From Solid to Gas

While there are others, matter typically comes in three phases: solid, liquid, and gas. Changes between two phases are known as transitions. For instance, when water (a liquid) is stored in a freezer long enough, it transitions into ice (a solid).  Global monetary policy may be in the midst of a phase transition itself.

Prior to World War II, British gilts were considered the dominant safe asset, playing the role of the top global reserve currency (a foreign currency held by most central banks). Following the war, the Bretton Woods system was implemented, and the rise of the U.S. dollar as the new top reserve currency coincided. Most foreign currencies then were pegged to our dollar, and it was backed by gold. This promoted exchange-rate stability and hindered competitive devaluations. Metaphorically, this was our dollar’s solid phase.

Initially, as the global economy grew, the dollar’s role of reserve currency was fortified. Countries increasingly transacted business in dollar terms, causing foreign central banks to hold a growing number of U.S. treasuries on their balance sheets. Simultaneously, America offered strong legal protections for investors and the nation’s financial markets were growing capacity. Then the currency reached its “liquid phase” as the United States ended dollar-gold convertibility in the early 1970s under President Richard Nixon. America’s central bank and government fiscal policies grew looser, markets more fluid as currency pegs began disappearing worldwide, and trade flowed relatively freely across borders during an era of globalization.

From a thermodynamic lens, molecules of gas move more freely than those in liquid and solid states. Today, even looser monetary and fiscal policies may be pushing markets into a similarly more volatile, gaseous phase. Rising national debt and the Federal Reserve’s expanding balance sheet are helping promote this shift. Increased volatility has appeared in U.S. markets at least twice over roughly the past year. When tariffs were introduced last year and stock prices fell, Treasury yields moved higher as bond prices fell. A similar pattern emerged this year when the war in Iran triggered a stock market sell off and yields rose again. Higher yields were not what most models would have predicted for growing stock volatility.

There could be some reason for cautious optimism, though. Phase transitions aren’t unidirectional. The depth and ubiquity of America’s treasury market make it worth preserving. Despite its flaws, there is not another market available with the scale, legal robustness, and institutional interconnectedness. These conditions may help condense the system back into something more stable again, but this will ultimately depend on the behavior of global investors.