Overestimated monetary regime switching effects
I have seen a lot of chatter about monetary regime changes. Although such an event may occur, there is no particular cause for rejoicing from the point of view of the developed countries.
The figure above shows official foreign holdings of treasury bills as a percentage of federal government debt – using the Fed Flow of Funds (Z.15) ratio. We can see why there was a lot of excitement about “China buying all US bonds!” at the onset of the 2008 crisis, but we can also note that this series has changed a great deal over time (mainly the result of the mercantilist policies of Asian countries). However, the decline in foreign reserve holdings over the past decade has certainly not resulted in a bear market for the Treasury.
Are there lessons to be learned?
Although some people claim that the West’s “militarization” of banking and payment systems teaches a valuable lesson to other countries, the realistic answer that the only lesson is: don’t conduct a foreign policy as stupid as Russia. Putin’s regime managed to create an incredible coalition of countries and parties willing to openly send weapons to be used against Russian tank crews and pilots. This coalition will probably crumble, but it’s not something that we saw after the Second World War. It would be extremely difficult for any other country to pull off such a feat, as it would be hard for them to do anything that galvanizes a normally distracted and divided Western public.
Of course, this answer won’t satisfy people, so we can expect a flurry of opinion pieces discussing how countries will move away from reliance on banks and western technology. Such a policy makes sense, and I would not be surprised to see movement on this front. This may matter for the growth of Western banks and tech companies, but this is a micro story, not a macro.
Increased use of the renminbi
There is a natural trade correspondence between Russia, China and many “non-aligned” countries. The only plausible “reserve currency” seems to be in China, perhaps with the use of gold held somewhere to allow it to be used to settle flows. The problem for this currency bloc is the question of trust – even if they don’t trust the West, they don’t necessarily trust each other either.
While such a possibility points to the “decline of the West/loss of reserve currency status,” it is nothing from the West’s perspective. Given the accounting identities, outflows of Western currencies must be matched by corresponding inflows. All that can happen is that currency prices (exchange rates) have to move. Given that the US dollar has appreciated in value during this crisis, this does not correspond to the usual “decline” scenario.
Events in recent years have hopefully made companies more aware of the risks associated with offshoring, and we may see less deflationary pressure from cheap imports. While stronger currencies elsewhere may exacerbate this trend, I don’t know how far it can go without causing heartache to economies trying to employ an export-led growth strategy. Even as China abandons this strategy, other countries are embarking on it.
Funding costs: driven by default risk
While all sorts of entertaining episodes can happen in the funding markets, we have to keep the duration in mind. The movement of a one-month rate is about one-twelfth the magnitude of a one-year rate and one-sixtieth of a 5-year rate. Obviously we are seeing some scrambling as funding schemes have to adapt to bank freezes, but as long as there are no defaults this will only be of interest to money market traders.
While market funding is important, we can’t get too excited about every little move in spreads. Popular debate about the financial crisis is often distorted by people who take too narrow a view of what happened. In early 2008, investors made the tragic mistake of listening to finance professors who came to the conclusion that leverage was the secret recipe for high returns. In addition to borrowing to finance investments, geniuses created derivative structures with huge notional amounts, creating operational leverage. When part of the market exploded, all exploded. Nobody knew who else was creditworthy, so the funding dried up. Although some companies have managed to blow themselves up in the current crisis, it’s harder to see wider contagion – short of a deep recession in the West that forces non-financiers out of business.
Longer term, the historical trend for money market investors is that they cannot keep banking system spreads well above 20 basis points above government rates once default jitters die down. fades.
Government risk-free rates will simply follow central bank reaction functions, with the long end being sensitive to asset-liability matching trends. One could look at foreign official holdings of Treasuries and try to disentangle a relationship with bond yields. I’ve seen many such attempts, but they were invariably data mining exercises.
Instead, we are on the wrong side of depletion curves for the most important commodities. It’s not too hard to see this creating inflationary pressures. It remains to be seen whether this will lead to a significant deviation of key rates from zero.
It is very difficult to argue that recent events have been a showcase for crypto from the perspective of governments.
Countries need commodities for consumption, not to serve as a means of settling transactions. Gold can be used for this purpose (since industrial uses are limited), but both sides of the transaction must be in the same place for this to be practical. Which means that the countries that leave their gold there have to trust the local government.
So we can’t really think of “commodity-backed currencies”, rather the fiat currencies of commodity producers will be attractive.
We will see further attempts by “non-aligned countries” to withdraw from the US dollar-denominated trading bloc. This could increase their policy space, but the implications for people in developed countries within the “US dollar bloc” are limited.
About to run?
Without a ceasefire, financialized commodity markets break down. I don’t know how much this will affect the commodity producers themselves. Although I’m not exactly aware, one of the main challenges is getting products out of Russia through the Black Sea. Although the sanctions cause difficulties, it could be much easier to find financial intermediaries than to obtain sealift capacity in a war zone.
The optimistic scenario for the end of the conflict seems to be the following and could be considered consistent with the news flow. Russia dominates on the ground in the south and can wear down the Ukrainian army there without having to do anything drastic. With Ukraine seemingly losing all hope of NATO membership, the talks seem to be all about determining Crimea’s borders and status. Since the Russian military is already exerting significant pressure, there is no need to undertake a drastic escalation. I want to emphasize that this is an optimistic scenario and it is very easy to come up with more pessimistic ones.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.