The Dollar: Ripples Presaging a Financial Tsunami

Yves here. While very bad outcomes seem to be baked in, with not just the US but other governments staring at bad market outcomes (France, the UK, Japan, Indonesia), weirdly there are some near term data points at odds with the notion that a dollar collapse is imminent. In 9/20/2025 Links, one entry from Reuters is Foreign holdings of US Treasuries surge to all-time high in July, China’s sink.

course, markets are fickle and this post works through the many pressures on the Treasury market and the dollar that could trigger catastrophic outcomes. And Trump continues to be a destructive force.

By Dennis Snower, Senior Research Fellow Blavatnik School of Government, University of Oxford; Non-residential Senior Fellow Brookings Institution; Founding President Global Solutions Initiative; Visiting Professor, Institute for Global Prosperity University College London (UCL); Professorial Research Fellow, Institute of New Economic Thinking and Visiting Professor, University College Oxford University of Oxford. Originally published at VoxEU

Loss of confidence in the US dollar’s reserve currency status could trigger a collapse of the US Treasury market and international financial fragmentation. This column argues that hedging is a rational response to recent fluctuations in the US dollar, as investors look to insure against exchange rate risks. However, widespread hedging itself makes Treasuries less attractive, which further weakens confidence. The Federal Reserve has multiple tools to stabilise markets in the short term, including providing time-limited liquidity, activating dollar swap lines, supporting non-bank cash conduits, and lending to non-banks. These actions buy time but are not sufficient by themselves to restore long-term confidence.

Financial markets are becoming aware that President Trump’s policies are undermining the dollar as the world’s reserve currency (Choi et al. 2024, Lachman 2025, Nagano and Kimura 2017, Subacchi and van den Noord 2025). This is important not just because the US enjoys an ‘exorbitant privilege’ – borrowing at low interest rates, running persistently large trade deficits, printing money to finance these deficits without fear of inflation – that the US could lose (Gopinath et al. 2020). It is also important because the loss of confidence in the dollar’s reserve currency status makes hedging the rational response, both as protection against dollar depreciation and as compliance with portfolio mandates of pension funds, insurers, and sovereign wealth funds. But widespread hedging itself can become the trigger of a financial crash.

The Danger

A financial crash triggered by a loss of confidence in the US dollar as the world’s reserve currency would lead to a collapse of the US Treasury market. Higher Treasury yields would raise US government borrowing costs, worsening fiscal sustainability concerns and feeding back into confidence loss. Reserve managers and private investors would diversify into gold, euro, yuan, and potentially digital currencies. Global trade and foreign exchange settlement invoicing would shift toward euro, yuan, or regional currencies. Long-standing network effects of dollar dominance begin to erode, making international financial transactions more inefficient (Snower 2025).

Beyond that, the international banking and financial system would come under severe stress. Banks’ balance sheets, heavily invested in Treasuries and agency securities, would suffer mark-to-market losses, weakening Tier 1 capital. Runs on money market funds could occur as redemptions spike, forcing fire sales of short-term US dollar assets. Stablecoins, which hold large Treasury reserves, could face redemption runs, compounding forced sales of T-bills.

The global spillovers are predictable. The cross-currency basis (reflecting the interest rate differentials between the dollar and other currencies, adjusted for the cost of converting from one to the other) would turn adverse, raising the cost of hedging US assets. Emerging markets would face tighter dollar funding, currency depreciation, and higher borrowing costs, leading to capital flight. Euro area, Japan, and China bond markets are not large enough to absorb massive reallocations, producing volatility and fragmentation across global markets (BIS 2022, Gopinath and Gourinchas 2023).

The macroeconomic consequences are also predictable. The US could no longer borrow cheaply in its own currency, forcing higher interest rates, tighter fiscal policy, and possible monetisation of debt, thereby risking inflation. The euro area and China would experience short-term currency appreciation and financial inflows, but stress due to limited market depth and institutional capacity to replace US dollar safe assets. The global economy would face higher transaction costs, exchange rate volatility, and weakened global financial integration.

The systemic outcome is international financial fragmentation (Aiyar and Ilyina 2023). A multipolar monetary system would emerge without a single dominant reserve currency. This would increase financial volatility, weaken international financial coordination, and heighten the risk of regional blocs with competing financial systems. Political alliances would shift as countries realign reserves and payments systems around alternatives to the US dollar.

The alarming point is that a speculative attack on the dollar is unnecessary as catalyst; hedging in response to market pressures is enough. Of course, once speculators realise that speculation is not necessary for the dollar to fall, speculation against the dollar becomes far more likely.

How the Dollar’s Reserve Currency Status Is Undermined

It is easy to see why each of the prerequisites for the dollar’s reserve currency status (Eichengreen 2011) are currently being undermined:

1. A reserve currency requires macroeconomic stability (low inflation, sustainable public debt, and sound fiscal and monetary policy), but President Trump has pursued large tax cuts without offsetting spending restraint, leading to rapid debt accumulation.
2. The country issuing a reserve currency must offer safe, highly liquid assets, particularly sovereign bonds, and investors must trust the government to repay and manage the debt responsibly. However, rising debt levels and threats of default undercut such confidence.
3. A reserve currency relies on a politically independent central bank, committed to price stability, based on a transparent rules-based monetary policy, but President Trump pressured the Federal Reserve publicly to cut interest rates and considers installing loyalists to key Fed positions.
4. A reserve currency must be freely tradable and exchangeable across borders with minimal restrictions. However, threats to block Chinese listings, penalise dollar-based payment systems, or exclude adversaries from SWIFT have created a climate of uncertainty around dollar access. (Setser 2021).
5. A reserve currency requires a legal system that protects foreign investors, enforces contracts, and provides recourse in case of disputes. President Trump used executive authority to sanction foreign firms, freeze central bank assets (e.g. Iran, Venezuela), and imposed tariffs on allies. These actions undermined the sense that US financial rules were impartial.
6. A reserve currency must be seen as a global public good, not a tool of national self-interest. But Trump’s policy of ‘America First’, disengagement from multilateral institutions (Paris Accord, WHO, NATO), and the arbitrary imposition of high tariffs has signalled that the dollar might be used strategically, not neutrally.
7. The reserve currency issuer must be large and influential in global trade and finance, encouraging broad usage. But countries like China, Russia, and Iran have increased non-dollar trade, and central banks have raised gold holdings and diversified foreign exchange reserves. ¹

All these factors help explain the recent fall in the value of the US dollar relative to other major currencies. If investors expect depreciation of the US dollar, hedging (through forwards and swaps) let investors neutralise exchange-rate risk by fixing future conversion rates. If many investors expect US dollar depreciation, hedging via these instruments produces large-scale US dollar selling pressure.

As of mid-2025, global foreign investors are estimated to hold approximately $14 trillion in unhedged US dollar assets — that is, investments in US dollar-denominated equities and fixed income that are not currently protected against exchange-rate risk (RBC 2025). Even small, expected US dollar depreciations can cascade into widespread hedging because so much trade and finance is invoiced in US dollars.

Pension funds, insurers, and sovereign wealth funds report returns in their home currency. As the probability of a weaker US dollar rises, fiduciary duty and internal risk models require them to hedge more systematically. Since euro, yen, Swiss, or CNY bond markets cannot fully absorb reserve flows, hedging is the ‘first line of defence’ for investors who want protection without dumping all US Treasuries. This makes hedging a natural and powerful response to waning confidence.

Widespread hedging itself makes Treasuries less attractive (via cross-currency basis widening), which further weakens confidence in dollar assets. Thus, once incentives to hedge emerge, they tend to multiply.

Implications of Hedging

The implications can be summarized in the following steps:

Step 1: Mass hedging. A large wave of US dollar-selling-forwards makes the US dollar more expensive to hold and hedge. That raises the effective hedging cost and therefore lowers the foreign-exchange-hedged yield foreigners earn on US Treasuries.

Step 2: Collapse of returns on US Treasuries. Once hedged yields are unattractive relative to local alternatives (Bunds, JGBs, Chinese bonds, cash, gold), marginal foreign demand for Treasuries weakens or reverses. Large institutional managers (pension funds, insurers) operate to target home-currency returns; when hedged returns fall, they must rebalance out of Treasuries. Rebalancing generates actual selling pressure in the cash Treasury market, not merely forward activity. Foreigners’ holdings are enormous and concentrated; the available alternative safe-asset capacity (Bunds, JGBs, Swiss, China) is too small to absorb rapid large flows.

Step 3: Liquidity stress in the US Treasury market. A large, concentrated sell wave causes dealers to increase margins, reduce quotes, and widen bid-ask spreads — creating market illiquidity. As the March 2020 ‘dash-for-cash’ indicated, even very liquid Treasuries became dysfunctional under stress.

Step 4: Fall in the value of dollar assets. A fall in the price of US Treasuries raises their yields (what investors require to hold Treasuries). This reduces the market value of other dollar assets (mortgages, corporate credit), and signals that the dollar is weakening as a store of value — prompting more reserve diversification.

Step 5: Margin calls and forced deleveraging. Leveraged players in derivatives and hedge funds face margin calls as dollar positions move against them; they sell assets (including Treasuries) to meet requirements, amplifying price moves. Many stablecoins hold T-bills and short Treasuries as reserves. A stablecoin run (forced redemptions) can produce real Treasury sell pressure at a speed and scale that traditional intermediaries cannot absorb, deepening illiquidity.

Step 6: Lack of alternative absorptive safe-asset capacity. Euro, yen, Swiss, and Chinese bond markets are too small, not fully open, or not sufficiently trusted to be immediate substitutes. That lack of a backstop amplifies the disorderly adjustment.

Step 7: Danger of dollar crash. A large rise in US Treasury yields in addition to liquidity dysfunction implies that the global supply of dollar-denominated safe assets no longer looks as safe or liquid as before. Reserve managers therefore reduce dollar share of reserves, increase gold, euro, yuan, SDR or other holdings, and use foreign exchange interventions and sales of dollars. Rapid and visible reserve shifts are interpreted by markets as a long-run structural exercise in de-dollarisation, leading to further selling of dollar assets.

Step 8: Stress on the US banking system. The stress arises from three sources. First, US banks hold large quantities of Treasuries and agency mortgage-backed securities. Sharp mark-to-market losses on Treasuries reduce banks’ book equity and regulatory capital ratios if losses are realised or if accounting and regulatory rules move unrealised losses through capital. Second, banks use Treasuries as collateral in repo and are counterparties in swap markets. A liquidity crunch can create margin calls and funding squeezes. If Treasuries cannot be rehypothecated at expected haircuts, banks may face funding shortfalls. Retail depositors may panic if they perceive bank solvency deterioration, leading to deposit outflows. Finally, banks’ exposures to dealers, money market funds, and shadow-bank entities mean stress in one sector propagates quickly. Overall, a run on Treasuries can provoke bank stress, particularly for banks that cannot rely on central-bank backstops, have large unhedged interest-rate exposures, or are forced to realise losses.

A crucial point is that such a crisis does not require a speculative attack against the dollar or a macroeconomic collapse in the US — only a shift in market expectations and a large mechanical flow (hedging) that stresses market plumbing. Markets are reflexive: liquidity and hedging costs matter at least as much as fundamentals. Because so much global finance is run to target hedged home-currency returns, a hedging shock is mechanically able to reprice, displace marginal demand, and create a run dynamic.

What Can Be Done?

The Fed has a toolkit (used in 2008 and in March 2020) to restore liquidity and calm markets quickly. First, it can provide large, time-limited liquidity to Treasury markets (primary market and repo market). It can engage in open-market purchases (buying Treasuries outright into the System Open Market Account (SOMA)) to absorb selling pressure and restore a functioning bid. It can offer overnight and term repos against Treasuries to primary dealers and other counterparties so they can warehouse Treasuries without being forced sellers. It can lend to primary dealers against Treasuries as collateral through the Primary Dealer Credit Facility (PDCF).

Second, it can activate dollar swap lines with other central banks to supply dollars abroad and reduce pressures that feed back into US Treasury selling. It can use currency swaps and foreign repo to help stabilise the global dollar funding market and limit cross-border pass-through.

Third, the Fed can support non-bank cash conduits and money market funds (MMFs). In particular, the Money Market Mutual Fund Liquidity Facility (MMLF) allows banks to borrow against securities bought from MMFs, preventing forced sales and runs. The Commercial Paper Funding Facility (CPFF) and similar facilities can backstop commercial paper and short-term funding markets.

Finally, with Treasury approval, the Fed can lend broadly to nonbanks and create special programmes (as in 2020) to support credit markets, including buying certain asset types. This is legally and politically constrained but feasible. The Treasury can use cash management (issue bills, offer to buy back or issue new maturities) to assist market functioning.

All these actions buy time, restore market functioning, and prevent a disorderly price collapse by providing counterparties with liquidity and absorption capacity.

However, large, prolonged Fed purchases (or an ‘unlimited QE’ promise) risk being interpreted as debt monetisation, undermining long-term confidence in the dollar as a store of value. That could accelerate reserve diversification — the exact opposite of the intended effect. Even temporary interventions may not restore foreign investors’ willingness to hold hedged Treasuries if foreign exchange-hedged returns remain unattractive relative to home alternatives. Thus, interventions can stabilise markets in the short term without stopping a longer-term shift in reserve preferences.

Because markets are reflexive, a risk that originates in otherwise prudent portfolio insurance (hedging) can become the very mechanism that destroys the asset being insured. The scarcity of credible alternative safe assets, the mechanics of the foreign exchange-swap market and basis, and the amplification via stablecoins and leverage mean that hedging alone — if done simultaneously and at scale — is a credible pathway to both a Treasury market crash and a broader loss of confidence in the dollar.

A sudden loss of confidence in the dollar as reserve currency would not only destabilise US Treasuries and the dollar itself, but also propagate through banks, money markets, stablecoins, and global trade invoicing. The result is systemic financial fragmentation, higher global volatility, and a restructuring of the international monetary system. In this fragmented world, countries become less dependent on one another economically and thus more prone to political confrontations.

See original post for references