Happy New Year

Some thoughts

Happy New Year.

For many, it is time to turn their attention to snow and the mountains. Skiing mixes the invigorating exposure to natural beauty with the element of danger. It is also time for thoughts about the year ahead. Here are some of mine.

Photo by Nicolas Cool on Unsplash

I note a fear among some US commentators that fiscal dominance will become an overriding problem in 2023, and cause the Fed to pivot completely in an effort to support the Treasury market.

Perhaps. I see the fiscal dominance as an US-centric expression of the threat I have focussed upon throughout 2022. Fiscal dominance sees government funding as the driver of disruption, and abrupt policy reversal. I believe global liquidity, overseen by the Fed, is the principal route. In reality, there is no contradiction, they are simply two sides of the same global dollar liquidity dynamic. However, there is a difference in timing: my assessment is we have already in the early stages of global liquidity ‘distress’, whereas the fiscal dominance argument suggests that distress is yet to arrive in the United States.  I concede I believe the FOMC will only take notice of distress once it arrives within the United States, so I don’t see there is much difference in our positions.

By the way, I don’t think distress is something that can be avoided, and I don’t think Jerome Powell believes it can be avoided. In fact, Jerome Powell and colleagues seem keen to avoid a Wikipedia entry that makes them responsible for freeing the inflation dragon Paul Volker is said to have slain. We can assume, therefore, they will continue to hike, ignoring UN requests to ‘go easy’.

Here are a few things to bear in mind for the coming year:

1. Post-GFC reforms have reduced the capacity of broker dealers to act as shock absorbers in the Treasury market, and also ensured money-market funds are capturing masses of collateral, and hogging liquidity, in the ultra-short-end of the market. As a consequence, the Fed is already flirting with loss-of-control of short-term rates. The main US banks will be fine.

2. Reserves via FedWire are now the main settlement medium for US financial markets. A key to asset market behaviour is the availability of that settlement medium. A higher fiscal funding need is likely to be accompanied by a rise in Treasury General Account holdings at the Fed, which is effectively a drain of settlement medium. That is unambiguously negative for asset prices. 

3. The Fed’s current tightening policy, and in particular, the QT element of that policy, results in increasing levels of distress for assets exposed to explicit or implicit ‘default’ strikes. After two decades of low interest rates/QE, the financial system is full of these types of assets, and distress will not be limited to what is commonly thought of as ‘vulnerable’ assets, though they are certainly not immune (for instance, dollar denominated Eurobonds, which amount to >12% of global GDP). The UK’s LDI episode is a good example of a surprise candidate to show vulnerability to ‘default strikes’. The spike in Gilt yields in October was caused by badly configured leverage in pension hedges which amount to an implicit ‘default strike’. This vulnerability was hidden by low rates – till recently. In October, the Fed’s withdrawal of global liquidity cause Gilt yields to rise and threatened the ‘strike’ and directly led to subsequent Bank of England intervention. A funding difficulty in Treasuries means the Fed may find itself in more-or-less the same position as the Bank of England, though with altogether more consequential responsibility. 

4. Few anticipated the ECB would become so openly hawkish. A recent speech by the German ECB Council member Isabel Schnabel was openly aggressive. But note, the ECB already made contingency plans for the distress caused by QT with their Transmission Protection Instrument (TPI) – which effectively allows them to turn on QE for selected countries while nominally following monetary tightening (including QT) elsewhere. With this instrument the ECB can tighten and ease for different member states at the same time – similar to the Bank of England’s ‘temporary lender of last resort’ behaviour in October 2022. If this instrument is deployed, it will further fray political cohesion in the EU. On current trends, expect the TPI to be deployed around mid-2023, perhaps earlier. 

5. Watching closely for policy changes at the BoJ – especially when Kuroda leaves office in April 2023. There is deep unease among BoJ staff about Yield Curve Control (YCC) policies in Japan. Japanese inflation has not been offset by wage increases, so price rises directly impact Japanese consumption. If the Fed has not pivoted by April, expect the BoJ to turn away from YCC shortly after Kuroda’s retirement. If that happens, there would be a whole other level of global liquidity mayhem to layer on top of the Fed’s disruption. 

6. The PBoC is actively engaged in monetary easing – 180 degree opposing Fed policy. This explains the recent behaviour of the renminbi. Underlying this is a recognition by Chinese authorities that their banking system cannot afford to follow the Fed, but equally cannot ignore the Fed. Consequently, COVID restrictions are lifted abruptly and Chinese banks are rapidly exiting the dollar carry trade, meaning deleverage of dollar balances. They also seem to be foreclosing on dollar loans to third parties, possibly swapping the debt for equity. In 1997, the withdrawal of global liquidity intermediation by Japanese banks precipitated the Asian Crisis. The Chinese banks now appear to be withdrawing funding from their foreign clients, so more difficulty can be expected. 

Carmen Reinhardt & M. Belen Sbrancia wrote a really good paper on fiscal dominance in 2015, arguing that financial repression (including inflation) may be needed to address the fiscal problem. That paper is even more relevant now – available here: https://www.imf.org/-/media/Websites/IMF/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp1507.ashx

That’s enough! Happy New Year.