The soft underbelly of US foreign policy

It’s been an eventful start to the new year on the US foreign policy front. For some time, rumblings surrounding US President Donald Trump and Greenland have been the headlines du jour — a topic that dominated discussions at the World Economic Forum in late January. In this piece, we break down the latest developments and unpack the market implications. 

What happened?

At the forum, President Trump walked back his rhetoric on the use of US military force to acquire Greenland. While this removes the most extreme risks, it doesn’t fundamentally alter the market or geopolitical implications of the ongoing episode. Instead, it clarifies how US pressure is intended to be applied from here.

Why it matters

Crucially, the Greenland development reveals a key potential weakness of US foreign policy strategy and its intersection with domestic policy — namely, US dependence on external capital, with a significant portion coming from Europe.

Market implications

• The European Union (EU) holds nearly US$5 trillion in USD risk assets¹ (financial assets excluding Treasuries and agencies), even after stripping out the custodial centers of Belgium and Luxembourg.
• If angered by trade measures or territorial encroachment on an area like Greenland, there are several economic levers Europe could pull that would prove painful for US consumers, savers, and elected officials.

What Trump clarified in Switzerland

At the World Economic Forum in Davos, Switzerland, President Trump stated that the US would not use military force to acquire Greenland. At the same time, he reiterated his view that Greenland is strategically vital to US national security and announced a “framework” deal on the issue.

This new development does matter in a narrow geopolitical sense, as President Trump reduced the tail-risk scenario of direct US military confrontation with a NATO ally. Such a confrontation would be no small thing, as NATO has been a bedrock national security institution for both the US and Europe since its founding in 1949. From a geopolitical perspective, a breakup would be historic and epoch-defining.

This reduced invasion risk has important implications for the Ukraine-Russia conflict, which will likely require a NATO role for security guarantees in any ceasefire agreement. It also matters greatly to US-China great-power competition as NATO has made countering China a central plank of its future security goals, particularly in the Arctic. 

But from a market perspective, the Greenland crisis is far from over. Why? President Trump’s remarks in Davos were paired with renewed tariff threats against European allies should upcoming negotiations fail. In other words, military coercion has apparently been ruled out, but the possibility of economic coercion against key European allies has been reaffirmed.

President Trump’s reframing sets a new trajectory for the Greenland crisis, which is now likely to move into a lengthy and complicated negotiation stage. It also reveals a potential weakness in this administration’s more assertive, transactional approach to US foreign policy. 

The soft underbelly of US power 

As noted above, the EU holds a substantial amount of US securities. The EU doesn’t necessarily have to sell them to inflict pain upon US equity and credit markets (though this could certainly be an outcome in a break-the-glass scenario).

Instead, it may merely defer adding to those asset classes over time. This would imply a headwind for equity valuations and additional risk premia in credit markets. Moreover, the headwind for capital markets would likely prompt a negative feedback loop that diminishes the wealth effect consumers are currently experiencing.

This dynamic also means that Europe doesn’t need a comparably sized military right now to push back on US actions in Greenland. It has a weapon in the sheer size of the US capital account surplus and the depth of its financial integration across the Atlantic. It’s important to note that not all of the assets are held by government or quasi-government entities, which could likely react faster based on government policy. But private sector preferences could also change, either due to policy uncertainty from the US and/or an outright buyers’ strike (which, it’s worth noting, is different from selling) by the European private sector, who may feel pressure or moral suasion to support their governments. We think there’s too much emphasis on Treasury markets, where the US government has several options to manage its liability portfolio, and not enough market focus on the risks to equities and credit.²

We also think it’s important to highlight the role of the dollar in this shifting geopolitical context. The European private sector need not sell its dollar holdings but merely hedge its dollar exposure at a higher rate over time. The cross-currency basis is often described as “shadow demand,” or hidden demand, for US dollars. It reflects the demand for US dollars in a world where covered interest-rate parity³ does not hold. The change in the basis (becoming less negative or moving into positive territory) shows that overall demand for US dollars has already started to decline relative to the euro, yen, and pound sterling.

Recently, we’ve seen movement in the basis as this shadow demand gradually weakens. Several factors could be driving this move, including more normalized interest-rate markets abroad and shifts in global monetary policy stances. But, in short, the moves in the cross-currency basis reflect reduced aggregate demand for US dollar assets. In a direct comparison, the US dollar never fully recovered from the shock of “Liberation Day” tariffs. This gradual withdrawal of dollar demand can, over time, have substantial cost-of-living implications for the US. 

At the same time, the trade deficit essentially signals that the US consumes more than it produces, and the trade differential is financed via the capital account. In short, the world is happy to give US consumers goods in exchange for dollar-based assets (which are liabilities for the US). Weakening demand for the greenback over time would impact the high standard of living that comes hand in hand with being the global reserve currency, a status the USD has enjoyed for many years. If this change were to happen slowly, it may not be immediately perceptible, but if it were to occur suddenly, the impact would be far more immediate for the US population, who would face substantially higher inflation.

Naysayers will assert that the EU’s possible reliance on central bank swap lines (such as those between the Federal Reserve Bank of New York and the European Central Bank) will prove too important to the EU. We disagree for several reasons: 

• Euro-area policymakers know that using those swap lines now would come at an exorbitant political cost, unlike in the summer of 2011, thus making their use fraught with danger. 
• Over time, these policymakers are likely to make sure their financial institutions become less reliant on wholesale markets for US dollar funding. 
• The European Central Bank could proactively set up swap lines with other central banks that already have access to substantial US dollar sources. 
• Euro-area officials can encourage goods and trades invoices, which have historically used the USD, to shift toward euros. 
• All these steps would require the euro area to maintain a close fiscal union to support a resilient euro. 

What this means for markets and geopolitics

Why does this matter? Capital market instability driven by foreign policy is toxic to incumbent parties who face elections. Three things power the US economy today: fiscal policy, AI capex spending, and — critically here — substantial spending by the upper quintiles of the US consumer. 

This third driver depends on these US consumers experiencing a wealth effect in the form of home-price appreciation and liquid net worth. Disrupting this effect would be politically damaging to the executive branch as well as the Republican Party in the House and Senate. This, along with the steepening of the 30-year Treasury bond, was the key pain point during the April tariffs episode. 

Previous US administrations moved slowly and deliberately in these areas, only upsetting the market when forced to and when they sensed broader consensus across their population. Undertaking foreign adventures with financial blowback on American consumers when there is a sharp divide in public opinion could be tantamount to forfeiting an upcoming election.

In this case, investors have been forced to consider a potential US military conflict with NATO allies. If such a nightmare scenario comes to pass, along with an ensuing trade war, US capital account flows would likely be devastated, while the government would have to consider the Armageddon-like policy of capital controls. 

These negative market outcomes remain possible until the Greenland issue is resolved, which adds new uncertainties and new risks to US foreign policy — despite the modestly positive developments coming out of Davos. 

What else should investors expect as the Greenland saga plays out? 

• Ongoing fraying of the US-transatlantic relationship, with even more urgency among European governments to decouple their national security from Washington 
• Accelerating fragmentation of the global order, with new geostrategic opportunities for China, Russia, and other countries now “caught in the middle” of great-power objectives
• Positive policy and market tailwinds for defense, defense innovation, energy, and other national-security-related themes
• Increased disruption and more differentiated outcomes — a structural positive for active-management and long-short strategies in particular 
• A wider set of potential geopolitical and policy outcomes, necessitating more scenario planning and new diversification strategies 

¹ US Department of the Treasury, Treasury International Capital (TIC) System, 2026. | ² Former US Treasury Deputy Assistant Secretary Brad Setser has already noted this, and we agree with his analysis. | ³ Covered interest-rate parity means that between currencies, the interest-rate differential must equal the difference between their spot and forward-exchange rate. This doesn't happen in practice, and the basis is the additional amount it takes to make that parity true.