Month: April 2022

Authored by Michael Lebowitz via RealInvestmentAdvice.com,

Financial sanctions weighing on Russia are sending up red flags around the globe. The seizing of Russian foreign reserves and eliminating access to SWIFT is leading Russia and other countries to reassess the role of dollars in global trade. Today, there are likely quite a few central bankers and heads of Treasury asking themselves- Dollars, Gold, or Rubles?

This article explores the problem vexing Russia and her trade partners. We explore how sanctions and the threat of sanctions may force some countries to contemplate weaning off the world’s reserve currency.

Reserve Currency Status

The rule of law, economic and military might, and the most liquid capital markets are the principal reasons the dollar is the preferred currency for most global trade, as shown below. Because of its status and global acceptance, the U.S. dollar is considered the world’s reserve currency. For more on the dollar’s status, please read our article Triffin Warned Us.

Despite Washington’s reckless monetary policy and burgeoning trade and fiscal deficits, the dollar remains the world’s reserve currency. The benefit to the U.S. is that countries with dollar reserves must invest in U.S. Treasury securities regardless of yields. As a result, about a third of U.S. Treasury bonds are held by foreign entities. Given the ability to run massive deficits and fund them easily, it should not be surprising that American politicians want to keep the dollar as the world’s reserve currency.

Some media and investment analysts cite America’s monetary and fiscal irresponsibility as reasons for the dollar’s death. Yet, with each crisis, financial, health, or geopolitical, the dollar appreciates against almost all currencies. Like it or not, there are no better options. Even our enemies transact in dollars and hold U.S. Treasury bonds as reserves. That may be slowly ending as Russia, and other countries are exploring.

“We are addicted to our reserve currency privilege, which is in fact not a privilege but a curse.” 

– James Grant, Grant’s Interest Rate Observer.

Regardless of your view of whether it’s a curse or a privilege, politicians will fight to keep the reserve status and do everything, including war, to retain it. The “privilege” allows politicians to run unthinkable deficits and live above our means. It also keeps politicians and their parties in power. Anyone considering a speedy death of the dollar best brush up on political priorities.

Russia

One of the most biting sanctions against Russia is freezing her U.S. dollar reserves. Reserves are currency, bonds, bills, and other government securities held by a central bank.

Like freezing your banking account or stealing your wallet, the sanctions against Russia cripple their ability to conduct foreign trade.

Here is how President Putin thinks about the freezing of Russia’s reserves:

“The illegitimate freezing of some of the currency reserves of the Bank of Russia marks the end of the reliability of so-called first-class assets. In fact, the U.S. and E.U. have defaulted on their obligations to Russian. Now everybody knows that financial reserves can be stolen.”

The U.S. and Europe took control of Russia’s primary means of conducting trade. We can debate the pros and cons of the sanctions. Still, from an investment perspective, our time is best spent thinking about how Russia and other countries, enemies, and foes, might shield themselves from similar tactics in the future. 

What Is Russia Doing?

Russia is a major exporter of agriculture, energy, and metals. They are heavily reliant on imports like computers, machinery, vehicles, and pharmaceuticals.

Russia has a colossal trade problem on its hands. In addition to many countries boycotting trade with them, their foes are likely not willing to accept rubles as payment for goods.

Why? For starters, there is no rule of law in Russia. Add to that a flawed and corrupt banking system and illiquid securities markets. Further, Russia most recently defaulted on its debt in 1998 and could easily do so again.

As if that weren’t enough to dissuade you from holding rubles, the ruble’s value, as shown below, is highly volatile. Maintaining purchasing power is a vital trait of a dependable currency.

Countries, such as India, are not able or willing to uphold sanctions and must have Russian imports. Despite sanctions, global trade between India and Russia will not end. Instead, countries like India are seeking a “workaround.”

Russia recently demanded that “unfriendly countries” pay for natural gas in rubles. Before the conflict, about 97% of Russian energy giant Gazprom’s foreign sales were in dollars and euros. Now it appears gold and rubles will play a role.

Can Gold Replace Dollars and Rubles?

Given that trade with Russia will not cease despite sanctions let’s consider how transactions might occur.

Most often, global trade transaction payments occur over money wires. They are the fastest and most secure way of transacting. Having lost access to SWIFT and not able to access its dollar reserves, Russia is seeking alternative payment methods. (SWIFT is a network of banks and financial institutions sending and receiving electronic funds transfers.) 

Russia would like to pay for foreign goods with rubles and receive gold or rubles for their goods. However, we doubt their trade counterparts have a desire to accept rubles for the reasons we note. Given that using dollars and euros is now exceedingly difficult, and no one wants rubles, the only feasible currency alternative is gold.

Gold, however, presents a different set of headaches due to the transportation and storage requirements to keep it safe.

That said, gold can be held as a reserve currency and converted to any currency the seller of goods prefers. For example, if Pakistan wants Russian goods, they can convert their rupees to gold and gold to rubles to complete the transaction.

Russia and other countries can retain their gold within their respective borders and not fall prey to seizure as is occurring with its dollars.

While currencies are now longer fully backed by gold, many countries hold substantial gold stocks. The graph below, with data from the World Gold Council, shows the top ten central bank holdings of gold.

Gold, Rubles, or Bitcoin?

We must presume other countries are thinking about the safety of their reserves. Shouldn’t the threat of seizure of dollar reserves worry countries like India, Iran, or Saudi Arabia? Their ability to trade rests on the whims and politics of the U.S. and Europe?

Bitcoin presents an option to gold reserves and traditional currencies. However, with Bitcoin come other problems.

First and foremost, it appears bitcoin might be subject to seizure. Per law firm DLA Piper: On February 8, 2022, the United States Department of Justice (DOJ) announced a landmark seizure of 94,000 Bitcoin valued at over US$3.6 billion, the DOJ’s largest seizure of cryptocurrency ever and the largest single financial seizure in the department’s history. 

Second, cryptocurrency prices or exchanges rates to other currencies are extreme. As we show in the SimpleVisor graph below, the price of Bitcoin has been cut in half twice in the last year. It has also doubled. Lastly, Bitcoin does not pay interest. That may not be a problem in the current low-interest-rate environment, but it will be in a higher rate situation.

Summary

We are not suggesting the dollar loses reserve status. But we do want you to consider that some countries now have more incentive to seek an alternative payments source to the dollar. Gold is not the only solution but a currency that has worked for millennia and is helping Russia today.

Will enemies of the U.S. stop using dollars? Highly doubtful. Will they possibly add gold to their reserves? Most likely.

Gold has been used in trade for over 5000 years, and we suspect its popularity will increase going forward.

We leave you with a recent headline from the IMF:

IMF WARNS RUSSIA SANCTIONS THREATEN TO CHIP AWAY AT DOLLAR DOMINANCE

First, the good news: after yesterday’s unexpectedly hawkish comments from Fed resident liberal, Hillary supporter and uber-dive, Lael Brainard, the potential for another hawkish surprise from today’s FOMC minutes has been largely eliminated. As a result, investors now anticipate an even more aggressive baseline on how the Fed will run down its balance sheet and that’s likely bearish for Treasuries.   That’s because Brainard made it quite clear: “the Committee will continue tightening monetary policy methodically through a series of interest rate increases and by starting to reduce the balance sheet at a rapid pace as soon as our May meeting.” Also, she said that she expects “the balance sheet to shrink considerably more rapidly than in the previous recovery, with significantly larger caps and a much shorter period to phase in the maximum caps compared with 2017–19.”

By endorsing (an accelerated) May balance-sheet runoff timing, she telegraphed what investors will likely learn at the May FOMC and that’s exactly how the Fed intends to reduce the size of its balance sheet in the coming quarters.

Of course, the bad news is that the Fed – which remains woefully behind the inflation curve…

… may surprise with even more hawkish pronouncements in today’s Minutes, which is why as Bloomberg’s Alyce Andres writes, “it’s tempting to sell the rumor and plan to buy the fact, but the problem is that Fed Chair Jerome Powell and team continue to deliver hawkish surprises.“

With that in mind, here is a preview of what Wall Street consensus expects today, courtesy of Newsquawk

SUMMARY: The FOMC Minutes will be critical for gauging the parameters of the balance sheet runoff process after Fed Chair Powell told us more details would be available within the release. Details eyed include the pace of the runoff, where expectations for the maximum monthly caps lie between USD 60-100bln per month of Treasuries and MBS. Whether the caps start small and grow or begin immediately at the max will be key, particularly for signalling, given the formal announcement will likely be made alongside an expected 50bps rate hike at the May FOMC. Other details include the asset composition of the runoff, any size or calendar guide for completion, and the Fed’s appetite for outright asset sales. On rates, with market pricing for a 50bps May hike at 80%, and probabilities of more ‘double’ hikes at future meetings also growing, commentary on the debate for the larger increments will be eyed given the appetite seen in some Fed Speak in recent weeks.

MARCH FOMC: The FOMC raised rates by 25bps to 0.25-0.50%, as the market had expected; Bullard dissented, calling for a larger 50bps move. Updated projections envisage the FFR target rising to 1.75-2.00% by the end of the year, and rates are expected to rise to 2.75-3.00% next year, staying at that level in 2024 before falling. The Fed lowered its estimate of the longer-run rate by one-tenth to 2.4%, implying a front-loaded rate hike cycle. The Committee introduced language explicitly referring to the Ukraine situation, noting its uncertainties to the economy, but could present upward risks to the inflation profile. Inflation forecasts were raised in the short term, while the median growth forecast for 2022 was cut.

BALANCE SHEET (B/S): The market will be looking to the minutes for any discussion on B/S reduction after Powell said at his Q&A that he is “sure there’ll be a more detailed discussion of our [B/S reduction] in the minutes”. The Fed is largely expected to make the formal announcement at the May FOMC. The March FOMC didn’t provide many new details aside from a light calendar guide, saying the Committee “expects to begin reducing its holdings… at a coming meeting.” Chair Powell even said plans could be finalised as soon as May. Powell was coy about going into too many details then but he did say the runoff could look very similar to the Fed’s prior B/S reduction, but faster, whilst assuring that the Fed would be mindful of the broader financial context, and would avoid adding to the uncertainty. Analyst expectations for the runoff process lie between USD 60-100bln per month total of Treasury and MBS. The Fed will also likely maintain optionality, noting they can adjust the pace as required. While these are the expected maximum monthly caps, it will be interesting to see if there will be a run-in period or whether the max caps will begin immediately. Other factors to watch out for include the composition (pace of Tsys vs MBS), if it will let its USD 300bln plus of T-Bills runoff (or maintain its bill holdings and just reduce coupons), any size/calendar guide for QT completion (BBG survey saw B/S at USD 8.5tln by 2022-end and 7.5tln by 2023-end, but not clear on final size), and debate around asset sales given a few Fed officials have been calling for MBS sales in the future. Meanwhile, with expectations for May leaning towards a 50bps move from the Fed, it raises the possibility of a run-in period for the monthly caps to refrain from being viewed as overly hawkish. While many Fed officials have said they are on board with hiking rates and implementing B/S runoff at the same meeting, the magnitudes of both will be key. Fed’s Brainard spoke on Tuesday, essentially cementing the May balance sheet reduction announcement while she also said it will be at a “rapid pace”. Brainard said she expects significantly larger caps and a much shorter period to phase-in maximum caps compared to 2017-2019, implying there will be a phase-in period, but a fast one.

50BPS: Money markets are currently pricing a 50bps rate rise in May with around 80% certainty in the wake of the March FOMC, and commentary from other Fed officials, who also seem open to 50bps rate moves at the May meeting– or meetings ahead (plural), to combat high inflation. At the press conference, Chair Powell was upbeat on the economy, arguing that although growth projections were cut, GDP was still seen growing at above-trend rates and strong enough to handle tighter monetary policy. Analysts noted that Powell’s remarks at a separate event after the FOMC meeting sounded more hawkish (note: at the FOMC meeting, Powell is understood to be speaking on behalf of the Committee, whereas when he is delivering remarks outside of the FOMC press conference, his remarks are seen to be more his own views). Powell said that the FOMC was able to move rates in 50bps increments if that is what is required to manage inflation pressures and heavily suggested that this could happen at a coming meeting or meetings, implying more than one 50bp move this year is possible. This was a hawkish upgrade of his views from the FOMC meeting, where he seemingly advocated a “steady” approach. The minutes will thus be eyed to gauge the FOMC’s broader views on moving in larger than 25bps increments.

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Finally, here is a preview of what JPMorgan’s trading desk expects will be unveiled by the Fed today at 2pm.

Wednesday brings the minutes of the March FOMC meeting and the size of the caps on QT. With speaking engagements from both Williams and Daly over the weekend they have very strongly signaled a 50bps hike in May with the start of QT. Brainard is also giving her first public appearance post meeting tomorrow.

JPM is calling for terminal caps of TSY $60BN/MBS $30BN phased in over 3 meetings with T-bills exempt and allowed to roll off as they mature.

1) Size of QT

The best guess of JPM’s Michael Feroli is that the Fed will double the size of the previous caps with a terminal size of $60bn Treasuries and $30bn mortgages. Caps will be phased in over 3 meetings (May, June, and July). As you can see from the graphics below, the mortgage cap will very likely not become binding and the Treasury cap will only bind on quarterly refunding months. JPM’s call implies the Fed will be buying zero mortgages starting in mid-August. A 50bps rally would make the $30bn cap briefly binding later this year, implying a small amount of reinvestment, but the base case view is that the Fed becomes a strict source of supply to the private market upon hitting their terminal cap. The below charts show ~400bn total reinvestment through 2024, mostly in 2022/2023.

2. Composition of balance sheet

There has been heavy debate as to what to do with the bill portion of the treasury portfolio which were bought originally to calm repo markets in the Fall of 2019. JPM thinks they will exempt T-bills from caps to allow them to roll off the balance sheet as they mature (blue bars below). Waller has also discussed moving residual MBS reinvestments to USTs only. Here JPM writes that it spent time thinking about the potential to change the current reinvestment strategy of SOMA add-ons proportional to issuance to just front-end but both options may not be worth doing if the caps run up quickly over 3 meetings and rarely become binding.

In the longer run, the Committee intends to hold primarily Treasury securities in the SOMA, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.

3. Outright MBS sales

The hawks on the Committee continue to discuss balance sheet wind-down but most have steered clear of discussing sales directly. Both Mester and Waller have advocated for selling MBS at some point and George last week looked to argue for a more aggressive path. Recall at the last set of minutes they used “many” to describe the number of participants who see either sales or rotation to tsys at “some point” in the future. Given the last month of Fed speak I would expect either the number to be upgraded to “most” or “almost all.” It is also possible they pull forward the timing to be in line with an earlier start to QT.

4. Terminal size of sheet and reserves

It is difficult to know the final resting size of the Fed balance sheet in this regime so I’ll borrow my favorite line from the Feb TBAC charge question: ”We estimate a wide range for normal, 20%-25% of GDP. Given that it will take at least 2-3 years for the Fed’s balance sheet to near this range, we don’t think it is important for Treasury to try to formulate a more precise view than this.” Combining our MBS and UST runoff assumptions we will arrive at ~20% of GDP with the balance sheet over $5trn towards 2026-2027. In terms of the impact on reserves, assuming TGA continues to grow to something like $700bn we anticipate bank reserves will decrease almost 2x as much as the ONRRP balance (see table below).

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Given that a handful of countries that rank among the top largest economies in the world have thus far been reluctant to firmly condemn Russia’s invasion of Ukraine, this could prove the significant monkey wrench in US-EU plans to severely isolate and wreak havoc on global Russian exports. 

Among these include the obvious – China, but also there’s India, the UAE, Brazil and Indonesia. India for example – standing just behind the UK as the 6th largest economy – remains the the single largest buyer of Russian weapons. India is also reportedly seeking more discounted Russian oil, in what looks to be a potential move away from Saudi crude. 

In early March, The New York Times noted that India was among those countries dependent on many Russian imports that’s attempting to “stay above the fray”. “When India abstained from a United Nations vote and the chorus of Western condemnation against the Ukraine invasion, it appeared to be taking sides: offering tacit support for President Vladimir V. Putin of Russia,” the Times emphasized previously.

And now Washington is putting New Delhi on notice that it faces ‘significant costs’ should it become aligned with Russia, and as a major export destination allowing Putin to side-step sanctions effects.

The Biden administraiton’s Director of the National Economic Council of the United States Brian Deese has said the US remains “disappointed” with aspects of the Indian government’s reaction to the Ukraine crisis.

“There are certainly areas where we have been disappointed by both China and India’s decisions, in the context of the invasion,” he said a Wednesday event in D.C.

He was cited as saying in Bloomberg:

The US has told India that the consequences of a “more explicit strategic alignment” with Moscow would be “significant and long-term,” he said.

India has so far rejected falling in line with the West’s anti-Russia sanctions, instead continuing to import Russian oil, which remains at an estimated 2% of its total oil imports.

Whatever you make of this emotion the salience of it is restricted to only a few of the dark blue countries. Ukraine’s supporters should worry that two thirds of humanity live in neutral or Russia-leaning countries. https://t.co/1IssHf6Qmb pic.twitter.com/kKYX5hfxqy

— Ben Judah (@b_judah) April 6, 2022

As NBC News reviewed of recent visits of top Washington officials to New Delhi:

A flurry of visits by Russian and Western diplomats is unlikely to change India’s neutral stance on the war in Ukraine, experts say, particularly since the war has the support of a public being bombarded by media coverage that blames the U.S. for the conflict.  

Russian Foreign Minister Lavrov has meanwhile praised the Modi government for the avoidance of adopting a merely “one-sided view” of the conflict in Ukraine.

On Tuesday, White House Press Secretary issued statements demanding that fence-sitting countries urgently conform to US and European sanctions measures. “We don’t believe it’s in India’s interest to accelerate or increase imports of Russian energy and other commodities,” she said directly addressing New Delhi in the press conference. She stressed that “every country should abide by the sanctions that we [ the U.S.] have announced and that we’re implementing around the world.”

Authored by Paul Joseph Watson via Summit News,

In an article about the potential for a peace deal between Ukraine and Russia, the Washington Post admits that some within NATO want to prolong the war for as long as possible.

The admission is contained in a piece titled ‘NATO says Ukraine to decide on peace deal with Russia — within limits’.

“Even a Ukrainian vow not to join NATO — a concession that Zelensky has floated publicly — could be a concern to some neighbors. That leads to an awkward reality: For some in NATO, it’s better for the Ukrainians to keep fighting, and dying, than to achieve a peace that comes too early or at too high a cost to Kyiv and the rest of Europe,” states the article.

“There is an unfortunate dilemma. The problem is that if it ends now, there is a kind of time for Russia to regroup, and it will restart, under this or another pretext.”

And there you have it.

NATO says Ukraine to decide on peace deal with Russia — within limitshttps://t.co/muomC9q1Iq

— The Washington Post (@washingtonpost) April 5, 2022

Now we know why the NATO-aligned legacy media and journalists are constantly lobbying for an escalation that could spark World War III.

NATO wants the war to continue for as long as possible so Russia can be drained and isolated, while the media is addicted to the clicks and ratings it brings.

The article also reveals how Zelensky wants a “legally binding security guarantees from the United States and others to defend it if it were attacked,” something that is totally delusional.

As Chris Menahan notes, a peace deal looked possible around a month ago when Vladimir Putin vowed to end the war “if Ukraine agreed to recognize Crimea, accept Donetsk and Luhansk as independent states, swear off joining NATO and disarm.”

However, despite being told by Israel to accept the deal, President Zelensky refrained from doing so immediately after the U.S. decided to sent $14 billion dollars in aid, an act that prolonged the war.

“(Zelensky) should have taken Putin’s deal as Bennet told him to four weeks ago,” writes Menahan. “Instead, he has insisted on sticking with his strategy of forcing all men aged 18 to 60 to take up arms and become enemy combatants so he could use their deaths as atrocity propaganda to con NATO into the war.”

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While the bond bloodbath of the first quarter has been among the worst in history, it is easy to forget that just one year ago bonds saw a similar (if slightly less bad) selloff (consider this article from last March “2021’s Bond ‘Bloodbath’ Is The Worst In Decades“.) And while much ink had been spilled one year ago in hopes of identifying the source of the relentless Q1 2021 bond selling, it was research from Morgan Stanley which found that the bulk of selling a year ago emanated out of Japan, where local funds where liquidating positions ahead of fiscal year-end on March 31.

Furthermore, once Q1 2021 was in the history books, we saw a reversal in flows with Japanese funds aggressively buying the very same Treasurys they were selling just days earlier.

So will history rhyme this time, and will Japanese buying be the catalyst for a sharp drop in yields following the historic Q1 rout?

Maybe not this time, because as Bloomberg’s Masaki Kondo writes this morning, investors in Treasuries expecting a wave of inflows of Japanese money look set for disappointment.

Echoing what we said above, Kondo writes that with Japan’s new fiscal year kicking off, global bond investors are wondering whether funds will step up their purchases of Treasuries. Rising inflation and Federal Reserve policy tightening that have been widening yield differentials are traditionally conducive to Japanese inflows: “That would mark a step up after years of tepid demand for the securities from the East Asian nation.”

But unlike last year, when we did in fact see a reversal in Japanese flows, there’s a good chance Japan’s giant life insurers turn their focus to Europe instead.

The main reason for this is that a deeply inverted USD/JPY forward curve suggests hedging costs for investments stateside will continue to climb as the Fed raises the policy rate. EUR/JPY’s forward curve is much less inverted, suggesting those costs are less likely to be an issue for Japan funds heading to Europe.

And Australian and Canadian bonds may also appeal to those who are concerned about the impact on the euro zone from the war in Ukraine. 

Of course, life insurers can choose to buy Treasuries without hedging given persistent yen weakness, but such flows will be far more limited than hedged ones.

And a potential source of demand from Japan’s new 10 trillion yen ($80.6 billion) university fund is unlikely to provide more than minimal support to Treasuries, as it has just a 35% allocation to bonds, according to its reference portfolio.