Stress Tested: How VaR Mechanics Weaken the US Dollar
Some clients have been asking whether the United States could lose its two star rating under our Net Foreign Assets (NFA) framework. While a formal downgrade to one star (the lowest rating) remains unlikely, this perspective illuminates how capital reallocates under stress and explains why the US dollar has been weakening in the current volatile markets—despite its traditional safe‑haven status—and highlights vulnerabilities to sudden outflows that conventional indicators may miss.
NFA measures a nation’s cumulative current account deficits adjusted for valuation shifts—such as changes in exchange rates, equity prices, and other asset values. When a country’s deficit roughly matches its nominal GDP growth, the NFA‑to‑GDP ratio stays stable; larger deficits weaken it, while surpluses or faster growth strengthen it. As the world’s reserve currency, the US benefits from dollar‑denominated liabilities that are largely insensitive to foreign‑exchange swings. Nevertheless, valuation changes—particularly equity market movements—still matter. Relative strength in US stocks inflates external liabilities, while sharp sell‑offs can moderately improve the NFA position.
Beneath these valuation effects lie deeper structural pressures. Chronic under‑saving relative to investment, persistent fiscal deficits, and a national debt exceeding 100% of GDP make US debt servicing increasingly burdensome. Demographic headwinds—slower growth in the working‑age population—further constrain potential output, limiting the extent to which productivity gains can offset fiscal and demographic drags.
However, the most decisive driver of capital flows during stress events is the mathematics of Value at Risk (VaR) models. Widely used by institutional investors, VaR algorithms attempt to cap expected losses by automatically adjusting portfolio risk to market volatility. In calm markets, VaR permits greater leverage, encouraging risk‑taking and asset-price appreciation. When volatility spikes, it forces systematic deleveraging to meet stricter risk thresholds.
This mechanism is entirely mechanical: as volatility inputs rise, risk metrics tighten, compelling portfolio managers to sell assets until they comply with VaR constraints. Since the largest providers of capital are institutions based in creditor nations, this forced deleveraging translates directly into capital withdrawals from debtor economies—including the US.
The currency effects are predictable. During recent stress episodes, the dollar weakened sharply while the Japanese yen, Swiss franc, Canadian dollar, and euro appreciated. For example, the Canadian dollar’s rally reflected Canada’s superior external position and stronger NFA standing. These moves result directly from VaR‑driven risk limits interacting with underlying NFA fundamentals.
The same principles apply to sovereign bond markets. Creditor nations with robust NFAs generally enjoy lower yields, while debtor nations face higher borrowing costs. The NFA differential fully explains the gap between US and Canadian government bond yields, and the same principle applies across the sovereign bond market—provided you know each country’s relative NFA standing.
Monitoring volatility indicators—such as the VIX index and credit-spread levels—provides early warning of impending capital shifts. VaR‑driven flows can override traditional safe‑haven assumptions: as volatility rises, capital systematically migrates from larger debtor nations (now including the US) into high‑NFA currencies and high‑credit-quality bonds. Recognising this dynamic—and acknowledging the gradual deterioration of the US NFA position—is essential for positioning portfolios during this and the inevitable next wave of market stress and capital repatriation.
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