A portfolio balance explanation of the 2025 dollar sell-off
President Trump’s April 2, 2025 tariff announcement produced a pattern that standard theory struggles with: the dollar depreciated while U.S. yields rose. This was the opposite of the usual flight-to-safety response, and inconsistent with the textbook effect of tariffs on a country’s terms of trade.
With commentators openly questioning the dollar’s reserve-currency status in the wake of that episode, Rohan Kekre and Moritz Lenel set out, in this paper, to test quantitatively, whether a plausible decline in foreign demand for dollar bonds, rather than the tariffs themselves or a generic flight to safety, could actually explain what happened.
Methodology
Kekre and Lenel build a general-equilibrium, multi-country portfolio-balance model in the Tobin-Kouri tradition:
- Households in each country trade their own local short-term bond freely, but hold largely inelastic and exogenously given positions in foreign bonds and long-term debt.
- Global arbitrageurs trade all asset and when foreign demand for a country’s bonds shifts, arbitrageurs must absorb the resulting flow. Because arbitrageurs are risk-averse, absorbing an unwanted flow requires currency and bond risk premia to move, which shows up as changes in exchange rates and yield curves.
- Importantly, the model treats a shift in demand for dollar bonds as coming from either private investors rebalancing or a government “managing its reserves” as official and private flows work through the identical channel.
- Price elasticities are disciplined using the observed market impact of the Federal Reserve’s 2008–09 QE1 announcements. The model is calibrated to the G10 economies plus 15 emerging markets, then used to run the April 2025 tariff shock.
Findings:
- A 3–12% decline in global demand for dollar bonds relative to annual U.S. GDP is enough to reproduce both the dollar’s depreciation and the rise in dollar yields.
- Because asset prices are forward-looking, this price impact appears even if the actual rebalancing is expected to unfold gradually rather than all at once.
- Currencies offering the highest average excess returns appreciated the least, and higher-yielding long-term bonds saw the largest yield increases. This is a pattern attributed to a simultaneous rise in arbitrageur risk aversion, not to tariffs themselves.
- Countries with the largest external surpluses and thus the steepest announced tariffs, appreciated the most against the dollar, precisely because they were perceived as “safer.” Tariffs alone cannot explain this.
- The same forces continued through the following year: the dollar kept weakening against G10 currencies as rate differentials narrowed, and against emerging markets as risk aversion eased.
What Do Asset Prices in April 2025 Say About Demand for the Dollar?
Authors: Rohan Kekre, Moritz Lenel
From: University of California, Berkeley, Princeton University
