Why crash of US bond markets threatens to undermine dollar’s hegemony

For a week in early April, the boring and staid world of the bond markets came alive as US President Donald Trump did a one-two jig on tariffs.

The dull monotony that characterises the bond markets, unlike the more glamorous world of equities, was suddenly agitated by whispers that the bond vigilantes were back in business after a while.

The market for US Treasuries, the bedrock of the global financial system, trembled in a fashion not seen in decades.

The world of bonds

First, a word about bonds. This financial instrument, a classic fixed-return asset, is the ballast that holds the global financial markets together in a world that is otherwise awash with risk. Let us work with an example to illustrate how bond markets function.

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Suppose you hold a bond that was issued in March 2022 that has a face value of Rs 1,000 (also typically its issue price) and bearing an annual interest of 8 per cent. Bonds are financial assets that can be bought and sold but their price will usually fluctuate within a narrow range.

Since the returns on bonds are fixed, the only variable that can change – which would reflect the broader market conditions – is their price.

Suddenly, with all three markets – equities, bonds and the dollar – in synchronised decline, the US looked like an emerging market economy.

In our example, the original buyer would have got Rs 80 per annum on an investment of Rs 1,000. But the person who now buys it for, say, Rs 900, still gets Rs 80 annually but on an investment of Rs 900, which means that for this person, the effective return is around 8.9 per cent, not 8 per cent.

Conversely, if the bond price rises to, say, Rs 1100, the effective return would be a tad under 7.3 per cent.

This is what sets the fundamental axiom in bond markets: that yields will vary inversely with the price of the bond. Thus, if for some reason in our example, the market determines that interest rates ought to now increase to 9 per cent, the bond you hold will be deemed to be less valuable. Intuitively, given the fundamental axiom of the bond markets, this will reflect in the price of the bond slipping in the market.

Bonds can be risky, too

In your hands, as a small investor, this may not matter too much but to large institutional investors who have investments of billions of dollars in bonds, the reduced price of the bond, which are ‘assets’ on their balance sheets, now have to be “marked” to market. They must be revalued to reflect their lower price/value.

The crisis in the US bond market has been markedly different from the financial crisis during COVID. During both episodes, market volatility increased spectacularly, but during the pandemic, investors from around the world sought safety in the US dollar, unlike now.

Moreover, if these bonds have, in turn, been used as collateral for leveraged bets (implying using borrowed funds) on derivatives – as some hedge funds did in the episode in April – the lower values may spark a call from lenders to make good the loss in value (termed margin calls in market parlance).

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This, in turn, may trigger a chain reaction of sales of assets. Suddenly, the boring and mundane world of bonds is on the fast lane to a disaster. In fact, the collapse of bond prices, following the US Federal Reserve’s pivot from ultra-low interest rates set during the pandemic, triggered the collapse of Silicon Valley Bank almost exactly two years ago.

The bank, which held a large proportion of its investments in US Treasuries, suddenly found the value of its “assets” diminished significantly.

The king of bonds

US Treasuries are the most important bond market in the world. The outstanding value of Treasuries is now in the region of almost $29 trillion. Because they are underwritten by the United States government, these bonds are considered among the most liquid in the world, as good as dollars in cash.

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Most central banks, including the Reserve Bank of India (RBI), have significant holdings in US Treasuries because they have been traditionally regarded as the ultimate safe haven asset, even better than gold because it provides a return, however small, unlike the precious metal.

And, because they are as good as cash, holders of Treasuries use them as collateral when they borrow.

Trump mayhem

With that basic primer on bond markets let us now turn to the real world of the Trump-inflicted trauma on markets.

In the ensuing mayhem, the prices of equities crashed. However, unlike normal times, when investors pull out of turbulent equity markets and move to the safe haven of bonds, this time bond prices also crashed as investors sold these assets too. Hedge and pension funds seeking to desperately cover their losses sold heavily as both markets crashed simultaneously.

The yield on 10-year US Treasuries – the anchor for the US mortgage market – increased from 4.01 percent on April 4 to 4.48 per cent on April 11.

During the same period, yields on the 30-year Treasuries, which are the staple for pension and insurance funds as well as other investors, increased from 4.41 per cent to 4.85 per cent. The average yield on the 30-year Treasuries between March 3 and April 3 was 4.59 per cent; between April 4 and April 28, this jumped up to 4.76 per cent.

Widened spread

Even more ominously, the spread – the difference between the yields on 10 and 30-year Treasuries – widened significantly after Trump’s tariff tantrum. The average spread widened from 0.32 per cent in the month before April 2 to 0.44 per cent between April 3 and April 28, implying that the market was demanding a higher risk premium for the longer-duration bond.

Ostensibly, this reflected the bond market expecting an uptick in the inflation rate as well as greater uncertainty about the future.

Does this crisis mean the end of the dollar’s pre-eminence? Not necessarily, simply because it is not easily replaceable by another rival currency.

These movements might seem trivial but investors in bond markets move trillions of dollars across markets in search of tiny arbitrage opportunities. In fact, the magnitude of the increase in yields in that fateful week in April saw the biggest weekly spike in 10-year US Treasuries since November 2001.

For the 30-year Treasury, the weekly surge was even more memorable – the biggest spike since 1982.

Nothing by the book

Normally, when equities crash and investors turn to Treasuries, the increased demand for the bonds causes their prices to increase, resulting in lower yields, which would then translate to lower interest rates. But this time nothing was happening by the book.

The surge in the yields of US Treasuries would logically (at least by the monetarist playbook) require the US Federal Reserve to set interest rates higher – exactly the opposite of what Trump has been demanding for months. His tantrum against the Federal Reserve Chair Jerome Powell only agitated markets further.

Normally, when bond yields rise, the dollar too appreciates because investors rush into cash in on the higher interest rates on offer. To do this they need to get dollars first so that they can purchase the Treasuries.

The feedback loop generated by the flood of investor interest drives the dollar up too. This explains why in normal times the dollar and yields move in step.

Dollar depreciation

But this time things were very different. The most striking aspect of the turmoil in the bond market is that not only did the price of equities and bonds slide at the same time but the dollar also depreciated rapidly.

For instance, the dollar lost almost 5 per cent between April 1 and April 22 against the euro; since March the decline has been more than 9 per cent.

The depreciation of the dollar also affects foreign bondholders adversely because the value of their holdings is effectively eroded. Foreign bondholders who sought to make investments in US Treasuries because it is a safe haven now find the value of their holdings declining in value in relation to other options.

Simultaneous slide

The economics textbook says when a country increases import tariffs, its currency appreciates. This is because of the expected improvement in the current account balance.

This is what happened during Trump’s first term when he hiked tariffs on imports from China. But this time, with investors in bonds as well as equities rushing to sell their dollar assets, the flood of dollars resulted in the depreciation of the dollar.

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Suddenly, with all three markets – equities, bonds and the dollar – in synchronised decline, the US looked like an emerging market economy. This is what usually happens to a less developed economy hit by capital flight, not the country that acts as the global currency hegemon that draws its power from the centrality of the US dollar in the global scheme.

To get a sense of how unusual this event has been historically, one has to go back to 1976, the last time when capital flight hit an advanced economy. In 1976, Britain, then led by a Labour Government headed by James Callaghan, was forced to seek a loan of $3.9 billion loan from the International Monetary Fund to deal with a crisis of capital outflows, which was triggered by a collapse of asset prices and a depreciation of the Pound Sterling.

Dollar as hegemon

The US Treasury market is critical to the maintenance of the dollar as the world’s preferred choice of not only a medium of exchange but as a safe asset. Roughly half of all international borrowings are denominated in dollars and almost 90 per cent of all international transactions are in dollars at least at one end of the transaction.

Although the Treasuries are the prime fixed-income instrument in the US, happenings in this market can trigger wider ripple effects in other fixed-income instruments such as the corporate bond market, the municipal bond markets and the money markets. The overall size of the outstanding debt in the fixed income instruments in the US was almost $47 trillion, 60 per cent of which was in Treasuries.

The dollar’s status as the currency hegemon ensures that capital inflows cover the US trade deficit. The US, which currently runs a current account deficit of $1.1 trillion would require at least that quantum of capital inflows.

Investment inflows

Theoretically, these inflows could be in terms of portfolio investments, foreign direct investment or could happen via the sale of US economic agents’ overseas assets.

In reality, only portfolio investment inflows are generally available to fill the gap in the current account. The catch is that if foreigners consider US assets – bonds or equities – too pricey, either the asset price must fall or the dollar must depreciate so that foreigners get more bang for their buck.

Indeed, it is quite possible that both may happen – asset prices fall and the dollar devalues – in order to facilitate the inflows.

A key imponderable in all this is the outlook for the US economy. Crucially, there is thus no guarantee that capital inflows would continue into the US economy when it is decoupled from a large part of the global economy.

Spectre of inflation

But two aspects of the crisis in the bond markets are particularly noteworthy. One, the spectre of inflation, directly inflamed by the high tariffs Trump has set, is a red rag that agitates the bond vigilantes who fear that their returns would be harmed.

Two, the actions and words of Trump and his adviser cronies that US debt may be extended in perpetuity – effectively a default – undermines the trust in the dollar as the preferred store of value by economic agents all over the world.

Unlike 2008, this time the US Fed would be alone in managing a crisis. Trump’s isolationist position effectively rules out any coordinated response to a crisis this time.

The crisis in the US bond market has been markedly different from the financial crisis during the Covid-19 pandemic. During both episodes, market volatility increased spectacularly, but during the pandemic, investors from around the world sought safety in the US dollar, unlike now.

Also, unlike during the global financial crisis of 2008, this time the US Fed would be alone in managing a crisis triggered in the US Treasuries market. Trump’s isolationist position effectively rules out any coordinated response to a crisis this time.

Fragmentation of financial markets

For decades, being the issuer of the currency hegemon and the home base of what investors around the globe regard as the safest of all assets, has endowed the US with the unrivalled privilege of being able to borrow its way out of trouble any time.

Unlike most other countries it has been able to tame crises by drawing from pools of investment that are readily available, effectively using them as a stimulus.

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Does this crisis mean the end of the dollar’s pre-eminence? Not necessarily, simply because the network effects of the dollar’s status as the prime vehicle for international trade and finance as well as it being the preferred choice as a store of reserve value, are not easily replaceable by another rival currency.

The combined global holdings of gold and Japanese, British, German and Swiss bonds amount to about 27 trillion dollars, a tad lower than the outstanding US Treasuries. This confirms that no currency or asset poses an immediate challenge to the currency hegemon.

However, the fragmentation of not just international trade but also global production chains that is manifest in the Trumpian logic may provide the basis for a fragmentation of currency arrangements among countries.

In fact, foreign holdings of US Treasuries have been in systematic decline since the global financial crisis of 2008 – from about 51 per cent of outstanding Treasury debt in January 2009 to about 30 per cent currently.

The erosion of the dollar’s status would trigger a further diversification of holdings of financial assets.

China’s move

The most striking aspect of the decoupling of the US-China economies is that Chinese holdings of US Treasuries have declined sharply since the financial crisis of 2008, and even more spectacularly in the last decade.

Between January 2022 and December 2024, China has reduced its Treasury holdings from $964 billion to $759 billion, a 27 per cent drop. Between 2017 and 2022 Treasury holdings had already declined by 17 per cent. China’s holdings have declined by about 42 per cent in the last decade.

The remarkable aspect of this winding down is the fact that it has been deliberate and orderly, not a panic-driven measure.

This is because any attempt to “weaponise” dollar reserves would attract countermeasures by the US Federal Reserve, including unleashing quantitative easing measures that would stabilise US bond prices and reduce yields on US Treasuries.

Gold strategy

Among the strategies China has adopted is the move to increase its gold reserves, although gold is still a small part of its overall portfolio of reserves. China’s gold reserves were valued at $229.6 billion at the end of March 2025 and accounted for 7.1 per cent of total reserves, up from just 2 per cent a couple of years ago. China’s overall reserves were valued at $3.241 trillion at the end of March 2025.

According to China’s State Administration of Foreign Exchange (SAFE), the increased holdings of gold are part of China’s risk mitigation strategy. This is aimed at reducing its excessive dependence on the US dollar and insulating it from uncertainty or turbulence in global financial markets.

Less room for manoeuvre in crisis

Two aspects of the long-term trends in US federal debt are striking. First, foreign holdings of US debt have been declining as a proportion of total debt. Second, private holdings of US federal government debt have displaced foreign official holdings (central banks and other government agencies) in importance.

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These developments, along with the United States’ shrinking ability to use the dollar’s privileged status to counter an economic or financial crisis, mean that the ability of global financial regulators to counter the next crisis would be severely compromised, if not undermined.

John Connally, Treasury Secretary under President Richard Nixon, famously said in 1971, “Our currency, but your problem,” when the Bretton Woods system that pegged the dollar to gold was abandoned. Now, the world seems to be retorting: “Your currency, your problem.”