, longstanding partners are reconsidering their economic ties with the U.S. and contemplating alternative alliances.
With its protectionist policy pivots, the U.S. is giving investors worldwide an occasion to rethink long-held assumptions about the U.S. investment landscape. Witness the recent parallel slides of the U.S. dollar, U.S. equities, and U.S. Treasuries – a combination more often associated with emerging market (EM) economies.
The U.S. has long enjoyed a privileged position, with the dollar serving as the global reserve currency and Treasuries as the go-to reserve asset. However, this status is not guaranteed. If global capital flows into U.S. assets dwindle, it could point toward a more multipolar world with a diminished reliance on a singular reserve currency.
Paradigm shift
For decades, the U.S. has operated on a model of consumption, importing more than it exports. The dynamic of U.S. consumers satiating themselves on an endless supply of cheap foreign goods, and the resulting current account deficit, creates a U.S. capital account surplus.
Nations in the post-Cold-War era – including allies bolstered by NATO security assurances – have been able to prioritize savings and investment over national security spending, often funneling dollars into American financial assets. These international capital inflows have bolstered the dollar’s reserve status, a cornerstone of U.S. economic exceptionalism.
With tariffs disrupting this balance, the financing of America’s twin current account and fiscal deficits may become more challenging, unless there is fiscal support, as countries pursue greater economic and military self-reliance. The breakdown of longstanding global correlations could be painful for a global investor, who may be left wondering how many U.S. assets to own.
A diminished policy safety net
The U.S. enters this period with historically high sovereign debt levels and inflation exceeding the Federal Reserve’s 2% target. If U.S. companies are compelled to manufacture goods domestically and shift supply chains away from China, production costs will rise, resulting in diminished productivity and higher prices.
The Fed will have to chart an interest rate path that balances resurgent inflation expectations with dimming U.S. growth projections. Conversely, currency appreciation in other regions may alleviate inflationary concerns, allowing the Bank of Japan and the European Central Bank to adopt a more dovish stance.
Investors have come to expect forceful government intervention during economic and market downturns. Today, U.S. fiscal support appears less likely – not by choice, but due to limited capacity for additional debt. This era of strained geopolitical relations could mean far less global policy coordination than during previous crises.
Investment implications
U.S. markets appear to be mirroring dynamics of the U.K. and EM, characterized by steeper yield curves, a weaker currency, and a structural risk premium – higher compensation for holding a country’s assets. A self-inflicted supply-side shock, similar to Brexit, has led to a stagflationary outlook. Lessons from the U.K. suggest that the U.S. economy may need to rebalance toward structurally lower growth and higher inflation in the absence of fiscal capacity.
Having long benefited in many ways from the existing ecosystem, the U.S. may face hurdles as the global order evolves. For investors, the return of equity may soon take precedence over the return on equity, prompting a shift toward diversification and a stronger home-country bias.
Based this outlook, here are some investment strategies:
- Underweight the U.S. dollar: The U.S. has the largest negative net international investment position (NIIP), financed by global capital. As this rebalances, the dollar may weaken.
- Overweight global duration (Europe, EM, Japan, U.K.): Duration – a gauge of interest-rate sensitivity that is typically higher for longer-dated bonds – is challenging to forecast in the U.S., but alternatives appear attractive (for more, see our April 2025 Cyclical Outlook, “Seeking Stability”).
- Favor trades that benefit from yield curve steepening: The shift from a global focus on economic efficiency to one emphasizing nationalism introduces a greater fiscal risk premium.
- Underweight credit: We expect a more significant divergence between investment grade (IG) and high yield (HY) credit, as IG balance sheets remain more flexible and insurance companies continue to support IG credit, a trend unlikely to extend to HY.
In a more multipolar world, there may no longer be a need for a singular reserve currency. Multiple options would be necessary to safeguard national security interests, ensure diversification, and deliver stable returns.
Thus far, this is a self-inflicted wound for the U.S. The dollar has only recently begun to structurally weaken. Sentiment and market performance could quickly reverse if we see a shift toward less disruptive – and more predictable – U.S. trade policies.
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Disclosures
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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