ROI-Why investors are getting the US debasement trade all wrong: Klement

By Joachim Klement

LONDON, Feb 16 (Reuters) - Chatter about the “dollar debasement” trade has become omnipresent, but one measure of risk suggests that investors are getting it all wrong. They are overestimating the trouble the dollar faces while underestimating the threat to U.S. Treasuries.

The dollar has depreciated against all major currencies over the last 12 months, while gold and other precious metals have sky-rocketed, recently hitting all-time highs. Does that mean we’re seeing debasement in action? Not necessarily, or at least, it’s not that straightforward.

While the term “debasement trade” is ill-defined, it appears to consist of two elements. On one side, investors are worried about a devaluation of the U.S. dollar if discontent with U.S. policy – whether fiscal or foreign – makes money managers reduce their exposure to the greenback, meaning it might no longer act as a safe haven and could even lose its status as the world’s reserve currency.

From the other perspective, investors are concerned that the U.S.’s eroding fiscal situation may eventually trigger a sharp devaluation of U.S. Treasuries – or, in extreme scenarios, a default – and a corresponding devaluation of the U.S. dollar.

On the face of it, the case for both seems pretty weak. The dollar declined around 10% last year, but that was after it rose by roughly 50% in the prior decade, and it’s nowhere near losing its status as the world’s reserve currency.

Meanwhile, Treasury yields are hardly ringing alarm bells.

But there’s another way to measure whether investors are growing more skittish about holding dollars or Treasuries: their so-called “convenience yield”. This is essentially the difference in yield between holding the U.S. dollar or Treasuries outright and creating synthetic versions of these assets via a series of currency and options trades.

Investors may do the latter because they need Treasury exposure but either don’t want to take on the credit risk of the U.S. as a counterparty or own government bonds from other countries that they cannot sell.

Creating a synthetic dollar or Treasury is cumbersome, so the replications should offer higher yields.

If the investors conducting these trades – typically among the most sophisticated in the world such as hedge funds and central banks – were afraid of dollar debasement, we should observe a declining convenience yield.

And we’re not, at least not if we’re looking at the dollar. The convenience yield for the greenback against the euro has remained stable for the last ten years and has stayed in positive territory, meaning investors would rather hold dollars than replicate them.

However, for Treasuries, the story is different. Their convenience yield against German Bunds has actually become negative over the past 15 years. This indicates that investors think it is significantly riskier to own 10-year Treasuries than to replicate them using 10-year German Bunds.

But note that this decline in Treasury convenience yields mostly happened during the 2010s when the U.S. started to persistently run large deficits on the order of 4% of GDP or more.

In fact, the convenience yield of Treasuries versus German Bunds has increased over the last six months, indicating a declining risk premium on U.S. bonds. This reflects the fact that Germany is increasing its deficit to spend on defence and infrastructure after years of maintaining a tight budget, reducing the fiscal gap between itself and the U.S.

Importantly, the same trends in convenience yields have been demonstrated not just against the euro and Bunds but against major currencies and developed market bonds overall, on average, according to a recently published academic paper.

THE LOOMING FISCAL RISK

This all suggests that fears of a dollar devaluation are exaggerated. It also indicates that there might be debasement concerns at play in the Treasury market, but they have been there for more than a decade.

That, in turn, raises another question: are investors actually under-pricing the debasement risk in Treasuries given the current trajectory of U.S. fiscal policy?

There are plenty of reasons why Treasuries should be demanding a rising risk premium, most notably the enormous supply of these assets due to persistently large U.S. deficits and the fact that foreign investors now have more options with so many developed market countries ramping up debt issuance.

So what might move the needle in the Treasury market?

Anxious international investors may continue to diversify their government bond holdings, reducing the demand for Treasuries and dollars somewhat.

But what might truly accelerate this diversification is a rapid downturn in the U.S. fiscal situation. And that is possible if the U.S. Supreme Court rules that President Donald Trump’s tariffs issued under the International Emergency Economic Powers Act (IEEPA) are illegal.

The nonpartisan Tax Foundation estimates that the IEEPA tariffs are generating some $100 billion to $130 billion in government revenues per year. If this disappears, or worse, if the U.S. Treasury has to return previously levied tariffs to U.S. importers, the country’s fiscal strain could significantly worsen almost overnight.

Even if the U.S. government tries to introduce the same tariffs under different legislation, these new levies would likely need to be somewhat lower due to legal limits, and they would take time to implement.

That means the U.S. deficit, which the Congressional Budget Office forecasts to be around 5.8% in fiscal year 2026 and which many economists expect could be north of 6.0%, stands a decent chance of rising a lot more.

And that suggests the current convenience yield on U.S. Treasuries may not be nearly high enough.

(The views expressed here are those of Joachim Klement, an investment strategist for Panmure Liberum.)

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