You can run, but you can’t hedge

Key points

• Bonds and stocks falling together stirs painful memories of the 2022 inflation surge. This time, trade and tariff uncertainty is to blame, along with a dose of questioning the Fed’s independence. The episode underscores the challenges to traditional portfolio diversifiers and the need to consider alternative sources of diversification.
• Reports of the “death of the dollar” are greatly exaggerated. The dollar’s decline is unusual in the context of falling stocks and rising uncertainty. That reflects the unique circumstances of the uncertainty and speed of tariffs impacting globally connected economies and financial markets.
• Signals of less extreme tariff implementation brought markets back from the brink, but market pricing largely reflects an unwind in post-election growth enthusiasm rather than a risk premium for the rise in stagflation and recession risks.

The return of the bond market vigilantes

Call it the return of the bond market vigilantes. What led to a reversal in last month’s Liberation Day tariffs just a week after their announcement? While stocks tumbled, we would suggest it was the simultaneous bond market sell-off that gave greater pause to the unintended consequences of the policy shift.

Synchronized declines in bonds and stocks stir painful memories of the 2022 inflation surge that drove both asset classes lower. Tariff increases to levels not seen since before the 1900s surprised markets and illustrated the potential shock to the global economic outlook. Consensus economic growth forecasts shifted lower—increasing odds of a recession—while acknowledging, in the Fed’s now-infamous phrasing, the potential for “transitory” inflation.

On the inflation outlook, both economists and the Fed have raised concerns that a one-time tariff-driven price increase may prove less transitory if it begins to influence expectations for future inflation. Some survey measures, such as those from the University of Michigan, appear to validate those concerns, while others, like the New York Fed’s, suggest expectations remain stable. Market pricing of inflation (Figure 1) highlights the split as well with near term inflation expectations rising dramatically, while longer term inflation expectations have been declining since the Feb 13^th Memorandum on Reciprocal Trade and Tariffs.

Revisiting the (new) bond market conundrum

At the start of 2024, we highlighted the potential for a “new conundrum” in bonds—echoing the original episode two decades ago, when long-term rates moved in the opposite direction of Fed policy.

Today, the concern is the reverse: that rate cuts under Chair Powell could coincide with rising long-term yields. The market’s reaction to the Liberation Day tariffs reflected this dynamic, with 2-year yields falling by 6–7 basis points, while 30-year yields jumped nearly 20 basis points.

Several factors help explain this conundrum. The tariff shock represents a stagflationary supply shock—raising prices while dampening output. In that sense, its economic impact is similar to the COVID shock, though on a smaller scale. However, the large scope of the proposed tariffs—at least initially—meant that markets were pricing in a supply shock that, while not on par with COVID, was more substantial than anticipated. One indication of this outsized impact was the historic front-loading of imports in the first quarter, with net imports subtracting 4.8% from GDP—the largest quarterly drag on record.

These fundamental economics triggered significant volatility across markets. Equity volatility surged, with the VIX rising from 20% to over 50%, while the change in volatility (VVIX) jumped from 100 to over 160. Interest rate market volatility also accelerated, with the MOVE index climbing from 90 to 140. Measures of interest rates between the cash bond and derivatives markets also became dislocated in early April. For instance, 10-year swap spreads—the difference between a fixed-to-floating interest rate swap and the 10-year bond yield—widened from -45bps to -60bps.

These moves unwound popular trades where investors buy bonds on repo (obtaining financing and leverage through a dealer) and hedge the interest rate exposure using financial derivatives. The position is attractive because the net spread earns positive carry, and when leveraged over the initial capital outlay, it can generate a high expected return on capital. The key risk lies in relative price movements between the bond and the hedge, which can lead to losses and margin calls. Figure 3 shows how significant underperformance of the bond leg (the long-risk side of the trade) resulted in large losses, with the potential unwinding of these exposures likely contributing to broader market volatility.

Finally, concerns over central bank independence have the potential to raise both inflation and risk term premia. While most of the attention focused on whether Chair Powell would—or could—be fired, potential replacement Kevin Warsh weighed in on Fed independence in his speech at the IMF Spring Meetings. The classic treatment of this issue is found in Alesina and Summers (1993), which supports earlier work showing that more independent central banks are associated with lower levels of inflation and less inflation variability. Figure 4 replicates their main findings.

While this issue likely generated more headlines than meaningful shifts in portfolio allocations, it continues to linger in the background—particularly for longer-dated bonds. Layered onto that are ongoing concerns around historically high debt and deficit levels, above-target inflation, elevated inflation uncertainty, and, as discussed below, questions about how tariffs may impact the global recycling of trade surpluses. Together, these factors weigh on the outlook for bonds as effective diversifiers.

You can run, but you can’t hedge

The broader concern beyond bond market technicals is the unusual behavior of traditional flight-to-quality assets—moving lower in tandem. As Figure 5 shows, even in the initial market response, gold declined alongside the dollar and bonds as equities sold off. While gold has since reemerged as the lone safe haven, the simultaneous decline in both the dollar and bonds during a period of heightened uncertainty underscores how trade policy risks are uniquely undermining their roles as effective portfolio hedges.

Reports of the “death of the dollar” are overexaggerated

At the heart of the “Liberation Day” tariff shock was a fundamental market misreading of what the Administration meant by “reciprocal tariffs.” Recall that when the concept was first introduced, it was initially met with relief. At the time, “reciprocal tariffs” were seen as a move toward equalizing tariff treatment and a more moderate alternative to a sweeping universal tariff. As such, it was viewed as more market-friendly.

In fact, as we analyzed the source of the Liberation Day announced tariff levels, we found they were calculated not by balancing tariff rates, but by determining the rate needed to balance bilateral trade deficits. Specifically, the methodology applied a formula that set tariffs at roughly 50% of the trade deficit as a share of imports. The result: projected tariff rates that far exceeded market expectations—and surpassed any tariff levels imposed since the pre–Smoot-Hawley era.

For the real economy, this translated into expectations of higher prices and slower growth—with the magnitude of the shock contributing to the surge in market volatility. But for traditional safe havens like the dollar and bonds, the shock introduced a distinct source of uncertainty: the potential disruption of the global recycling of dollar reserves that underpins the international financial system.

Exorbitant privilege and its consequences

Barry Eichengreen’s Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System takes its title from the events that preceded the collapse of the Bretton Woods system. This system marked the transition from the ancien gold regime to a dollar-based system, prompting French finance minister Valéry Giscard d’Estaing to coin the term “exorbitant privilege.” It refers to the unique advantages enjoyed by the U.S.—notably, its ability to run sustained balance of payments deficits, as imports are priced in its own currency.

The Liberation Day tariffs, aimed at reducing the U.S.’ large and persistent trade deficits, would also affect their counterpart—persistent capital account surpluses. Stephen Miran, Trump’s Chair of the Council of Economic Advisers, explored these issues in his November 2024 paper, A User’s Guide to Restructuring the Global Trading System, which has fueled speculation about the administration’s economic direction. In one section, he echoes themes from Exorbitant Privilege, highlighting the hidden costs of America’s privileged position in the global system.

The “Triffin Dilemma,” named after economist Robert Triffin, captures the tension the U.S. faces as issuer of the global reserve currency: balancing international monetary stability with domestic priorities.

In this view, persistent U.S. trade deficits aren’t driven by overconsumption but by the need to supply reserve assets—primarily U.S. Treasuries—to the world. As Stephen Miran puts it, “America runs large current account deficits not because it imports too much, but it imports too much because it must export US Treasuries to provide reserve assets and facilitate global growth.”

The dilemma is that sustaining global liquidity through deficits eventually erodes confidence in the dollar, while limiting deficits could constrain global trade. Miran notes that this creates “permanent twin deficits” and an unsustainable buildup of debt, ultimately threatening the dollar’s reserve status.

Post-Bretton Woods policy has favored sustaining global liquidity; Trump’s approach, as Miran describes, shifts focus to domestic consequences. As deficits increasingly strain the U.S. export sector and fuel socioeconomic stress, he concludes, “the bargain becomes less appealing,” and a shift in America’s stance is underway.

The dollar’s decline—contrary to the strengthening Miran anticipated in his November 2024 paper—came as a surprise, possibly reflecting market shock at the scope of the policy shift or the early pricing-in of objectives like a “Mar-a-Lago” accord to weaken the dollar. The combination of a weaker dollar and rising rates may reflect expectations of reduced foreign demand for U.S. debt. Meanwhile, the inflationary pressure from a falling dollar has added to the Fed’s challenge in balancing growth and inflation.

The investment implications are clear: the traditional roles of U.S. Treasuries as a hedge and the dollar as a safe haven—especially for foreign investors—have weakened. With currency considerations less central for domestic investors, shortening debt maturities may help restore hedging efficacy (Figure 6). At the extreme, moving to cash replaces the potential for asset class diversification—such as positive bond returns offsetting equity losses—with the more limited benefit of reducing drawdown potential.

Economic outlook and the pricing of risks

Survey-based indicators have begun reflecting the economic uncertainty following the post-Liberation Day tariffs. Regional Fed surveys and the ISM purchasing managers’ indices now point clearly to a sharp rise in recession risk. Front-loaded imports and inventory buildups in the first quarter suggest that the weakness could soon show up in the hard data. The key question now is: how much of this have financial markets already priced in?

One perspective worth highlighting is the “roundtrip” seen across many financial markets following the initial post-election enthusiasm around Trump’s victory. That early rally partly reflected expectations of pro-growth policies such as tax cuts and deregulation. But much of that optimism has since been unwound, with key market indicators returning to pre-election levels. In this context, markets haven’t fallen in response to rising recession fears, but have given back prior gains tied to upgraded growth expectations. The concern, then, is that if recession risks do start to price in, there may still be further downside ahead.

Figure 7 tracks several equity market indicators alongside the dollar’s performance. A consistent pattern emerges: a pre-election surge tied to rising expectations of a Trump victory, continued momentum after the election, followed by a slowdown beginning around Inauguration Day. That deceleration turned sharper after Liberation Day, though most of the losses have now been retraced in equity markets amid hopes for a more moderate tariff implementation and broader exemptions. However, the dollar remains well below its earlier levels.

From a credit market perspective, recession risk remains largely absent from current pricing. High yield spreads, which were around 300 basis points just before Liberation Day, briefly widened to about 450 before settling in the 350–400 range by the end of April. As Figure 8 shows, typical pre-recessionary conditions would push spreads to the 600–650 level. While credit fundamentals, like macro data, have yet to reflect meaningful deterioration, markets appear to be underpricing the risk. That leaves credit vulnerable if the confidence shock—already visible in “soft” survey data—ultimately feeds through into real economic weakness.

Conclusion

In a world where traditional hedges are faltering, investors face a difficult challenge: managing risk in portfolios where traditional diversifiers no longer reliably cushions shocks.

The simultaneous declines in stocks, bonds, and the dollar—assets that don’t historically move in tandem during periods of market stress—underscore the need to reassess hedging strategies. Shortening duration can help investors access the part of the curve where hedging has remained most effective, while seeking alternative sources of diversification beyond traditional bonds may help further build portfolio resilience.

More broadly, markets don’t appear to be fully pricing in recession risks across equities and credit, leaving portfolios exposed if soft data weakness turns into hard data deterioration. For now, much of the recent pullback seems more like an unwinding of post-election optimism than a repricing for downside risk. If that risk does begin to materialize, asset prices could still have further to fall.

In this context, you can run, but you can’t hedge is more than a quip—it’s a reminder of the limitations of past investment playbooks in today’s increasingly uncertain environment.

Download commentary