Even prior to Russia's attack on Ukraine, the global economy was facing an extraordinary moment. Now things have become massively more complex. In addition to the attack itself, rich Western governments have unveiled historically powerful sanctions against Russia, most notably by freezing much of the country's FX reserves. So what are the immediate and long term ramifications? On this episode, we speak with Credit Suisse short-term interest rate strategist Zoltan Pozsar on what this all means, how the Fed will react, why gold is important again, and how could this mark a turning point for the global dominance of the U.S. dollar. Transcripts have been lightly edited for clarity.
Tracy Alloway:
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal:
And I'm Joe Weisenthal.
Tracy:
So Joe, there is a lot going on at the moment.
Joe:
It is truly an extraordinary time. I would say kind of unprecedented. Already, I think just this sort of economic environment was pretty novel -- not many people familiar with it. And now of course, the start of Russia's war, the attack against Ukraine, making things potentially exponentially more complicated and difficult to understand.
Tracy:
Absolutely. And there are all sorts of impacts from what's going on in Ukraine with the Russian invasion, people have been talking at length about the commodities impact, what that's going to mean for inflation, but there is also this monetary impact. And we are starting to see shades of that now.
So obviously the ruble, I mean, if you look at a chart of the ruble right now, I think it lost another third just today on the day that we're recording, which is Monday, February 28th. It was down at an all time low of, I think, about 109 rubles per dollar. But that is after the slide that it already encountered last week. So really extreme movements in FX. And at the same time, of course, we have the Western powers, central banks across the world, talking about excluding Russia from basically the global payment settlement system known as Swift.
Joe:
Yeah. So that's exactly right. And basically, at this point, there's no indication that other, you know, U.S./European powers are actually going to get involved in combat directly. So in lieu of that, there's been a lot of attempts to use economic and financial penalties to go after Russia for its aggression. And so that includes both sort of traditional sanctions, but also as we're seeing some very extreme moves to cut off Russia from its own money, from its ability to conduct business, from its ability to engage in payments, that is in part what's caused the ruble to collapse. We've seen lines at ATMs in Russia, scramble for hard currency and this is a very new element of sort of economic and financial warfare of sorts against a relatively sophisticated and rich country.
Tracy:
That's exactly right. It's something that we haven't really seen before. And so there are all sorts of questions around what this means for the broader financial system, how exactly it would work, what it means for the U.S. dollar. And we've already seen some signs of a scramble in money markets for people to get their hands on the safety of the world's reserve currency. There's a lot of uncertainty, a lot of questions around the mechanics. And I’ve got to say, whenever we want to go deep into financial market mechanics or plumbing, there is one person that we turn to…
Joe:
The most requested guest by far on Odd Lots. And somehow we have a tendency to speak with him at the start of almost every major crisis.
Tracy:
This is true. All right, well, we're going to be speaking with Zoltan Pozsar. He is of course, the global head of short-term interest rate strategy at Credit Suisse. So Zoltan, welcome to Odd Lots again.
Zoltan:
Thank you for having me! Nice to be back guys.
Tracy:
Yeah. Your timing is impeccable as always. I suppose, just to begin with, could you maybe give us a sense of Russia's place in the global financial system? So in your research, you've described it as a surplus agent in the financial system. What does that mean exactly?
Zoltan:
A surplus agent means that you are a nation with a central bank which has a lot of FX reserves. We are not talking about sudden stops. You know, we're not talking about a current account deficit country that needs to tap funding markets to import stuff. You're talking about a country that is exporting, you know, vast amounts of commodities and has accumulated a lot of FX reserves on the back of that. And so, you know, when you sanction a central bank with a lot of FX reserves, naturally I think one impact of that is that the central bank, the way it runs its portfolio is going to, number one, change. I mean, you know, the entity is a sanctioned entity. So if you have been lending those FX reserves in the FX swap market, what's going to happen with all those trades, right?
I mean, all the FX swap trades go through Western financial institutions. When you lend dollars in the FX swap market, you sell those dollars and then you get euros, you place those euros at the Bundesbank. You place them in various securities, which are all at Euroclear. So when all these things get frozen, I think it's definitely going to have an impact on funding markets. And also, you know, don't forget, the FX reserves are partly used by the central bank to be able to provide dollars to the domestic financial system. And if all these balances are frozen, you know, one channel of dollars to help the local banking system dries up. So, so I think it's quite a complicated situation. The, the present situation has elements of a little bit of everything.
I think it has, you know, definitely a local currency crisis, a local bank funding crisis, a little bit of crisis of FX reserves, where typically we are used to situations where central banks that show they have something -- they don't have it and then, you know, the market gets surprised by it. For example Southeast Asia in 1997. This time around, you know, the central bank did have a lot of reserves, but then these were seized. So I think it's pretty uncharted territories and it's hard to tell which way this is going to go from here, but, you know, one day into it, we've had a big impact in the FX swap market, which has calmed considerably since the overnight session began. But again, I think it will take a couple of days to figure out where the bodies lie, because we're not just talking about the central bank getting sanctioned, but also some banks being excluded from Swift. We see the natural progression where, you know, the sanctions were initially X and now they are 2X. And we don't know how the sanctions are going to evolve as the week progresses, but we know for example, that energy-related payments are still excluded. What happens if energy-related payments get included as well? So I think it's quite a fluid situation as we speak -- still.
Joe:
So just to back up even a little bit further, you know, when we think about a country's FX reserves, maybe in our minds, you know, you think, okay, this is a war chest, or this is a pile of money that's stashed away somewhere, but it's not literally a pile of money. It's liabilities of some foreign banker, as you mentioned, the Bundesbank. And it can be seized. It's not something that just sits in a pile somewhere in Moscow. What are the numbers? What do we know about how much there is and where the money is right now and how extraordinary is it to think that countries’ FX reserves, foreign central banks or foreign countries can just say, no, we're not going to give it to you.
Zoltan:
Okay. So, you know, to frame the discussion about this, sure. There is inside money and outside. Inside money are all the claims that are someone else's liability and outside money is the type of money that is the liability of no one. And you're absolutely right. Most FX reserves that exist in the world today are all forms of inside money, i.e. are the liabilities of someone. In the case of Russia, I mean, the numbers are quite transparent. I mean, you know, they're subject to interpretation, but the IMF provides monthly data about the FX reserve composition of every country in the world. And so we know from that, that Russia has just rough numbers, you know, $500 billion of FX reserves, non-gold FX reserves, about $200 billion of that is in the form of securities.
And about a hundred-some billion of it is central bank deposits. And then the rest of it is bank deposits. And so what this means in practical terms is that, you know, Russia's FX reserves are basically deposits at Western financial institutions. They are securities balances at Euroclear, or, you know, the custodian is for the securities that they hold. And they also have balances at central banks like the Bundesbank, obviously not the New York Fed because they've sold out of all their Treasuries. So there's that, but again, I think when you look at the currency composition of these FX reserves, I think you require some careful interpretation there because, you know, the widely-held assumption is that the dollar exposure is quite low and the dollar exposure, and the true dollar exposure you will only be able to capture if you think about things in the context of the FX swap market.
If you have dollars and you land those in the FX swap market, it's a spot sale of dollars today and then in some future point in time forward, you purchase those dollars back, but once you sold those dollars in the FX swap market, you would typically get Swiss francs or euros or yen, and then you would take that local currency collateral, and you would you a deposit at the local central bank. So in the case of euros, that would be the Bundesbank. Whether you hold the sovereign debt of a country, or you keep a deposit at a central bank of a foreign country, or if you keep deposits at Western financial institutions, these are all forms of inside money that you don't control. Someone owes it to you. And these things can be sanctioned.
Joe:
Right.
Zoltan:
Outside money is something completely different. It's gold. And it so happens, I read it somewhere that all this gold that Russia has for example, is in the vaults of the central bank in a basement in Moscow.
Joe:
So that's real money, so that no one can sanction, right?
Zoltan:
Yes. So, you know, unlike France in a second world war, you don't have to enlist, you know, the Navy to kind of rescue your gold somehow. And again, I think there is probably a medium- to long-term lesson in all this, because this is precedent number two. I mean, we've seen what happened with the FX reserves of Afghanistan.
Joe:
Right.
Zoltan:
And we have seen with what happens with inside money type FX reserves in the case of Russia. And so what does this mean for gold as a monetary instrument going forward? You know, I've heard some, you know, clients, for example, go what does this mean for dollars or for gold? Are they going to have to sell to get the dollars to help the domestic financial system? Far from it. You know gold, it doesn't have, have to be sold. It can be repoed just like any other financial instrument. So if you find a willing financial system and a willing central bank to, you know, reverse in gold in a repo transaction for you in exchange for dollars, you can use it to raise dollars to make payments. But again, this inside versus outside reserves is something to think about because, you know, in the case of China, for example, it's the same setup. They have a lot of inside FX reserves. And what does that mean in situations like this?
Tracy:
So the implication here is that if you have a lot of inside reserves, these are reserves that are tied up in other financial institutions or with other entities that can ultimately be tied up in times of conflict or war, or, you know, what we saw in Afghanistan where the reserves were sort of frozen and the Taliban no longer has access to them. I want to ask a really basic question here, but what do central banks actually use reserves for? Like what would Russia need these reserves for? I mean, obviously they would want presumably to stop the fall of the Ruble, but are there other things that they might use this for?
Zoltan:
You know, reserves are reserves. I mean, we can go through the basics. You know, if your currency is too strong, you buy FX and print local currency. If your currency is in a free fall, you sell FX and you buy the local currency. If there's a dollar shortage in your local banking system, and you don't have access to the FIMA repo facility, and you don't have any Treasuries, you can repo with the Fed. If you don't have swap lines with the Fed, you tap into these reserves to provide dollars for the local banking system. So it's basically be there to buffer liquidity shortfalls and to be able to defend your currency. If you don't have it, you don't have the ability to do any of these. So these are painful. I mean, again, in the grand scheme of things, energy-related flows, commodities and payments for commodities still continues.
So we have not completely turned off the pipes yet. You know, this is the way you think about FX reserves. I mean, for example, if you go back to March, 2020, I mean, we've seen a number of central banks, the Swedes, Brazil, for example, you know, they were landing dollars to the domestic financial system without tapping the swap lines. Even though they had access to the swap lines. And again, the mechanism there was, you turn into cash some of the inside FX reserves you have, and then you get that cash and you lend it on, you lend those U.S. dollars onto the domestic financial institutions. But again, you need to be able to trade these instruments to do these type types of things. I mean, you know, the, the fact that Russia, for example, restarted its gold purchases overnight, from what I understand on the domestic market -- I guess naturally because of all the sanctions the central bank couldn't trade on international markets and buy gold there -- But think it's just an interesting question again, depending on how, how the geopolitical aspect of all this evolves, you know, if a central bank is in a situation like this and the currency’s under pressure, would it ever come to having to re-anchor your currency to something like gold? I think these are all questions that should be top of mind. I don't know if it'll come to that, but if things get worse, you could basically re-anchor to a pile of gold because you need an anchor in situations like this.
Joe:
You know, one of the questions that's come up in various forms is this idea of, okay, well, if Russia gets too shut off, it may seek totally alternative scenarios, or it may sort of develop something with China or use the Chinese yuan more or something like that. Or maybe a new Swift, we'll talk about Swift more in a second. Are there really alternatives to the existing system? I mean, I guess you just mentioned the idea of, okay, maybe the ruble could be gold backed, but is there actually any realistic opportunity or ability to create sort of like a separate financial system?
Zoltan:
Well that's a big question.
Joe:
Yeah. It's so open-ended.
Zoltan:
Again. I think your imagination is the limit to how you can devise alternative systems and then how realistic those are is another question. Obviously, I mean, we all know that there is transatlantic taskforces that have been set up to check if anybody's helping sanctioned entities circumvent sanctions. That aside, you know, you have gold and you have commodities. And so it's possible to accumulate a new pile of surpluses. It's possible to still get U.S. dollars. If you have a willing intermediary, who's willing to give those dollars to you and things can be, I'm sure there are ways to kind of structure these flows such that they don't really show up on balance sheets or if they show up, it's not very obvious what's going on. Signs you want to look for -- because there's a couple of things we know. Russia doesn't have any more Treasuries because they sold of it. It's in the TIC data. Because they don't have Treasuries, they have no ability to use the FIMA repo facilities. You need Treasuries for that.
They also don't have a swap line, but they have gold. And so can you do gold repos between central banks? Yes. Can you provide U.S. dollars versus gold? Yes, you can. Are there some central banks that are so flush with FX reserves that they lend a lot in the FX swap market so exactly if you don't send it on the world market, but you send those dollars to another financial system, is it gonna really show up? Not really. Could it be a situation where some large central bank starts to pour collateral into the U.S. repo market to raise dollars and then, you know, take those. These are all possible, but I think the point here is that it is possible to do these in a way that no one's gonna find out about them because, you know, we are probably talking in orders of magnitude of like $100, $200 billion, which is, you know, possible to hide on a balance sheet that's a couple trillion. Yeah.
So I think these things are all possible, but I think this is also, again, going back to the idea of, you know, Afghanistan and seizing inside reserves. This is probably going to lead to seeding financial centers in the east, in friendlier jurisdictions, because it's pretty obvious that FX reserves can be used against. Currencies, I don't wanna say die and are born, but you know, the prominence of currencies, I think, fades and rises in war time, you know, sterling to dollar, dollar to RMB, I think it's situations like this that foment a lot of change. And these are definitely going to be catalysts in that type of direction where you have us versus them and, you know, their financial system and our financial system and things change.
Tracy:
So a related question on this point, but energy exports are excluded from a lot of these restrictions, it seems. And so one way for Russia to generate reserves at the moment is through energy exports, but those reserves generated through energy exports -- are those still going to be accessible to the central bank? Is it still going to find willing counterparties for those?
Zoltan:
As Perry Mehrling would say finance is hierarchical. So there is the central bank. There is, you know, the national wealth fund and there is Gazprom Bank, a bank entity, which is not sanctioned. I think the situation itself is extremely complex where Europe clearly needs the energy, Russia clearly needs the cash, and some parts of this whole thing are just carved out and are untouched by sanctions. So again, for now, I think the exclusion of energy-related payments is making things a lot less severe than they otherwise would be. I mean, Gazprom Bank, just like any other bank can trade with domestic Russian banks. So if you think about the extreme scenarios of, okay, well, the Russian central bank can’t provide dollars to the local banks anymore, Gazprom Bank can. So again, depending on how tight the sanctions get and how wide the net of sanctions is cast, and, you know, is Gazprom bank going to be a part of it, that is going to change things on the ground, and that's going to change, you know, the way the Ruble trades the way funding markets trade. I don't think we've seen everything yet.
Joe:
How prevalent is the dollar in the Russian economy? I mean, we've seen these stories about people scrambling for dollars. You mentioned Gazprom Bank would still be able to supply dollars, but how significant and how much dollarization is there in Russia?
Zoltan:
Russia kind of insulated itself from FX liabilities somewhat, not totally. I don't have exact numbers at hand, but I mean, I think any commodity exporter is going to trade in a lot of dollars. I think it's just hard to kind of go down this path of figuring out the exact ramifications of all this. Because again, I think you’re meddling with these flows. And so we'll just see how tight the sanctions are going to get.
Tracy:
So maybe we should talk a little bit more about what this means for the wider financial system. So Russia, to some extent is potentially a little bit insulated from, I guess dollarization or dependence on dollars. But what we've seen so far in the rest of the world is that all the uncertainty around this situation has sparked a scramble for greenbacks. So people are trying to get more dollars. We've seen, you know, some signs of this in money markets in FX swaps, which you already mentioned, where does it go from here? Is there going to be enough dollar liquid to satisfy this demand?
Zoltan:
Make no mistake, there's a lot of dollar liquidity in the system especially now. You know, FX swaps traded a hundred basis points wider a couple of hours ago, that calmed down considerably. So those spreads are much more normal. I mean, they're still wider but more normal as we speak. You know, FRA/OIS is wider. And I think the general posture of any bank in a situation like this is exactly what we are talking about. You don't know what the sanctions are going to look like tomorrow. You don't know what all this means. I think people are tallying their exposures again, not to say that this is a Lehman moment, but some experienced hands that I spoke to last night, you know, reminded me, two people actually, that when things like this happen, everybody's going to take time to tally up the true exposure.
And then you don't know where the bodies lie, but you know, it's going to take at least a week to actually find out what all this means. So yes, there is a dash for dollars, there is also kind of unwillingness to part with your dollars. And so whatever excess liquidity you have, you are keeping it close to the vest, and you don't trade it in the FX swap markets, because, you know, you like to harvest spread dislocations where you know that someone just had a bad funding day and this money is likely to come back tomorrow. But you know, these situations are the exact opposite of that. Dollars are tighter.
Last time I was on this call, we were talking about all this excess liquidity and funding being extremely boring for a while. You know, the year-end turn wasn't that boring. I mean, you know, the market did price some premium for eurodollar basis, despite all this liquidity in the system, the basis did gap as much as it did overnight. And so, you know, having a lot of money doesn't mean that you're going to be, you know, lending to harvest every basis point you need to. You need to have confidence you’re going to be able to get that money back. Another line of argument that I'm hearing again from experienced hands is, okay, well, if you freeze Russia’s FX reserves, what does it mean? They don't have access to it, but it's still with someone. And that someone is still probably going to be trading that money. I mean, not on behalf of Russia. And so the interest you earn on those FX reserves is not going to accrue back to the Bank of Russia but whatever custodian has that money or whatever dealer is stuck with the dollars of Russia, it's still going to kind of deploy that. Okay. Interesting. But again, you know what are the legal aspects of all this? I mean, I think another theme that I've heard from a number of participants is that there is a lot of self-regulation in the marketplace at the moment, whether you are a Western financial institution, if you are a commodity trader moving ships with Russian oil or processing energy-related payments for Russia, which again are still not sanctioned, in the back of your mind, you are thinking about whether it will be sanctioned by the end of this week. And do you want to deal with the headache of, you know, having dabbled with having moved Russian oil and Russian money and having traded that? And so what does that mean? So you just don't trade them and you don't move oil around. So again, I think the self-regulation aspect of all this, despite the fact that energy-related payments and flows are excluded, are making things difficult. So again, we will see.
Joe:
So at the beginning of that answer or the very beginning of that answer, you said it's not a Lehman moment, which is sort of ominous, what does that mean? And then you say, okay, it's gonna take a week before we see the true effects of that. So in other words, over the next several days, what are we going to be watching for? Who it turns out has big Russian exposure in some way that will be taking huge losses? Is that what people are watching for over the next several days?
Zoltan:
Well, I think the first thing we are going to watch for is how the war evolves. That is going to drive the severity of sanctions. So I don't think that we freeze this moment in time this package of sanctions, let's see who gets hit. The sanctions are moving goal posts, more and more entities can be added, so things can be ratcheted up. So it's dynamic number one. Number two, we will tally up exposures. I mean, it's just basic things like, okay, you know, that we've seen headlines on Bloomberg, certain Russian-affiliated banks in Slovenia and Croatia, according to the ECB, are likely to go into difficulties. We know that you have a number of European banks with sizeable Russian exposures, corporate exposures. I mean, anyone who claims to have a view that we are in the clear and this is as bad as it gets is, is probably not right.
You know, I probably overuse the Lehman analogy just to perhaps sharpen ourselves into thinking, but, you know, let me just say that last week we were not talking about FRA/OIS widening and FXOIS blowing up a hundred basis points. I mean, my first piece on this was Russia is a surplus agent. You will mess with these surpluses and that's not going to have zero impact in funding markets. And now here we are in this situation, which is a think far worse than anyone thought we would be in last week. And I'm sure that there will be some repercussions of this, not nearly as bad as Lehman obviously, but still an impact nonetheless.
But perhaps where I got the Lehman analogy from just, you know, kind of thinking things through, I mean, you guys know the plumbing quite well. So, you know, that Leman at its heart was some clearing bank unwilling to unwind repos right in the morning because if you give all that cash back to the money funds, you are stuck with the intraday exposure to Lehman. There is I'm sure some parallel, at some level with Swift. Excluding certain banks from Swift, people being unable to make payments and that clearing bank decision to not unwind repos. And again, you know, Leman was not obvious the Monday after, it took the entire week to kind of have a read on how bad the damage is. Switzerland for example, just adopted the EU sanctions, that's another new iteration. I don't know what that means, but there's a lot of commodity traders in Switzerland.
Tracy:
I mean, we've been talking about settlement risk all during this episode, but Russia certainly would not be the first financial institution or entity to encounter this. And there is a history of banks that have been not just caught up in, but basically destroyed by settlement risk. Lehman is sort of one of them, if you think about the repo market, but there are a couple others that you've mentioned. What does history tell us about this kind of risk?
Zoltan:
Well, history tells us that the safety net around the world, whether it's the swap lines or standing repo facility or discount windows in those, or, you know, any central bank being able to provide local currency to the financial system is that, you know, there's obviously a solution for all these things. Again, I think the big context is Russia has its own problems, which we talked about earlier. If there is a spill back from that onto Western financial institutions, there is all sorts of ways to kind of backstop settlement risk and liquidity hiccups that a bank experiences because the payments didn't come from Russia. You know, the FX swap market again is a reflection of those types of fears and money getting gummed up. But I think the solution to all this is quite simple. The swap lines are there and you should be ready to provide whatever currency needs to be provided, in whatever jurisdiction, on a daily basis. So far it wasn't necessary. If it comes to that, I think that liquidity will be forthcoming and from from pretty obvious places.
Joe:
You know, one thing that we haven't fully touched on, but we've been sort of talking around it is Swift specifically. It's not a household name, although everyone's sort of like get up to speed on what it is. Not all of Russia is going to be disconnected, it appears, but it appears that at least some Russian banks will lose access. What does it mean specifically to lose access to Swift, which I understand is more a messaging system to make the payments happen? How much does that disconnection specifically, how disruptive and powerful is that?
Zoltan:
It throws sand in the wheels. I mean, it's the messaging system for interbank payments. I think it is material. The more banks you exclude and again, it's just your inability to, I mean, you know, you take your email account and you can't communicate with the world, how’s that? And so again, you are freezing assets of banks, you are making it harder, not impossible, to alternative channels to wire money to various part of the world, central bank sanctions. So I think, these are these, these things are cumulative. I think it's the ‘IT backbone,’ of the international payment system.
Tracy:
So one thing we haven't spoken about is what this means specifically for the Federal Reserve. And before all of this happened, you actually published a piece of research that got everyone on the street talking where you were discussing the idea of the Fed's exit strategy and what it actually needs to do to bring down inflation and things like that. And you argued that the Fed should perhaps engineer, or maybe not engineer, but allow a controlled correction in the market in order to reintroduce volatility. So I guess the point I'm trying to make is, you know, even before all of this happened, we were at this very strange and interesting juncture for the central bank and Joe and I have recorded a bunch of episodes on this. Now we have the Ukraine-Russia situation to throw into the mix. How difficult is it going to be for the Fed to actually raise interest rates and start winding down its balance sheet this year?
Zoltan:
So we will see. Let me take a step back. The basic idea of that piece was we need to inject volatility into the system mechanically by adding duration risk back into the system in a massive kind of, you know, surprise way. And so that's going to take some wind out of the sails of asset markets and asset prices correct and maybe that would bring about some some increase in labor force participation. But you know, this whole idea that we have this dynamic ever since Greenspan, where we hike a little bit and we flatten if not invert the curve. And so something's up with that, right? Because you're hiking, but that follow through, the real meaningful follow through in the backend is just not occurring.
So that was two weeks ago today. What does it mean for inside FX reserves demand? What does all this mean for that? It means you probably buy more gold and you diversify away from Treasuries. So when you think about scenarios that can bring about surprise injections of duration, and through that interest rate volatility in the backend of the market, you know, over the medium term, it's not just the Fed going from passive to active duty. It is now I think going to be decisions of FX reserve managers as to how much money to keep where, inside versus outside. It is the threat of war. And, you know, there's no more peace dividend. I mean, I think what we've seen in Germany for the first time since the second world war, you basically are talking about massive defense spending on the back of all this, is also going to mean that in that in Europe, you will probably have a lot of fiscal spending on the back of this.
I think the kind of theme I touched on with ‘let's do a Volcker moment and go from passive to active duty’ at the end of the day is about injecting supply of long-term Treasuries into the market. Whether that's going to come from the Fed or now in this, you know, brave new environment, FX reserves diversifying on the margin, the west increasing defense spending, and increasing issuance on the back of that, I don't know, but I think over the past two weeks since I've put out that piece, a lot of things have changed and all of them are kind of pointing in the same direction, which is more supply and higher rates.
And perhaps in the midst of all this, I think one of the most interesting things to me in watching the screens over the past week or so is, I mean, just for context, you know, if North Korea shut up a rocket without a warhead, I think the 10-year rallied massively in the past. Here we have open war in the heart of Europe and the 10-year isn't really rallying. I think that's huge. There is this underlying kind of fear of inflation. And in addition to that, what are central banks going to do about inflation, higher rates, , potentially more issuance, potential diversification away from inside FX reserves, perhaps in favor of outside reserves. I think the world is a very different place. You know, my sense would be that there's a tremendous amount of pressure on long-term interest rates going higher from here than any time over the past 10, 15 years. So that's what I think all this means for central banks and long-term interest rates.
Joe:
I mean, it does feel like already, even prior to this particular moment, obviously we weren't getting the 10-year yield response that we normally get in a market downturn. I mean, when we had pretty intense selling and a lot of stuff really starting middle of November, not much of a flight to Treasuries because of the elevated inflation. Does it change, I mean, it still seems like a tricky spot for the Fed -- setting aside the reintroduction of duration, whether they do it passively or actively -- this general effort to hike rates, normalize, fight inflation. In general wars or supply chain disruptions increase commodities. It seems like it's going to complicate the rate hike part of normalization quite a bit.
Zoltan:
Yeah. For sure. I mean, everything that is happening is also highly inflationary, potentially even more, again, depending on how sanctions and energy related stuff goes. And yes, I think these are extremely complicated situations. I don't think that central banks are particularly able to do anything about this kind of inflation, but, you know, the markets are kind of pricing in more inflation and more hikes on the back of this. I think the situation is extremely complicated.
Joe:
I just want to go back to, you know, I thought one of the more striking things you said is that in periods of war, we sometimes see a handoff from currencies. And so you mentioned the end of the British pound amidst the war. You know, there's no immediate prospect as far as I can tell for a real, like new global currency to replace the U.S. dollar. But can you talk about that a little bit further? Just this idea. It's like, okay, we're seeing essentially the weaponization of FX reserves of central banks and this idea what you said about could this mark a sort of significant turning point for the role of the U.S. dollar on the international stage?
Zoltan:
Yes. I mean, again, it's us versus them. You can probably imagine a response on the back of this where a lot of exporters of whatever -- commodities and widgets -- decides to invoice things in a different currency, because you know that all these dollars you're earning and all this money you keep in the west is at risk. Just to think out loud, you know, the One Belt One Road sphere of influence, I mean, should that all be invoiced in dollars, or should it be invoiced in RMB? I think these types of things are, because again, we are talking about seizing assets you thought you had, so we know how to diversify away from that -- commodity reserves, gold reserves, what have you. Again, you can seed new financial centers by invoicing a bunch of trade in a different dominant currency. And there's all sorts of reasons to do that now.
Joe:
So would you expect China to accelerate its own efforts of the internationalization of the R B?
Zoltan:
Probably. I think, you know, two points make a straight line in geometry. So we had one example. We have another example. And so it will go like that. All the payments for all the gas, you know, what are some of the left field options? I mean, maybe, you just don't accept payment for this gas in euros and dollars, please pay me in RMB, right? I think that could be a very interesting variation on all this and clearly the eurodollar market would probably feel that over time.
Tracy:
Alright, well, Zoltan, it's been great having you back on the show as always. Really appreciate you coming on.
Joe:
That was great Zoltan, thank you so much.
Zoltan:
You for having me.
Tracy:
So, Joe, there was so much in that conversation, and I feel infinitely smarter for having spoken with Zoltan but one of the things that struck me was he mentioned this idea of a lot of the financial institutions self-regulating before the sanctions even came into effect. And I wrote about it a little bit in the Odd Lots newsletter last Friday, but it kind of reminds me of the Federal Reserve when it started buying corporate bonds. And you know, after it made the announcement that was enough to settle the market and to backstop it. And it didn't even have to buy that much debt in the end. It's sort of a similar effect playing out right now. So because sanctions might be coming, a lot of financial market counterparties have stepped away from Russian assets altogether. But I guess the tricky thing in terms of inflation and financial stability is whether or not they, you know, decide to step away from everything, including commodities, even when those should be exempt, or whether they start stepping away from things in a disorderly manner.
Joe:
Yeah. I mean, I think that's a key thing. Financial conditions are going to tighten, at least I at the margin, and of course there are the sanctions, there’s the cutting off of the banks, there’s Swift. And then of course there's the war and nobody knows exactly how this is going to unfold. The fact that there is a war in Europe right now, we don't know whether it's gonna be short. We don't know that it's gonna be long. We don't know anything about how it's gonna end, you know, just think as we were talking about two weeks ago, the conversation, you know, as Zoltan was talking about, was introducing more duration into the market to introduce volatility…
Tracy:
Now we have volatility!
Joe:
And so even setting aside the financial restrictions, periods of a war are not typically when financial institutions, banks, etc. become sort of liberal with their lending.
Tracy:
No, of course. And if you combine that with a central bank that is supposedly still on course for quantitative tightening and interest rate hikes, it's gonna be, I know we overuse that word ‘interesting,’ but I really don't know how else to describe it because of all the uncertainty involved, but it is certainly going to be an interesting moment.
Joe:
The other big thing and, you know, hearing Zoltan talk about like wars potentially are turning points for currencies. And obviously one hopes that this war is short and somehow comes to a resolution, but the weaponization of FX reserves -- the fact that it's like, okay, you have euros or you have dollars in a bank and now you don't have them. And you thought you had this money and now you don't. And so do you want to trade or do you want to have a currency that's of the denomination or of the nation that's potential going to be a rival or hostile towards you? And what does that mean for every other country that has FX reserves, do you really want to hold dollars now that it's made clear? And I thought it was interesting that Zoltan brought up Afghanistan as well…
Tracy:
Oh, totally.
Joe:
Yeah. It’s like, okay, the precedent is being set. That what’s your money may not be your money, it’s hard to see how that wouldn't affect the thinking of, as you mentioned, reserve managers all over the world.
Tracy:
Totally. You could definitely see a rethink of reserves as a result of these two instances. And I suppose to some extent we have that already, right? Like the fact that Russia does hold so much of its reserves in gold and that it's sold down its Treasuries and things like that, but definitely one to watch.
Joe:
And the gold conversation was also particularly … because gold, I think for a while has felt, well, like a barbarous relic, but you think like, Zoltan is one of the best at talking about the difference between inside and outside money -- a big demand for outside money at a time when your inside money can just be shut off.
Tracy:
Absolutely. Shall we leave it there?
Joe:
Let's leave it there.