I'm back from Croatia and Italy, great trip. Go in May or Sept., better weather and smaller crowds; avoid during June - August if possible)

Treasury Basis Trade Did Not Unwind

Perli, the NY Fed’s Manager of the System Open Market Account, recently gave a speech where he discussed the Treasury market developments that occurred in April. He would have the definitive view on developments, and he indicates that is was a swap spread unwind, rather than a Treasury basis trade unwind, that caused the market volatility.

Recent Developments in Treasury Market Liquidity and Funding Conditions (NY Fed)

A key point that I would like to emphasize is that, although liquidity in Treasury cash markets became strained in early April, those markets continued to function, in part because of the resilience of funding liquidity in the Treasury repo market. That resilience, even amid heightened yield volatility, likely prevented the unwind of certain shorter-term relative value trades, which would have exacerbated market dislocations.

One factor that appears to have contributed to this unusual pattern is the unwinding of the so-called swap spread trade. Reportedly, many leveraged investors were positioned to benefit from a decrease in Treasury yields of longer maturity relative to equivalent-maturity interest rate swaps, partially due to the expectation for an easing of banking regulation that would bolster bank demand for Treasuries. Since swap spreads are defined as the swap rate minus the Treasury yield, leveraged investors were making a directional bet that swap spreads would increase.

One factor that could lead to a rapid unwind of the basis trade is substantial repo rate volatility or a persistent increase in repo rates, which could in turn increase the cost of financing the position and therefore make it unprofitable. But this by and large did not happen in April since repo rates were fairly stable and dealers remained willing and able to intermediate. As a result, according to Desk staff’s estimates, the basis remained relatively stable.

Related:

The FT reports that hedge funds may already be reestablishing the trade as the fundamental ideas (change to SLR, more orderly liquidity conditions) remain in place. Swap spreads: Reloaded? (FT)

Cost of Uncertainty

I’ve written in the past about the difference between (measurable) risk and (unmeasurable) Knightian uncertainty. In the Costs of Rising Uncertainty economists from the Feb Board channel the spirit of Knight in its discussion of policy, trade, and geopolitical uncertainty.

The paper discusses six types of uncertainty: Real Economic Uncertainty (REU), Inflation Uncertainty, Economic Policy Uncertainty (EPU), Trade Policy Uncertainty (TPU), Geopolitical Risk (GPR) and Financial Uncertainty.

Tariff threats and announcements during the Trump era triggered large, frequent spikes in TPU. This caused firms to delay cross-border investment, particularly in global value chains — a key feature of U.S. multinational operations. Such delays created macroeconomic drag that weakened real economic activity, particularly in tradable sectors.

The paper shows that the drag on investment is sharp but short-lived in the case of TPU — peaking within 3 months and dissipating in a year. This suggests short-term currency overreactions to trade rhetoric are likely.

US Dollar Developments & Thoughts

Regardless of the eventual resolution of the trade imbalance/tariff disputes, damage has been done to the US dollar’s status. Major global investment banks have sounded increasingly urgent alarms about the threats to dollar stability.

Safe Assets

Parking money in America used to be easy. For decades, U.S. financial markets were seen as the "routine, fuss-free, neutral option" for investors worldwide, resting on an implicit trifecta: the rule of law, policy predictability, and institutional independence. Today, that foundation appears to be cracking. Whether this shift proves transitory or structural remains to be seen, but the implications are profound—especially for the dollar’s role at the center of the international monetary system.

During the tariff events, the USD did not benefit from traditional ‘safe harbor’ flows. The Swiss Franc did, and investors are willing to pay the Swiss to hold their money.

As Katie Martin noted in an FT Opinion piece1:

The dollar is not acting like a magnet during periods of stress, nor like a currency anticipating an upswing in American economic growth.

… the country’s core financial assets — Treasuries and the dollar — are losing the sheen of global hegemonic dominance that they have enjoyed for decades. The trust has gone, or at least weakened significantly, and it is hard to see what can bring it back while Trump is in the White House, or even beyond.

Exorbitant Privilege

The concept of exorbitant privilege refers to the unique advantages the United States derives from the dollar’s status as the world’s primary reserve currency. As the issuer of the global unit of account and the most sought-after safe asset, the U.S. can borrow more cheaply, run persistent current account deficits, and exercise extraordinary influence over global capital flows. But that privilege, once assumed to be untouchable, is now under scrutiny.

As we’ve stated before, voices within the Trump administration (Vance, Miran) have questioned whether the dollar’s dominant status is a net benefit at all. Chatham House2 describes the views thusly:

The view that the dollar’s reserve-currency status is a problem springs from the idea that its central role in the international monetary system is a form of ‘Dutch Disease.’ This is the phenomenon in which a country’s one big commodity export – natural gas, in the case of the Netherlands during the 1960s – leads to an appreciation of the currency that renders the rest of the economy, and especially its manufacturing sector, uncompetitive.

By analogy, some in the Trump administration argue that the dollar’s attractions as an international monetary haven have created so much demand for it that the exchange rate has become structurally overvalued and subsequently caused a loss of competitiveness.

Deutsche Bank strategist George Saravelos, who has been one of the starkest commentators states:

The Trump administration is now half way across the Rubicon

FT Alphaville3 quotes from a Goldman Sachs note:

… the negative trends in US governance and institutions are eroding the exorbitant privilege long-enjoyed by US assets, and that is weighing on US asset returns and the Dollar, and may continue to do so in the future unless reversed.

And adds their own summarization of Goldman’s views:

The upshot is that Goldman’s new base case is now the dollar’s “exceptional” position over the past decade is now reversing, which will benefit the euro and the Japanese yen in particular.

However, the most interesting part of the note is that even Goldman Sachs is becoming worried that the sun may finally be setting on America’s famous “exorbitant privilege” (and is willing to say so publicly).

… we can begin to freak out if we ever see multiple days of US Treasury yields rising and the dollar falling in tandem. That would be a pretty clear sign that some of that $26tn NIIP is truly heading for the exit.

Wigglesworth4 quotes Evercore ISI’s Sarah Bianchi:

Our real concern is that while Trump may be able to cut a few tariff deals, when the issue is a broader loss of confidence in the United States, even a much fuller retreat on trade might not work.

Maybe It’s Not That Bad?

Ed Yardeni and Meyrick Chapman would say the above is “absurdly alarmist … an overreaction to the recent correction in the S&P 500.

Yardeni7 argues:

… financial markets can be volatile without confirming that the end is near for American exceptionalism. Recent events can be explained quite simply and without implying any dire consequences.

He argues the stock market selloff was a result of fundamentally expensive US stocks and cheap European stocks, and a reallocation from one market to the other. Further:

… the US Treasury market [remains] the largest, most liquid, and (still) the safest capital market in the world. The dollar should remain the pre-eminent reserve currency.

Meyrick Chapman8 argues:

The ‘exorbitant privilege’ is much, much bigger than a president. There is no immediate challenge to the dollar - not because it is guided by wise councillors, but because it is quite able to rebuke those councillors and change policy.

US can't shake off 'exorbitant privilege' even if led by donkeys.

Mmm. I don’t know.

Dollar Depreciation—The Trump Tariff Paradox

The Miran doctrine was elegant: impose tariffs, reduce the trade deficit, and the dollar will rise. Textbook logic said so, and the markets initially agreed. The conventional wisdom – championed by Treasury Secretary Scott Bessent and CEA Chair Miran – held that tariffs would lead to dollar appreciation. As Bessent stated, "a 10 percent change in tariffs would lead the dollar to appreciate by 4 percent.

But the real-world reaction has been the opposite. Since Trump’s April “Liberation Day” tariff shock, the dollar has fallen sharply—even as tariffs rose. This dissonance is more than inconvenient; it is deeply revealing.

Brad Setser9 provides a nuanced explanation: while tariffs reduced imports, they also functioned like a consumption tax, dragging on U.S. growth. That led markets to price in lower Fed rates, reducing the return on dollar assets.

One of the most compelling frameworks for understanding current dynamics comes from Louis-Vincent Gave of Gavekal Research, who describes the current situation as an "Asian-crisis-in-reverse." Reuters10 quotes him:

"Since the Asian crisis, Asian savings have not only been massive, but they've had this tendency to be redeployed into U.S. Treasuries. And now, all of a sudden, that trade no longer looks like the one-way slam dunk that it had been for so long."

The evidence of this reversal is mounting:

1. Taiwan saw a stunning 10% two-day leap in its currency against the dollar, with Reuters reporting "difficulty executing trades, such was the one-sided wave of dollar selling."

2. Hong Kong's dollar is testing the strong end of its peg, suggesting substantial capital inflows.

3. The Singapore dollar has "soared close to its highest in more than a decade."

4. Goldman Sachs reports that "investor clients had recently flipped from short yuan positions, to long positions, or in other words, they are shorting the U.S. dollar expecting further weakness."

A particularly telling sign is that Hong Kong's de-facto central bank announced on Monday "it has been reducing duration in its US Treasury holdings and diversifying currency exposure into non-US assets."

Taiwan’s Formosa Bond Fallout

Most U.S. investors have never heard of Formosa bonds. I hadn’t before I worked at AIG. These are U.S. dollar-denominated bonds issued by foreign entities and sold in Taiwan to satisfy the investment appetite of local life insurers. With more than $300 billion outstanding at their peak, Formosa bonds offered foreign borrowers access to deep pools of capital, while giving Taiwanese insurers long-duration dollar assets to match against their local-currency liabilities.

Importantly, about half of the roughly $300 billion worth of Formosa bonds are callable, according to Barclays11.

… most important, while long-dated callables account for a large amount of vega supply to the US vol market

Taiwan’s insurance giants have built portfolios stuffed with long-dated U.S. dollar bonds while funding themselves in New Taiwan dollars. And they didn’t fully hedge. According to recent estimates, these insurers are running open FX positions that may exceed $200 billion—over 25% of Taiwan’s GDP.12 The surge in the Taiwan dollar, up more than 9% in just weeks, has turned that mismatch from theoretical to acute.

If the Taiwan dollar continues its ascent, and if hedging becomes unviable, the insurers may need to liquidate portions of their massive dollar bond books to raise local currency. That could create a cascade effect—disrupting U.S. credit markets, widening spreads, and upending yield curves.

Just as the German banks monitization of expiring government guarantees led to their Irish SIVs being the marginal buyer of subprime CDO tranches before the GFC, Taiwan’s role in global bond markets came not from exports, but from regulatory arbitrage and monetary sleight of hand. And now, as the tide turns, a local insurance mismatch threatens to ripple through global dollar markets.

American Ethical Decline

I was silent when golf sold out to the Saudis. I was quiet when our President praised the monarch that ordered the killing and dismemberment of a US journalist. I’m not even commenting about the gold plated aircraft.

But baseball caving is a bridge too far.