personal views of a former fed trader

Breaking The System

The banking system is built on trust that the money one places in the care of others will be there when needed. This is as true for the retail investor with deposits at the local commercial bank, as it is for the sovereign with FX deposits at a foreign central bank. Hard earned trust is part of the magic that enables developed market sovereigns to massively deficit spend with limited consequence. The world happily holds their liabilities, be it in the form of deposits or sovereign debt. But that trust is weakened when sovereigns are seizing the assets of their own citizens and other sovereigns without due process of law. The liabilities of the banking sector and sovereign then cease to be risk free assets. Foreign sovereigns must now diversify as a matter of national security, and some citizens must now diversify as a matter of self preservation. This regime change can force a wild scramble into stores of value outside of the banking system including gold, real estate and even crypto.

Financial WMDs

Western sovereigns appear to increasing view the banking system as an efficient weapon for enemies both abroad and within. Targeted financial sanctions have the advantage of quickly subduing without the death and destruction of conventional weapons. The Russian economy was brought to its knees overnight through sanctions that effectively confiscated the deposits the Central Bank of Russia (“CBR”) held at major central banks. There is even ongoing discussion of confiscating the CBR’s assets held at the IMF. Without access to its foreign reserves, the CBR was unable to defend the ruble from significant outflows and watched helplessly as it collapsed by 50%.

Ruble depreciated 25% against the dollar overnight then continued to bleed

Canada also recently deployed similar measures against its own citizens. Canadian Prime Minister Trudeau invoked emergency powers to seize the bank accounts of truckers protesting pandemic related restrictions. Reports also suggested that donors who made legal donations to the protestors were prosecuted based on a retroactive application of the order. Protestors lost assets without any warning, due process of law, or potential recourse. Although this happened in Canada, many outside Canada took note and interpreted it in light of the rapid expansion of government power they see in their own countries. They realize that money in a bank can go poof at anytime regardless of deposit insurance.

Just in Case

Sovereigns across the world are now all alerted to sizable tail risk that they must manage. Foreign reserve managers are a risk averse group who are far, far more interested in safety than profit. They will happily accept -5% real yields, but even a remote prospect of losing all their assets is completely unacceptable. They now understand that the US and EU view banking sanctions as an effective tool that can even be deployed against prominent members of the global community. Risk free assets are no longer risk free.

Just as the unveiling of nuclear weapons in WWII set off a global arms race, so this revelation will start a scramble for alternatives. Any sovereign who aspires to conduct its affairs without kowtowing to foreign powers must be able to survive the confiscation of its foreign reserves. A quick glance shows enormous vulnerabilities for China and India, who both interestingly voted “abstain” on the UN resolution condemning Russian actions. Fiat currencies will continue to be essential for global trade, but there is no point in keeping so much if they may disappear when most needed. A much larger gold allocation is a necessary safeguard against the existential risks posed by financial sanctions.

China and India hold only a sliver of their fx reserves in gold.

Some members of the public will also hedge their assets in fear of government seizure. At least in the U.S., a sizable percentage of the population already perceive that they will lose their job or be “cancelled” for holding dissenting opinions. Trudeau’s actions confirmed their worst suspicions – “debanking” as a tool to suppress dissent. The public’s potential alternatives are broader than reserve managers and include gold, but also assets like real estate, crypto, and paper currency. Dollar currency in particular has long been a favorite of those evading government.

Dollar currency outstanding has been surging with $100 bills the most common denomination outstanding

Safety is Priceless

Safe asset status plays a key role in underpinning the the ability of advanced economies to run loose monetary and fiscal policy with limited consequence. In 2020, advanced economies spent 12% of their GDP on pandemic related fiscal stimulus while the emerging market economies only spent 6%. Poorer countries understand that they could not follow the US and spend 25% of their GDP without imploding their currency. Global investors happily hold newly printed dollars, but would quickly get rid of less established currencies.

Exorbitant privilege in action

This privilege can fade even without affecting the relative dominance of the dollar and euro. Investors could simply follow a well trodden playbook of shifting out of currencies and into tangible assets. This is common behavior in any country with weak institutions and increasingly relevant as advanced economies tarnish their halos. For the typical country, forever deficits and zero interest rates imply high and persistent inflation.

35 Comments

  1. Zaid

    The problem with shifting reserves to gold or some other asset is that countries that raise funds in USD and EUR will take on FX risk. The FX mismatch between foreign currency liabilities and reserves becomes a risk that could blow up their economies like in 1997-1998.

    This is true in Russia and China, both of which fund in foreign currencies. In the case of Russia, we will shortly find out what happens to all that USD-denominated debt owed to foreigners. Could the winners in this war demand reparations and enforce them by simply using the foreign reserve accounts? This happened recently when the US decided to pay victims of 9/11 using Afghanistan’s frozen foreign reserves.

    • Anthony

      All these developments just mean that interest rates and currencies will be increasingly driven by balance of payments, which will evolve primarily based on each country’s evolving competitiveness. In that sense there is lesser need to keep too much FX reserves around as buffer. China (and Russia and other emerging markets too) will switch to focusing more on their respective domestic markets to grow demand rather than external trade. China has been talking about dual circulation for example for a long time, which is really code name for building self-sufficiency.

      • Anthony

        Having said that, the potential FX mismatch on their books is real and is a risk to monitor. My guess is that the balance of USD-denominated debt will be debased/inflated away gradually over time, barring any big blowup event like what we saw with Russia.

  2. Zaid

    Correct me if I am wrong, but banks typically do not take any material risk on FX because of regulatory requirements on controlling FX mismatches between assets and liabilities.

    So the key metric here is total credit to non-bank borrowers in the reserve currencies.

    The last figures we have for Russian borrowing in sanctioned foreign currency, according to the BIS, is USD 149 billion and EUR 60 billion.

    Am I wrong to assume that this borrowing in foreign currency creates an equivalent and balancing position in reserves at the Central Bank?

    From a risk management perspective, it makes sense for the Central Bank to maintain USD and EUR reserves to offset this FX risk. Buying gold would be taking a directional bet at the country-level and would risk a similar crisis to 1997-1998.

  3. WhoCares

    A few quick thoughts.
    1. There is no such thing as risk free assets. It’s all relative. But you have a point and I even agree with it, with some of the caveats below.
    2. Safety is not priceless. It seems to be now, because we are still in a low-return environment and we have de-risked a truckload of investments. But the party is over now and it’s dandy time for markets to stop fumbling their pubes and start earning their fees again.
    3. Markets in general, financial ones in particular, tend to have – in my experience, at least – a quite short-lived institutional memory. Econ text books espouse the mantra that debt defeault or outright repudiation is a once-in-a-generation-type event, because markets will punish you for it. But recent (last half-century, or so) reality, by and large refutes this. Now we have a kind-of panic and it’s understandable. Why should it last forever? IMHO it will “re-normalize”, in a messy, perhaps even in a contradictory way. Like markets work, in general.
    4. What other safe (risk free) assets are out there? Well.. not many. It’s in vogue today to turn to crypto, which is a pile of hot mess and won’t go anywhere. Gold is very difficult to trade in large quantities. And I don’t think China or India would be able to provide a lower risk-environment than US Treasuries.
    5. Btw, the “risk free” nature also comes from other, more indirect features of any system: how deep, liquid, active, competitive the markets are. What kind of regulatory, legal, political, etc. risk there is or isn’t. How the fundamental macro stuff looks like – in simple terms: the net wealth of the country, region, place of that market. And so on. – These are very, very difficult to build/improve within a short time frame. Heck.. it’s difficult to build them well over the long run.. – You think China or India will provide better systems than the West? Or Russia? 🙂
    6. Risk free doesn’t mean we would have to play by the same rules even if our counterparty tramples on them. You’ll cross the red line, you’ll get slapped. It’s that simple. – If that makes you run to someone else.. by all means. Go see if anyone else is a better bedfellow.
    7. So I tend to think that this will be temporary.

    • Anonymous

      China doesn’t have to be better than the US. China only has to be not too risky. The way you engineer reliability out of unreliable systems is with redundancy. A 50/50 allocation of reserve assets to US+EU/China is less risky than a 98/2 allocation either way.

      Russia in particular still has 40% of its reserve assets available. Losing half of your reserve assets is painful but survivable.

      What is clear is that most of the world is overallocated to EU and US in terms of reserve assets. Chinese assets should be at least 30% of global reserve composition.

  4. Will

    what’s your take on how this differs from when this was done against Iran back in the mid-2000’s?

  5. Sebastian

    Bitcoin is undeniably the safest asset in human history. It is currently perceived as a high risk asset and thus – as you point out – not an option for reserves. However, a realization of its qualities by the public may very quickly set a dynamic in motion.
    Other than that, I really wonder why gold is not rallying much more.

    • Aaron

      “Bitcoin is undeniably the safest asset in human history.” – Sebastian

      In the past year BTC is down 25%, which whatever. The issue is how it got there.

      From Mar. 8, 2021, to today, it went up 20% and down 55% and then up 130% and most recently down 50%. That on the risk scale of assets is what is called extreme risk.

      The volatility that makes BTC good to trade is exactly why it’ll never be viewed as a safe asset by those who have other choices. Meaning everyone but sovereign dictators and criminals and criminal organizations of various types.

      • Philip Almond

        The volatility is a function of the time horizon, in one year it looks like crap, but in 10 years it looks great. If you are storing value, you’re not all that bothered about a 1 year horizon.

        • Anonymous

          View the bitcoin comprehensively, you can see its price soared in 2020 enormous times.

      • Carlo

        There are 100 million people from all over the world who choose to hold Bitcoin. We are a heterogeneous group with different ideologies, polticial beliefs, and reasons for holding.

        It may not be for you, but that doesnt mean it’s only for criminals and dictators. Have an open mind buddy. Cheers.

        • Anonymous

          According to the article written by Business Insider in 2018, there are 350 million people from all over the world who choose to use dollar.

          • Anonymous

            Just in US is 330mln people… Dont understand your point….

      • Josep

        The volatility of Bitcoin it is just as the volatility of any other commodity.

        • Anonymous

          That means Bitcoin is nothing more than some kind of commodities, not a monetary unit.

          • Anonymous

            Was federal reserve note (USD) stabile monetary unit after fist 13years of its existence after it was introduced in 1913???

    • Max

      This is absurd claim because bitcoin requires a highly organized human society to function. You need a lot of electric power. You need sophisticated computer production. You need a global connected network that is expensive to maintain.

      Global warming is risking all of the above. Ultimately it’s a highly risky asset with a probable value of zero.

      • Anonymous

        “… You need a LOT of electric power…”
        A LOT compared to what? Existing financial system? You’re wrong. It consumes more than 3x less energy…

    • 911Truther

      Real assets don’t require the greater fool. Cytpo investors have one exit strategy, and one only: sell to a greater fool.

      You could buy a house. You don’t have to sell it to a greater fool in order to realize the benefits of owning it. You can live in it, use it as a 2nd home or rent it out. You don’t have to sell it.

      Stock can be held for dividends. With companies that don’t pay a dividend, you can sell to someone else, but the buyer can see the potential for earnings which could be used to pay dividends. The guy buying your non-dividend stock is buying the potential earnings (which lead to dividends). This is not greater fool.

      If you are dumb to loan money today, you could buy bonds and hold to maturity and collect the interest payments. You don’t have to sell to a greater fool.

      You could also stock pile ammo, gold or canned goods. You could use these things yourself or you could sell them to someone else who has a use for them. The buyer is not a greater fool.

      When you realize your only exit strategy is to sell to a greater fool, you know it’s a foolish “investment”.

  6. Paul OBrien

    Really important topic; glad you are on it. Two points of disagreement:

    Gold does not help much. To use it you need to transform it into a fiat currency, at which point the sanctions get you.

    The major reason countries hold liquid FX reserves is to back up FX indebtedness of their public and private sectors. If those reserves are deemed unsafe, the main response will be to restrict/prohibit borrowing in foreign currencies. EM countries will have to bower more in their local currency.

    • Kanefire

      In that context, i would put gold in a similar category as a reserve note. Not usable in cash, but a liquidity provision that allows the system to optimally function… and a far more trustworthy (over history) than any fiat.

  7. Kevin Waspi

    Time for a new asset class?
    How about Return Free Risk.

  8. Anonymous

    Can we assume CCP corrupt officials may have moved 10 to 20 times the 3 trillion foreign reserves overseas? If so, the US could seize all that dirty money and repay the national debt?

    • William Sperry

      lol

    • Shane Martinez

      That would be the equivalent of an act of war. One of the reasons that China isn’t invading Taiwan is because the corrupt upper ranking members of the CCP have parked all of their assets overseas.
      It’s strange to see nuclear superpowers stepping on each other’s toes.
      And if this continues that I would be bullish for gold bullion and doomsday bunkers I guess.

  9. Steve A

    Real Gold and other Real assets can now be tokenized unto the blockchain. A number of blockchains such as XRPL is doing it.
    That could be the solution for asset transfer between parties. I don’t have the full details as to the mechanics of the process.

  10. Aaron

    ” Reports also suggested that donors who made legal donations to the protestors were prosecuted based on a retroactive application of the order. ”

    I’m no fan of Prime Minister Trudeau, but Joseph, for your information, the story you linked to in the DailyMail should not be even classified as “suggested”.

    The MP who made the reported tweet was subsequently called out in public after the RCMP, Canadian Bankers Association, and Government of Canada, upon learning of the allegation, all publicly denied money/accounts had been frozen pre-emptively. News agencies asked the MP for further details to substantiate the story he had presented and he refused to provide them. In short, sadly in Canada some of our politicians lie for attention too.

    Here’s a news story in the Globe and Mail (Canada’s newspaper of record) about it. I think the real link is pay walled (not exactly sure, as such, I’m providing a link to the Google cache text version.

    “RCMP, banks and Ottawa say convoy protest donors won’t have accounts frozen after viral tweet said otherwise”

    http://www.theglobeandmail.com/canada/article-rcmp-banks-and-ottawa-say-convoy-protest-donors-wont-have-accounts/

    webcache.googleusercontent.com/search?q=cache:KErZ0L4xk8QJ:https://www.theglobeandmail.com/canada/article-rcmp-banks-and-ottawa-say-convoy-protest-donors-wont-have-accounts/&hl=en&gl=ca&strip=1&vwsrc=0

    • Aaron

      Sorry there was a typo at the start – where is says “pre-emptively” it should say “retroactively”. In this case meaning prior to the legislation coming into force.

      Further for context about all of this, much of the hoopla that led to this was because over half of the money that the protest organizers received came from the U.S. Which I think you’d agree steps into that sticky area of potential foreign interference in domestic politics. Now off the top of my head I can’t seem to place it at the moment, but I’m pretty sure that sounds like something the United States has dealt with recently perhaps? 😉

      • suddyan

        [over half of the money that the protest organizers received came from the U.S. Which I think you’d agree steps into that sticky area of potential foreign interference in domestic politics.]

        No, it did not.

        No, it does not.

        • Aaron

          Great rebuttal. The strength of your comment is equivalent to its length.

    • suddyan

      [“Reports also suggested that donors who made legal donations to the protestors were prosecuted based on a retroactive application of the order.”

      I’m no fan of Prime Minister Trudeau, but Joseph, for your information, the story you linked to in the DailyMail should not be even classified as ‘suggested’. ]

      “However in at least one instance detailed by Mark Strahl, Conservative MP for Chilliwack—Hope, a single mother in his district had her bank account frozen under the order after she gave $50 to the convoy when it was ‘100% legal.'”

      [Here’s a news story in the Globe and Mail (Canada’s newspaper of record) about it.]

      Oh yes, of course, Canada’s official newspaper of government propaganda.

      • Aaron

        You do realize the MP that I was referring to above was Strahl? When he was called out on tweet and asked to provide evidence that the “single mother” was real, he refused. So thanks for playing, but I’ll take the word of the RCMP, Canadian Bankers Association, Government of Canada, and Globe and Mail (Canada’s #1 Business newspaper on par with the Wall Street Journal), over a lying politician any day of the week and twice on Sunday.

  11. raef

    Wiemar Germany people, look it up a classic as to why you should have a couple of ounces laying around the house and ready to go at a moments notice. Im sure if the general population of both Ukrain and Russia could put a couple of coins in there pocket a bag of clothes they would be leaving with some hope. The russians will be getting their visas deniesd soon and unable to leave russia.
    The gold price has been manipulated down since the eighties Greenspan admitting in the early 2000’s that the US gold reserve was held in Deep Storage in Russia no doubt. Bernanke’s printing press speach of 2004 about not needing gold on and on about gold not having any value. The central banks have worked together for years to devalue gold simply to promote affordable gold plated plugs and chips for technology advancement.
    Well here we go what percentage of the world is about to be displaced from there homes through war and natural disasters and plagues / famines that are comming this way. High fuel and fertiliser prices may deter farmers from planting crops. More outbreaks of aleged Natural Viruses are highly probable.

    Big trouble ahead have a back up plan in place be ready to leave your house at a moments notice with something in your hands. Have at least some alternative directions to go.
    My thoughts only.

  12. Josep

    You are the best Joseph, tysm.

    I suspect Michael Saylor was (at least partially) right. “The entire world will be desperate to find a Store of Value”. The other side of his ecuation is Bitcoin, for its superior censorship resistance and superior generational wealth transfer (real assed, treasured within a predictable inelastic supply fashion) attributes against other real assets.

    Sell off in bonds?????

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