Europe and Investors Rethink the U.S. Debt

Global investors rethink the dollar’s safety

Zhengyang Jiang, Arvind Krishnamurthy, Hanno Lustig, Robert Richmond, and Chenzi Xu, in this paper, analyze the unusual behavior of the U.S. dollar and U.S. Treasury markets following the U.S. administration’s announcement of new tariffs and the subsequent retaliatory measures by China in early April 2025. Historically, during periods of global market stress, the U.S. dollar appreciates due to its status as the global reserve currency and the perceived safety of U.S. Treasury assets. However, this time, the dollar depreciated despite rising U.S. interest rates and increased market volatility, prompting the authors to investigate what this signals about the dollar’s reserve currency status.

Key Findings

Unusual dollar depreciation despite rising yields:  After the tariff announcements and retaliations, the U.S. dollar depreciated by 3.4% between April 4 and April 14, 2025, even as U.S. long-term interest rates rose and market volatility (VIX) more than doubled. This is a stark contrast to previous crises (e.g., 2008 GFC, 2020 pandemic), where the dollar typically appreciated due to a “flight to safety”.

Declining demand for U.S. Treasurys: The spread between yields on synthetic U.S. Treasurys (created from German Bunds hedged into dollars) and actual U.S. Treasurys (the “Treasury basis”) turned negative for the first time since before the pandemic, signaling that foreign investors now prefer other G-10 government bonds over U.S. Treasurys.  The 1-year Treasury basis dropped from +1.8 bps to -22 bps since January 2025, and the 5-year basis widened by 25 bps, suggesting a persistent shift in investor preferences.

Falling convenience yield of dollar assets:  The “convenience yield”—the premium investors are willing to pay for the safety and liquidity of dollar assets—has sharply declined. European investors now require a higher return to hold dollar-denominated safe assets, indicating diminished trust in the safety and liquidity of U.S. Treasurys.

Market perception of regime change:  The market interprets the U.S. administration’s tariff policies and threats to foreign holders of Treasurys (e.g., possible user fees, forced maturity extensions) as a regime change, undermining confidence in the U.S. as the global supplier of safe assets and in the dollar’s role as the world’s reserve currency. Historical precedent shows that reserve currency status can shift when the safety of government assets is in doubt (e.g., Dutch Florin to Pound Sterling to U.S. Dollar).

Potential long-term consequences:  If the U.S. is no longer viewed as the supplier of the world’s preferred safe assets, its fiscal capacity may be impaired, and global demand for dollar-denominated assets could fall further.  The dollar’s sensitivity to changes in the Treasury basis indicates that this is not just a temporary episode but may reflect a lasting shift in investor sentiment.

Dollar Upheaval: This Time is Different
Authors: Zhengyang Jiang, Arvind Krishnamurthy, Hanno Lustig, Robert Richmond, Chenzi Xu
From: Northwestern University, Stanford University, New York University, UC Berkeley

Should Europe follow China in reducing U.S. dollar holdings?

In this paper, Paola Subacchi and Paul van den Noord assess to what extent Europe should follow in the footsteps of China to trim its US dollar reserves invested in US Federal debt. A significant share of U.S. federal debt is held by foreign investors, historically led by Japan and China, but more recently by European private and official sectors.

Economic rationale for reducing U.S. Dollar reserves

• Using a three-country dynamic general equilibrium model (representing the U.S. as the “monetary hegemon,” Europe as a “conventional creditor,” and China as an “emerging creditor”), the paper finds that it is economically sensible for Europe to consider reducing its holdings of U.S. federal debt, especially if trade with the U.S. declines or geopolitical risks increase.
• The opportunity cost of holding U.S. sovereign debt rises when global trade contracts or when the U.S. pursues destabilizing fiscal and trade policies, making alternative reserve allocations more attractive.

Scenario analysis: Trade war and de-dollarization
The model simulates two main scenarios:

• Exorbitant privilege: When foreign demand for U.S. debt is high, U.S. yields are low, and the dollar is strong in the short run, but the long-term exchange rate outlook weakens as debt repayment looms.
• Trade war and de-dollarization: If international trade contracts (modeled as a rise in “home bias”), the opportunity cost of holding U.S. debt for foreign creditors rises sharply. This provides a strong incentive for Europe (and China) to reduce their U.S. dollar reserves, even absent explicit retaliation.

Limits to dollar dominance

• The model suggests that a collapse of the dollar’s dominant reserve role is unlikely unless China acts based on geopolitical, rather than economic, motives.
• The absence of a credible alternative reserve currency means that even if Europe and China reduce their U.S. dollar holdings, the dollar will likely remain central to the international system.

Policy implications for Europe

• Europe should reassess the economic validity of maintaining large U.S. dollar reserves, especially in light of increased geopolitical risk and the Trump administration’s willingness to use the dollar as a tool of coercion.
• Reducing U.S. Treasury holdings would mitigate exposure to U.S. policy risks and could strengthen Europe’s negotiating position in future global monetary arrangements.

Should Europe continue to fund U.S. federal debt?
Authors: Paola Subacchi, Paul van den Noord
From: Sciences Po, Amsterdam School of Economics

The Chicago Booth economists’ survey

Debt and the Dollar
From: University of Chicago-Booth