The end of exorbitant privilege?

The dramatic shift in trade policy this year by the new US administration initially laid bare a fissure across developed markets (DM) that hides in plain sight. While announcements of the end of US exceptionalism and expectations for a monumental disruption in asset flows now seem overstated, the long-term shift in fundamentals is not. Exorbitant privilege, the term long-used to describe the hegemony of the US dollar as international reserve currency, is under historic pressure.

The post-global financial crisis (GFC) era saw a massive transfer of debt from the private sector to public balance sheets as governments in DM bailed out private enterprise. This became the template for the debt accumulation binge in DM. The new model featured countercyclical/easy money policies designed to keep economies afloat and allowed steady debt accumulation at low rates. Policymakers proved unable to either kick the debt habit or move beyond easy money. And then the pandemic hit, producing round two of massive stimulus from monetary and fiscal policy as debt funded fiscal stimulus and quantitative easing (QE).

A world of difference

Now again, with the pandemic in the rearview mirror, policymakers refuse to face long-term reality and continue to borrow and spend. This has driven debt/GDP ratios to equal or surpass national income in most DM countries. Front and center, in the US, the Congressional Budget Office estimates the ‘One Big Beautiful Bill’ will lower tax revenues by $3.7tn over the next 10 years, while proposed spending cuts would only save $1.3tn, leaving the primary deficit $2.4tn wider than would otherwise have been the case. Moody’s became the third ratings agency to downgrade US debt in May, before the bill passed, contributing to the nascent ‘sell America’ theme that emerged with the ‘Liberation Day’ dramatics of early April.

The emerging market (EM) local currency yield versus the US 5-Year Treasury bond shows that local yields have compressed to US yields over time – signaling growing acceptance that EM risk has deteriorated.

The top headline currently is the weakest US dollar since 1973. President Donald Trump has been outspoken about wanting a weaker dollar, in theory to make US goods prices “more competitive.” His tariff and policy announcements since taking office for the second time have resulted in downward pressure on the USD against both DM and EM currencies, primarily because global investors have been reducing their exposure to US assets. As markets have managed to calm somewhat entering the second half of the year, the fundamentals of the ‘Sell America’ trade remain in place, with the scope and depth of the trend yet to be determined.

That was then

EM countries were hit hard in 2013 during the infamous taper tantrum as the former-chair Ben Bernanke Fed’s reduction in bond purchases (QE) created, in addition to broad market disruption, ‘the fragile five’ – referring to Indonesia, Turkey, India, South Africa and Brazil. Since that time, the ongoing convergence of the broader set of EM economies with their DM counterparts has been dramatic, especially when we consider that typically, external debt acts as a restrainer on EM policymakers, who don’t enjoy the same latitude from markets as their DM peers — not to mention the exorbitant privilege afforded to the US. 

This is now

As with any market disruption, after the initial shock wears off, the focus shifts to longer-term outcomes. In terms of opportunity across emerging-market debt (EMD), tariff disruptions and DM debt/GDP ratios potentially amplify existing trends.

Uncertainty around US policy, external and internal, is telegraphed daily in yield volatility at the long end. US high yield is back to being priced for perfection and assumes a world where growth persists in spite of tariffs and without spiking inflation and employment disruptions. There are many ex-US economies that are currently more attractive. In terms of EMD, opportunity drivers include:

• Emerging market debt (EMD) ownership is at a 20-year low as investors stayed away post-pandemic in favor of DM and private debt.
• Despite general tariff concerns, many EMD opportunities exist out of the storm path and potentially benefit from a weaker USD environment.
• In addition to USD and local currency opportunities, many EM countries offer attractive yield and diversification potential.

 Read the full paper: The end of exorbitant privilege? (federatedhermes.com)