COLUMN-Investors could exit tariff purgatory only to enter capital controls inferno: Klement

By Joachim Klement

April 29 - Investors are currently in tariff purgatory, as they anxiously eye the end of the 90-day ceasefire in President Donald Trump global trade war. Tensions have eased in recent days, but if this pause expires with few substantial trade deals, markets could panic again, potentially forcing the U.S. to consider introducing capital controls.

It is anyone’s guess what will happen on July 8 when the current reciprocal tariff delay expires, but it essentially boils down to one of three options: (i) the tariffs come into force as originally intended with very few trade deals struck by then, (ii) the tariffs are delayed once again, creating prolonged uncertainty, or (iii) several countries manage to get deals and lower tariffs, while many others face the original tariffs announced on April 2.

Given these fairly unattractive options, many international investors appear to be choosing to move their money out of the U.S. Over the three weeks through April 25, European investors reduced their holdings in U.S.-focused equity ETFs by over €4 billion, according to my calculations, while they invested almost €6 billion in European-focused ETFs. These flows and continued uncertainty around U.S. economic policy have, in turn, weighed down the U.S. dollar and the stock market.

‘CONVENIENCE YIELD’

I recently argued that the tariff chaos had triggered a healthy portfolio rebalancing among foreign investors. Yet, I warned that if the dollar did not stop weakening, it could become something altogether more worrisome. And since then, the U.S. dollar has continued to wobble.

So all eyes now turn to the Treasury market, as a persistent string of net sales of Treasuries by international investors would be the clearest sign that investors are losing trust in the U.S. government and the U.S. dollar.

While official data on U.S. Treasury flows in April is not yet available, researchers have started to uncover some tell-tale signs that international investors are starting to question the safety of U.S. bonds.

In a paper published on April 16 titled Dollar Upheaval: This Time is Different, a group of academics looked at the ‘convenience yield’ of holding U.S. Treasuries, meaning they calculated how much investors were willing to pay for the 'safety' of Treasuries.

They did this by comparing what it costs to hold Treasuries versus replicating them via German Bunds and a combination of interest rate and exchange rate derivatives.

If this convenience yield is negative, it suggests that investors consider German Bunds to be safer than U.S. Treasuries; thus, a declining convenience yield indicates a deterioration of the credit quality of Treasuries versus German Bunds.

After ‘Liberation Day’, this convenience yield dropped rapidly and, as of April 23, was around 15 basis points below the April 2 level for notes with maturities of five and ten years. The longer the maturity of the Treasuries, the larger this impairment has become.

THINKING THE UNTHINKABLE

Yet, we are only in tariff purgatory. If the current situation is resolved via something resembling option one, reverting to most of the tariffs announced on April 2, the minor impairment we have seen in U.S. Treasuries could worsen rapidly as international investors rush to the exit.

In this case, the capital flight could become so destabilising that the administration would seek to stem the flow by using a tool typically associated with emerging markets: capital controls.

Typically, this would mean restricting investors’ ability to move capital outside the country. Businesses might only be allowed to buy foreign goods up to a certain amount or for certain purposes. Banks and asset managers might be unable to sell investments on behalf of foreigners, and American tourists could even face limits on how much cash they could take abroad.

But even though such extreme measures might stem the bleeding in the short term, as was seen in Malaysia in 1998, they would only exacerbate fears about U.S. institutions. And if left in place for more than a few months, they could distort markets by causing the misallocation of capital.

A less onerous form of capital controls would be the introduction of a Tobin tax. This would be a levy on foreign exchange transactions, which would have the added benefit of generating additional tax revenues.

But the problem with a Tobin tax and other forms of ‘soft capital controls’ is that they do not work in a panic. Indeed, if the U.S. were to introduce such measures, it would likely only accelerate the capital flight as more investors rushed to the exit before the door was shut completely.

Ultimately, capital controls are a form of central planning and a severe restriction of free market capitalism. They would typically be unthinkable in a modern U.S. context, but if we see a true panic run on the dollar, unthinkable options may need to be considered.

(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).