Zoltan Pozsar has built a reputation for covering the intricacies of money markets. For the past eight years, he published those insights as a strategist at Credit Suisse. But in this episode of the Odd Lots podcast, Pozsar reveals his next career move following his departure from the Swiss bank earlier this year. He also gives us an update on his Bretton Woods III thesis, or the idea that the global financial system is going through a "monetary divorce" from US dollar hegemony and becoming more multi-polar. He also gives us his take on the recent banking crisis and what it means for global funding markets going forward. This transcript has been lightly edited for clarity.
Key insights from the pod:
Zoltan reveals his next move — 2:06
The meaning of Ex Uno Plures — 2:31
Is the Bretton Woods III thesis playing out? Plus a new angle on CBDCs— 5:19
Are big macro stories actionable for investostors? — 15:26
Changes in structural demand for US Treasuries — 24:13
The role of commodities financing in Bretton Woods III — 27:21
Thoughts on the recent banking drama — 33:36
Strength of the banking system now — 39:51
CBDCs and central banks a the new shadow banks — 44:02
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Tracy Alloway: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.
Tracy: (00:16)
Joe, do you remember what we were doing this time last year?
Joe: (00:20)
No.
Tracy: (00:22)
Yeah, I can barely remember two weeks ago. Yeah. No, but I actually, I remember this one mostly because I looked it up right before we started doing this recording, but this time last year, we were preparing or organizing our first live Odd Lots debate between Zoltan Pozsar and Perry Mehrling.
Joe: (00:42)
We have to do that again, more debates.
Tracy: (00:44)
So we were sort of frantically doing a lot of the sort of travel arrangements and things like…
Joe: (00:51)
Waking up early in the morning, like of the day of the debate, entering names into a database so that people could get into the Bloomberg office. Do you remember that?
Tracy: (01:00)
Yes, I do.
Joe: (01:01)
That was fun.
Tracy: (01:02)
All right. But my point is, it's been a while since we've spoken to Zoltan Pozsar.
Joe: (01:10)
It has been a while and it's unfortunate because he is one of our most requested guests. People would listen to him every month if we interviewed him.
Tracy: (01:18)
I agree. In fact, I think we should do monthly or even quarterly interviews with Zoltan. But I'm very happy to say, without further ado, that Zoltan is, he's back.
Joe: (01:29)
He's back. And so, right. So he was at Credit Suisse, he left Credit Suisse. He's been kind of silent. There has been this incredible mystery about what he's going to do next. And we don't know, but he's coming on the Odd Lots podcast. So let's find out.
Tracy: (01:43)
He's going to tell us now. Zoltan, welcome back to the show. We're so glad to have you back on.
Joe: (01:48)
This is like when LeBron James announced ESPN all those years ago what he was going to do next.
Zoltan Pozsar: (01:55)
Very nice to be back. Thanks for having me guys.
Tracy: (01:57)
All right. So what are you doing? Let's just jump right into it.
Joe: (02:01)
Let's, yeah.
Tracy: (02:03)
You were a strategist at Credit Suisse, as everyone knows at this point. And now what are you up to?
Zoltan: (02:06)
Well, the next step is I have founded my own macroeconomic consultancy. The name of the firm is Ex Uno Plures. And I will be providing research to institutional investors and consult institutional investors about the plumbing, as I always have.
Joe: (02:25)
Okay. Many questions. Well, let's just start simple. What does Ex Uno Plures mean?
Zoltan: (02:31)
Ex Uno Plures is the opposite of “e pluribus unum,” which is this little motto that we can find on a great seal of the United States and on the dollar bill. It means in English, “out of one, many.”
It's meant to capture two ideas. The first idea is, you know, my retrospective on what I've been doing for a strategist for a decade is basically anticipating moments when prices fall apart in funding and rates markets. So the basic idea is that most of the time things are straight on top of each other, you know, the interest rate structure is orderly. And then when something bad happens, whether it's panic or a pandemic or a balance sheet constraint or liquidity constraint, prices fall apart. So out of one price you are dealing with many prices. And so that's basically the bread and butter of what a rate strategist and a rates trader is doing, anticipating those moments and being on the right side of those moments.
And then the other idea is that, you know, global macro as such, I think it grew up as a concept and an asset class, if you will, in a unipolar moment where globalization was moving forward, the dollar was the undisputed global hegemonic currency. And so we were all kind of trading the global dollar cycle.
And going forward, as we discussed this in the context of Bretton Woods III, that's no longer going to be the case. So it's kind of capturing the zeitgeist in that, you know, China is trying to extract itself from the Western financial system, much like the Western real economy is trying to extract itself out of supply chains that are running through China.
And so we are, I think, at the beginning of this era, the next five to 10 years at least, where we are going to go through this monetary divorce. And you know, the dollar’s hegemony is going to be challenged by some geo-financial moves that China is [doing]. So out of one dominant reserve currency, we'll have a world where we'll have many.
Joe: (04:36)
That's a great name.
Tracy: (04:38)
So, you know, you mentioned moments in macro and I think last year when you released that Bretton Woods III thesis that you talked about on the show and wrote a number of research notes about, it definitely demarcated a thing that seemed to be, you know, floating out there in people's minds. This idea that maybe finally some things were changing around dollar hegemony as you just mentioned. Talk to us about that original thesis a little bit more and whether or not you think it's been borne out over the course of the last, I guess, 12 to 15 months or so.
Zoltan: (05:19)
I think the concept is very healthy and it's alive. I personally see more and more signs that some of these themes that we have discussed on that first show when we talked about Bretton Woods III are coming to fruition.
And also in the conversation with Perry, I think we did a quick temperature check on the idea. And the conclusion I had there was that, you know, Bretton Woods III is a healthy baby boy, so to speak. So it's growing and developing rapidly.
Look. A couple of things to frame that. My answer to that question is, I think it's becoming very obvious that when you talk to policy circles and investors in the West, I think the primary focus is on how do we, so to speak, de-risk supply chains that are running through China? How do we become more, you know, self-sufficient in terms of rare earths, all the capital goods we need for energy transition? Chips and so on and so forth.
And so the focus in the West is on making sure that the real economy is decoupled from the East, so to speak. And when you speak to market participants and policymakers in the East, the primary focus there — because they have all the supply chains and so they are in control of that part of the equation there — the primary focus is on how do you extract yourself from the Western financial system and how do you de-risk this relationship that you have financially with the US dollar and Western financial institutions and financial centers in general.
And I would say that since we last spoke about this topic, there have been a number of news headlines, you know, readouts from state visits, what have you, where things like the renminbi invoicing of commodities is moving ahead. We are reading about more and more stories where natural gas deals and oil deals are invoiced in renminbi and not the US dollar.
I have not talked about this aspect of Bretton Woods III, but I kind of uncovered the new aspect of it, which is the whole central bank digital currency topic and how all that fits into Bretton Woods III. And you know, when you start digging in that domain, I think you uncover several things that are kind of eye-opening.
So let me just offer one. For example, you know, the real economy analog again is, you know, in the US for example, we don't allow Huawei to build cell phone towers for obvious reasons. You know, there is a risk of eavesdropping and espionage. And you know, the central bank digital currencies are basically the same story. I have been kind of cursorily following CBDCs, but I couldn't really fit it into an overall macro picture as to what are CBDCs about.
But you know, if you think about it, China has been quite busy trying to internationalize the renminbi and use it more for trade settlement purposes since the middle of the last decade. So around 2015 is when they started and then that process somehow stalled. And I think the reason why that process stalled is that they recognize that it's pointless to internationalize their currency through a Western financial system. Through London, through New York and through the balance sheets of Western financial institutions, when you basically do not control that network of institutions that your currency is running through.
For you to do something like that, you basically need a full new correspondent banking system. Okay. And so, you know, this is also the time when Russia annexed Ukraine, sort of financial sanctions became a much more dominant topic in the financial press. So I think that was a wakeup call for China, that if they want to indeed internationalize the renminbi, they need to start from scratch and they need to build a de novo financial network that they control.
And so this is also the time when CBDCs has become a hot topic. You know, CBDCs started in China, you know, the eCNY. And the way I think about CBDCs is, and developments in that space today, is that you basically need to imagine a world where five, 10 years from now we are going to have the renminbi that's far more internationally used than today, but the settlement of international RMB transactions are going to happen on the balance sheets of central banks. So instead of having a network of correspondent banks, we should be thinking about a network of correspondent central banks.
And a world where you have a number of different countries and each of those different countries have their banking systems using the local currency. But when country A wants to trade with country B, you know, Thailand with China for example, the FX needs of those two local banking systems are going to be met by dealings between two central banks.
And so when you reimagine a system like this, it's basically a state to state and a central bank to central bank network that is completely independent of Western financial centers and the dollar. So there's a ton of development — we can devote some time later in the show to talk about this — so there's a ton of development on that front.
And also the context here is that if you want to imagine an alternative to a dollar based system, you know, the single most important thing that makes the dollar so important is that 90% of FX transactions any given day in the world use the US dollar as one leg of the transaction. Okay. So basically, that's because we inherited the system where if you want to settle, you know, if you want to settle a transaction between someone in Hungary and Thailand, okay, the way you would do that today is you would sell your Hungarian forint, buy euros, sell the euro and buy the dollar and sell the US dollar, and buy back.
So that's basically three different currency pairs, three market-makers, three bid-ask spreads. It’s incredibly inefficient. But again, if you go back to this concept of correspondent central banks as opposed to correspondent banks, this transaction just can settle between the local Hungarian banking system and local Thai banking system. You have to do central banks act as dealers of last resort in the FX markets.
And so that's the last, you know, piece I want to mention in this part, which is that, you know, in the West we are talking about this dealer of last resort thing a lot. And the context in which we talk about dealer of last resort in the West and in the US case specifically, is that we need a dealer of last resort for the Treasury market because the Treasury market is not liquid. That's where the focus is.
Of course, we need the dealer of last resort in the repo market and the FX market. But I think it's also time to start thinking about dealers of first resorts in terms of FX market-making for the global East and South, which is the central bank digital currency, central bank correspondent system that I'm describing.
Joe: (12:23)
This is so interesting because I don't think I'd ever heard anyone talk about CBDCs within the context of a new kind of plumbing. I mean you hear stuff about, okay, well you know, it's 2020, it’s the 21st century and we need to be able to pay for stuff on our phones, which we already can do. Or sometimes you hear about it in the context of privacy. I've always had this theory that CBDCs are just a way for central bankers to get invited to panels and get really plush jobs after they leave the central banking world, like doing digital money for Visa or something like that.
So, this is actually sort of an interesting theory. Before we go a little bit further down this road, because I want to talk more about it, can you just talk a little bit more about, I'm still curious about the business. You know, you're going to be going out to, you know, be independent. What is your sort of vision for Ex Uno Plures? Which again, I think is a really clever name, the opposite of “e pluribus unum.” What is your vision for what kind of business it'll be? Is it going to be… Who are your clients? Talk to us a little bit about what your vision for your firm is.
Zoltan: (13:29)
Yeah, well thanks for coming back to that. I mean…
Joe: (13:32)
I figured if you're going to announce the decision, the big decision here on Odd Lots, I’m happy to like… I'm actually also just, I'm very curious about how this world works.
Zoltan: (13:39)
Okay. So look, I will offer two streams of publications in terms of research. The first one will be “Money, Banks and Bases.” This will be the publication that most people kind of, you know, identify me with. So I will be looking at the 50 largest balance sheets in the world with a lot of attention. You know, what the big banks are up to, what the G6 are up to, what are they doing in their portfolios, where are the balance sheet constraints? And it's going to be basically a research piece about the day-to-day working of the dollar system as we know it today.
And then the parallel publication will be “Money and World Order,” which is going to keep track of how Bretton Woods III is evolving because, you know, these topics: de-dollarization, the re-monetization of gold, you know, using central bank digital currencies to build out, to knit out a de novo financial system, you know, the petroyuan and the renminbi invoicing of commodities and traded goods going forward.
I think these are basically the two lenses through which one should be following dollar funding and dollar rates markets going forward because, you know, the day-to-day we just have to live with, but then we absolutely cannot lift our eyes off all the geopolitical realities and challenges that the dollar will be facing. So these will be the two publications that subscribers will get.
As I said, you know, it's a high price tag so, you know, target audiences – institutional investors exclusively and not retail investors. And so I will be completely behind the paywall and subscribers will be able to chat with me and have conference calls and meetings. And that's basically the simple vision.
Tracy: (15:21)
I was actually going to circle back to that towards the end.
Joe: (15:25)
Oh, so sorry…
Tracy: (15:26)
… But since you gazumped me, let me ask a question that sort of squares these two thoughts: the new business and the Bretton Woods III vision. So, one of the criticisms that we sometimes hear about big, bold predictions about changes in the overall financial system is that it's hard to actually invest money based on that. So I guess the question is, you know, if someone hears Bretton Woods III, central bank digital currency, forex lenders of first resort, things like that; what's actionable about those ideas? What does it actually mean for investors?
Zoltan: (16:07)
Well, I think it means a lot. So, number one, I think if we are looking at a whole new plumbing where, so let's back up. For example, I mean we are used to thinking about a world where there is either a dollar shortage in some regions or dollar surplus in other regions, and then these surpluses get recycled either in the FX swap market or in the rates market.
And you know, I think if we end up in a world where countries are now going to have several options, for example, as to how they pay for commodities, I mean, let's take oil for an example. You know, people hold dollars for many reasons. One reason why people hold dollars is because oil has been historically priced in dollars. So if you are a poor country that needs to import oil on the margin, you need to have dollars to be able to do that.
Now, if you are going to live in a world where you can pay dollars for oil, but you can also pay renminbi for oil. But if you are a gold miner, you can also pay for oil with gold. Like Ghana, for example. You know, that's basically three options you're looking on at a screen. And so you would just choose whichever one is cheaper.
And that picture gets, you know, further complicated by the fact that there is oil flowing west, which is one price, and oil flowing east, which is another price. So it's not just… Again, “out of one many.” It's not just one price anymore, but it's a bunch of prices and a bunch of currencies and choose whichever works best for you.
So, if you go into a world where trade is not dominantly invoiced in dollars – so people don't have to borrow dollars to import stuff and the exporters don't earn dollars exclusively – then it's no longer a machinery where, you know, the dollars are getting created on the margin, the dollars are getting accumulated on the margin. And the question is how do you recycle the earned dollars back into funding and rates market?
So if that world splits into, you know, we are now doing half of this in renminbi and the other half we're doing it in dollars, then naturally… For example, the FX swap market. The landscape of the FX swap market is going to get redrawn the following way. There will be regions that used to be short dollars, but now they are not because they can, you know, source renminbi through the renminbi swap lines from the PBOC. So dollar shortages in certain regions are going to disappear. Then there will be regions that used to recycle dollar surpluses into the FX swap market. You know, maybe the Reserve Bank of Australia putting in the FX swap market and then you know, some Japanese investor picking those dollars up in the FX swap market to hedge their Treasury portfolios.
But you know, if Australia ends up earning only half as much dollars than as they used to in the past, and the other half is now invoiced in renminbi, then the dollar recycling is going to suffer as well. So you know, the supply of dollars in FX swap markets and the demand for dollars in the FX swap market is going to get redrawn. And I think there will be some regions that are going to be turned on their head. You know, so there will be positive cross-currency bases that could turn negative and there will be negative cross-currency bases that could turn positive. So it's just one example, for example, in terms of FX swaps.
And then in terms of, you know, the rest of the world's demand for Treasuries, which is a big question. Again, you know, dollars you historically need because you need to import a bunch of things which have been exclusively invoiced in dollars. But if you have a world where things are being invoiced half in dollars and half in renminbi, you know, that need to accumulate dollar reserves doesn't exist there.
China I think is a very important example in this regard because one reason why China has so many FX reserves is because that's kind of like your life insurance policy because all the commodities and food stuffs that they need to import. I mean, I think the big five commodities that they import: natural gas, oil, soybeans, copper, God knows what else. But you know, the annual bill for those imports is running in the $500 billions, you know. So if you don't have the dollars to pay for those, you're toast. So you have to have a lot of dollar reserves.
But if you end up in a world where you can now force commodity exporters to accept your currency for those commodity imports and not the US dollar, you basically have gained sovereignty from a monetary perspective. And so again, you will not have to run with as much FX reserves. And so you know, this is going to have feedback effects on, you know, demand for Treasuries in general and on the margin. You know, things are always on the margin in finance.
So I think if these themes are going to play out over the next five to 10 years on the margin, you know, demand for Treasuries and the recycling of dollars in the front end and the back end of rates markets I think is going to get pushed around.
Joe: (21:10)
Would you anticipate or do you have some timing – we talked about this on a recent episode with Karthik Sankaran – that we'll see, you know... There are a lot of countries around the world that float dollar bonds for one reason or another. Do you anticipate that we'll see, if renminbi internationalization continues, that we will see various EMs float more renminbi bonds? Or would that be a crucial aspect towards a successful internationalization of RMB?
Zoltan: (21:42)
I think it can be a part of RMB internationalization. I mean, you know, it's just a way of kind of raising offshore RMB that's out there and now you can either tap swap lines with the PBOC. You know, that's a very important aspect of it. I mean, PBOC has swap lines with way more countries than the US has swap lines with, for example.
So there is, you know, when you kind of look at the topography of that PBOC swap line network and when you look at the topography of the central banks that are actively planning to have a CBDC or they actually have a CBDC pilot up and running already, I mean there's a perfect overlap, you know.
So if you think about the FX swaps as the funding angle to the renminbi that you don't have in the system yet, and then if you look at the CBDC as the kind of swapping and clearing of existing local currencies in the system, I mean you basically have a spot FX and a market and a funding market infrastructure around it. So you know, you can internationalize the renminbi, that way you can internally nationalize it by EM countries raising RMB bonds to raise term RMB liquidity.
But again, I think the most important thing here is that we are starting to see evidence that more and more commodity trades are being settled in renminbi. And also, over the past year, the renminbi’s share of trade finance has increased tremendously. I think it has increased from barely one percent to five percent in a 12 month period. And now it's at par with the euro’s share of trade finance. And again, if that one 12-month period is any sign, you know, you project that five, 10 years out, you can have a lot of ground that renminbi could gain.
Tracy: (23:21)
You know, Zoltan, you mentioned changes in structural demand for Treasuries. And I wanted to ask you about this because this is one of the, I guess, last research notes that you wrote at Credit Suisse. I think it was in January, so definitely not the final one. But you were talking about at some point the Fed is going to need to come in and support the Treasury market once again because you have all these natural buyers of bonds who are starting to step away. And I think you talked about potentially the Fed having to restart asset purchases as soon as the summer. Is that something that you still see on the table?
Zoltan: (24:01)
Well, it's the summer. So let's put it this way. I mean, we have now the offer on buyback program. That's up and running if I'm not mistaken, correct?
Tracy: (24:11)
Yep, you're right.
Zoltan: (24:13)
Yep. Okay. So, there is that and then we had, you know, the problems around SVB and some other banks. So, let's just put it this way, I think that when we think about these what is the government going to have to do to step in on the margin to calm things down? You know, I always tell you that the answer is always along the spectrum.
So, I think we are in the anteroom of something. You know, we are dealing with illiquidity with the buybacks. So far so good. We have dealt with underwater bank portfolios. I mean the bank term funding program, effectively your ability to raise, you know, to value underwater bonds at the Fed at par and raise liquidity that way if you have to. I think that's a pretty big support to market functioning.
So I think, you know, things are happening on the margin, which kind of points to the Fed and the Treasury building scaffolding around the Treasury market to deal with the illiquidity issues and kind of this lack of marginal buyer issues that we have been talking about.
You know, the other point here is that, you know, in the front end there's a ton of liquidity. And so all this issuance that the Treasury has been doing and will be doing is going to be front end heavy, you know. So that's another way of dealing with Treasury market functioning. I mean, you have $2 trillion in the RRP facility, you're just going to issue where you can most likely soak up a lot of liquidity without any glitches.
But again, I think this underlying issue that we are talking about – that the world is probably going through a split where demand for Treasuries from the rest of the world is probably not going to be what it once was – is going to be an issue. And as these issues pop up, we are going to be dealing with them in a step-by-step fashion. But again, I think these illiquidity problems are present and we are dealing with them as they pop up.
Joe: (26:23)
I want to get, you know, your take further on some of the banks and particularly the aftermath of SVB, etc. But before we do, you know, thinking back a year ago, this conversation or the versions of this conversation might have been much more commodity centric. And obviously oil has fallen quite a little bit. There was a lot of stress a year ago about the European electricity cost which have come down significantly. Generally, there's been a lot of easing there.
But I'm curious, do you think that, was that just a sort of a onetime reset in terms of maybe post pandemic shocks and of course the invasion of Ukraine and that things are settled? Or will sort of commodity fragility, commodity volatility, anxiety about sourcing energy be sort of a permanent or semi-permanent condition over the next several years as part of this sort of Bretton Woods 3.0 vision?
Zoltan: (27:21)
Yeah. So, you know, to be intellectually honest to ourselves and to the listeners, yes, we did talk about, you know, commodities taking a bigger role in, you know, reserve management practices and whatnot among many other themes.
So, I would say that for me, what survives that commodity aspect of the Bretton Woods III thesis is that I think gold is definitely something that's coming back as a theme. I mean, just to give you a very good example. When I saw – I think Barry Eichengreen was a co-author on that paper – the IMF published a paper about gold. And the title I think was “A Barbarous Relic No More?” And it was co-authored by Barry Eichengreen.
So, I'll hide behind Barry a little bit. But I think it's noteworthy when someone like Barry Eichengreen, who's probably the official biographer of the dollar, writes a paper like that. And I think we are seeing this more and more in the data that especially the countries that are not geopolitically aligned to the US are shunning Treasuries and shunning the dollar and they are buying gold instead.
I think there's also a number of other headlines which I think are important to keep an eye on because individually they might not sum up to much. But I think in the totality of these things, probably pinpoint a trend. You know, Ghana and Russia basically had an oil-for-gold deal whereby Russia ships oil to Ghana and Ghana pays gold for the oil that they receive. I mean, the basic idea was that a country that uses FX reserves, US dollars mostly that also mines a lot of gold, it's kind of pointless for them to spend their precious dollars on oil when they can just swap gold for oil and kind of get their oil that way and then they have, you know, FX reserves left for other stuff. You know, pharmaceuticals for example.
Again, geopolitics is the angle here, but you know, Russia and Iran are establishing a special economic zone along the Caspian Sea where the trade is going to be settled in a gold-backed digital token. I forget which country it was, but you know, there's another gold rich African country which is playing with this idea of a gold-backed a digital token. Again, I think these are interesting developments, but again, some of the last ones that I mentioned are probably on the fringes. But again, you know, in the IMF data and in the data of the Gold Council, we see this massive increase in foreign central banks purchases of gold.
So that gold aspect definitely survives. And yes, you know, energy markets have gone up and they have come down. But again, I think it's just hard to escape the reality that, you know, Saudi Arabia is not exactly falling over backwards to increase oil production. But in fact, there's this tug of war where, you know, I think the Crown Prince has a domestic economic agenda. It needs oil prices to trade between $80-$100 a barrel for them to pull up that quite ambitious domestic and regional and also geopolitical agenda.
And I think there is this tug of war between the oil consumers and the oil producers where, you know, things haven't really broken out into either side. But I think that OPEC is basically giving us a body language where, you know, if there's not enough demand for oil and oil prices are falling, we need our revenue. So we are just going to nudge supply such that prices don't fall too much. So again, I think the commodity shortage and this, you know, I think the theme that I used was “our commodity, your problem.” I think it's definitely there in oil.
Again, you know, Russian oil, surprisingly, I think it all found a way to alternative markets. So, you know, tanker rates are up. We talked about this a year ago, that tanker rates being the balance sheet for the real economy balance sheet equivalence in the oil market, and the tanker rates are through the roof because these shadow fleets have to be assembled to find alternative markets for Russian oil. And I think, you know, the supply chains are probably getting more caught up in this theme involving energy transition, getting the lithium and all these things that are needed for that. So I would say that the commodity aspect is a mixed bag except for gold.
Tracy: (31:33)
That other African country, I think it was Zimbabwe doing a gold-backed digital token.
Zoltan: (31:36)
Zimbabwe, yes.
Tracy: (31:37)
So I guess make of that what you will, but I wanted to go back…
Zoltan: (31:42)
Well, I just wanted to say make of that what you will, and perhaps a lot of countries that we will mention in this conversation are going be, I don't know, the sanctioned countries, let’s put it that way. But I think that's precisely, I mean, these are not the countries that you think about when you talk in the financial press about things.
But I think the underlying theme here is very much one where if you look at this unipolar world that we are, you know, talking about. Whether it's supply chains or whether it's the monetary regimes, whether it's foreign policy alignments between East and West. You know, two great powers and a bunch of non-aligned countries, I think it's important to pull in these fringe countries because you know, there is power in numbers and, yeah, one country's GDP is not much, but when you kind of clump them all together and they kind of sign onto one system as opposed to another system, these things are going to be meaningful on the margin. So I think that's why it's important to think about basketcase countries, so to speak. But yeah, that's why we mentioned that.
Tracy: (32:44)
Yeah. And I mean US dollar transactions I think are a pretty big thing in Zimbabwe. So you know, the fact that they're experimenting with a new type of thing to try to maybe get away from that is interesting.
But I wanted to go back to what we saw in the banking system because everyone who knows your origin story probably knows that, you started out working at the New York Fed, there was the famous shadow banking chart that you did before the financial crisis, sort of laying out how this entire system actually worked. What do you make of the most recent banking crisis? And I know some people take issue with actually labeling it a crisis. We can call it a banking drama or whatever, but is the drama over for now?
Zoltan: (33:36)
Well, let me tell you this, it feels very different from 2008 obviously. I mean, there it was an existential moment and you know, the central nervous system of the global dollar system was at risk, you know, the big banks. So the big banks were a source of strength this time around.
I would say that we basically have three institutions that became collateral damage, either through crypto or the tech implosion or you know, your inability to underwrite, you know, mortgages intelligently.
So, you know, Signature Bank is crypto-related. SVB I think is a very unique case because what it kind of tells you is that it is important for a bank to kind of be diversified both in terms of its lending portfolio and also its deposit mix. You know, when I was following the SVB debacle, the thing that came to mind for me was, I don't know if you remember this Tracy, but Bear Stearns used to have two hedge funds, which were the first hedge funds to blow up in…
Tracy: (34:41)
Oh, I remember.
Zoltan: (34:43)
I forget what they were called, but they had, I think the Bear Stearns enhanced leverage fund or whatever they were called. You know, those hedge funds were the first ones to blow up because they had the worst assets imaginable and they had the worst liability structure imaginable.
Tracy: (34:59)
Yeah. I think they were like really high yield structured credit or something like that?
Zoltan: (35:04)
Yes. And high yield structured credit, you know, CDOs. So that stuff on the asset side and you know, overnight funding. So repo funding. SVB I would say is a case where on the liability side, I mean we know who the big depositors, who the clients were, we were reading about some of them you the financial press
But basically, if you think about the tech sector, the venture capital sector where all the valuations have basically taken a big nosedive after tech stocks corrected, you basically had the depositor base that was liquidity constrained. So they basically pulled money from one bank where a lot of tech entrepreneurs kept their cash. And so that's a liquidity drain and it wasn't diversified. On the asset side, SVB had a lot of duration. You guys know that my bread and butter is going through all the quarterly reports of the biggest institutions, and you know, I mean very few banks have as big a share of their HQLA portfolio in stripped mortgage-backed securities as they did. They had a lot of coupon exposure, they had a lot of principle exposure there. They had a lot of duration in these portfolios and they didn't hedge them properly.
They also had a lending book where they were lending to the same, you know, customers that were pulling funds away from them. But again, the collateral on that lending book was tech-related. So you had valuation issues. So that was just kind of a perfect storm. Systemic, absolutely not. But it hurt them.
And you know, First Republic, I mean, I have to say I have a friend in New York who once texted me when First Republic was going under saying, “Hey, I didn't realize I got such a great deal on my mortgage that it's going to be the end of First Republic.” And I said, you know, I told him that, “well next time you get a mortgage that's too good to be true. You should also short the bank. Maybe the mortgage is going to pay itself up faster than you, than you anticipate.”
So again, I think this is basically the story of these three banks that got into difficulties. The solution that the Fed crafted for some of these liquidity problems, I think they were extremely powerful. I was surprised, even shocked when I saw the terms of the BTFP.
When I talked to my contacts, there were two types of responses to this BTFP program. Number one, yes, that's the right move because the letter and spirit of Basel III says that Treasuries, and Ginnie Maes and reserves are Level 1 assets, no haircuts. But again, that assumes that you also have the brains to hedge the interest rate exposure there. And also, I mean, you know, you can put some of these bonds that were underwater into a hold to maturity portfolio where if you are sitting on huge market losses, it doesn't hit your bank's equity and you don't have to book those losses and it doesn't hit your capital.
But again, that assumes that your deposit base is sticky and so you're not going to lose deposits in the aggregate to the point where you actually have to liquidate these underwater bonds. And you know, it was not the case for SVB, it's the case for other banks like Bank of America, for example.
You know, and the other response to the BTFP is that, you know, this should not have happened because it basically euthanizes the need for interest rate risk management in bank portfolios. So it was a kind of a polar response.
But again, what's done is done. I think it's a part of the system now. I think the BTFP is going to be there as a standard feature of the system, much like the Standing Repo Facility and swap lines are there. So you know, these facilities tend to be born and then they stick around. But again, it's the part of the scaffolding that we have.
I mean imagine the Treasury market coming under strain because some of these banks have to meet, you know, liquidity shortfalls and then instead of pledging to the Fed off-market to get liquidity, you basically have to dump it on dealers and imagine what that would've done to the Treasury market. Nothing good. So we just basically kept these Treasuries off the grid, so to speak.
Joe: (39:01)
When SVB failed, there were sort of two conversations that sprung up right afterwards. One had to do with this sort of, okay, all deposits in the US are [de facto guaranteed]. Do we just accept that they're all implicitly guaranteed regardless of what the formal FDIC cap is? And then there's also a conversation about, you know, 5,000 banks in the US which is I think probably the most banked country in the world.
Does anything change with the business model of banking or do we just sort of accept that there are these contradictions and these tensions, but we don't talk about them and we just sort of let these issues go on and occasionally we have to clean up a mess. But by-and-large, some of these structural questions about the banking system, we just sort of kick the can and let them persist?
Zoltan: (39:51)
Well look, I mean I don't think that blanket deposit insurance is in the cards. But I think again, you know, other than the BTFP, we have this other tool which is the FDIC steps in between the Fed and the troubled institution. And so there's a capital buffer. So you know, it's some of the same playbooks in a different fashion that we have seen in 2008.
You know, the Fed always has to be secured to its satisfaction that it's lending, you know, it always wants to eliminate credit risk and you know, the FDIC is standing in between. Plus, the special loans that the Fed extends to trouble institutions serve exactly that purpose. So, I think we will be dealing with whatever problems we will be dealing with on a case-by-case basis. Again, I think SVB, you know, conceptually the problem of underwater liquidity portfolios, we kind of dealt with.
Commercial real estate is going to be a slow-burning problem. You know, as Perry Mehrling likes to say, a bank can be insolvent but liquid, but it cannot be solvent and illiquid. For as long as deposits don't run, we will be able to kind of deal with these issues.
You know, in interest on reserves is manna from heaven. You know, it's providing banks a steady stream of interest income. So if you have capitalization issues, that's going to be a backdoor way of kind of pre-filling your capital base. You know, back during the early 1980s when Paul Volker was in charge and we had the Latin American debt crisis and banks were underwater and had their capital issues, the Fed had to generate a steep yield curve in the system, which was a way to recapitalize the banks, you know, with interest from reserves. That's no longer necessary, so that's actually easier.
So, you know, I think the banking system is fine for now. I think we had a scare, and you know, we are definitely going to be dealing with issues in credit portfolios. We are going to be dealing with CRE lending books. There will be consolidation across the banking system. But there are many levers that the Fed pull to help clean things up. You know, JPMorgan for example was an institution that came in as a helping hand. I like to remind people, I haven't written about Wells Fargo in a long time, but you know, don't forget…
Tracy: (42:08)
Now you can!
Zoltan: (42:09)
Yes, now I can. You know, that bank is still under an asset cap. You know, it has a ton of unused balance sheet capacity. So, you know, that's a lot of balance sheet capacity to unchain if you need a helping private hand to clean up some stuff.
And I mean some of the banks that are already very big and were big beneficiaries of dislocations and banking crisis in recent times, they're probably not going to be able to add much to their balance sheet because they are already too big. But you know, I think Wells Fargo is another kind of ace in the back pocket of the Fed that could be pulled out if need be.
So I think the system is fine. I think we are just going to be dealing with these micro-dislocations here and there. Regional bank here, regional bank there, Treasury market. But again, people will be dealing with these things. But you know, the name of the game is to anticipate these and the appropriate positions.
Tracy: (43:04)
Well can I ask one more question? Just going back to your sort of shadow banking origins. But the expectation now seems to be that, you know, if banks maybe have to hold even more capital or maybe delever in one way or another, that a lot of that activity is going to end up being pushed into shadow banks essentially. So private equity perhaps. Or some sort of non-bank lender.
And to some extent this is what we've seen since the 2008 financial crisis by design of the financial regulators. There is some concern that even more starts to get pushed out now and maybe if you have interest rates that remain substantially higher, that's going to be a big hit for both corporate credit and commercial real estate. Should we worry about exposure to those sectors in non-banks?
Zoltan: (44:02)
Yes, because I think credit has yet to have its reckoning and commercial real estate has yet to have its reckoning. But again, it's better to suffer those losses in non-banks than banks because, you know, banking crises are very nasty things. But if these losses get booked and absorbed in balance sheets that are — I don't want to say not levered because they are — but that leverage doesn't really have much to do with money markets. That's orders of magnitude better to deal with than dealing with a lot of these concentrated exporters in the banking system.
Regarding that shadow banking question that you also asked Tracy, I think where we started this conversation, is that world trade, trading of commodities is going to get invoiced in currencies other than just a dollar. You know, renminbi and all these central bank digital currencies, market making and FX markets migrating to the balance sheets of central banks and instead of correspondent banks, you should be imagining correspondent central banks.
If that thesis is true, I think over time that's going to provide balance sheet relief to all the GSIBs because FX market making, credit lines exclusively provided in US dollars to oil and copper and other commodities around, you know, that's the bread-and-butter domain of JP Morgan, Bank of America and Citibank. You know, if you kind of move to this world that I'm describing, that's going to provide balance sheet relief for the big US banks on the margin. Now you can use that for other things, you know, as the shadow banks are licking their wounds because they are suffering their credit and real estate problems, the banking system is going to be potentially a source of strength in a sense that not only do you have capital to lend, but you also have the balance sheet to do so. So I think things are going to work themselves out. I think it's a good thing that things are happening in the shadow banking system.
The shadow banking system we are talking about today is very different from the shadow banking system I had. I didn't come up with the sexy definition of shadow banking. That's Perry Mehrling, who said that shadow banking is money market funding of capital market lending.
And I think the general understanding about shadow banking these days is that anything that happens outside of a bank that involves credit is shadow banking. That's not true to me at least because, you know, you have to have a very strong money market component, which is what amplifies things.
And so that shadow banking is fine, and if you will, you know, basically a lot of traditional bread and butter, Western financial market making, credit provisioning financing functions migrating to the balance sheet of central banks, CBDCs, different currencies. I think that's the new shadow banking terrain that we need to be focusing on, that I will be focusing on, and I will be mapping and thinking about because I think that's the frontier that's going to drive rates and funding markets going forward.
Joe: (47:05)
All right, Zoltan, I have one last very tiny question and I'm only asking this really because I need to know it for the outro of the episode. Are you going to join Twitter?
Zoltan: (47:15)
I will not be doing Twitter.
Joe: (47:16)
Really?
Zoltan: (47:15)
I will not do social media. Maybe we can say this at the end. I will say the name of my website where people can go and that's going to be live.
Joe: (47:25)
Wow. Incredible. That’s incredible restraint. That's an incredible restraint and I'm very impressed with it.
Zoltan: (47:34)
But is it a good thing? Is it a good thing? I think it's a good thing.
Joe: (47:37)
I mean it will make you very scarce, but it's incredible restraint, so I'm impressed.
Zoltan: (47:43)
No, I will be strictly behind the paywall and, and probably this could be my last public appearance and then I would just disappear beyond the paywall.
Tracy: (47:54)
This is a gift for Odd Lots listeners.
Joe: (47:55)
Thank you. It was a pleasure.
Zoltan: (47:58)
Thank you very much for having me.
Tracy: (48:17)
All right, well thanks so much Zoltan and the website, the new website, is exunoplures.hu. You should definitely check that out. Joe, I love talking to Zoltan.
Joe: (48:28)
Me too. That was such a treat.
Tracy: (48:31)
That the quote about “we are in the anteroom of something,” I'm going to steal that for coverage. I mean look, every time we talk to him there are a number of really interesting big picture points. The one thing I would say is I remember when the Bretton Woods III thesis came out last year. There were a lot of people saying that this was “never going to happen” and many of those people now have sort of tweaked that statement to “Oh, you know, “it may happen, but not for a long time.”
Joe: (49:01)
You know what I think is a really interesting point that I don't think gets discussed enough in this, which I appreciated Zoltan bringing up, was, you know, people look at this from a very sort of financial angle or they talk about China specifically. But I liked that he brought up, you know, all these other countries, the sort of non-aligned countries, they matter to a significant degree, particularly when it added up and sort of the politics of unaligned countries who don't necessarily see the world through the same lens as the US or have the same perspective on many of these global trends.
Obviously, some of the BRICS nations, etc. Geopolitics sort of gets trotted out too much, but the sovereignty and the impulses and desires of all these other countries, they really matter. And as their wealth grows and as their needs grow, what they do economically and who they trade with is going to sort of be determinative to some extent about who rises and falls.
Tracy: (50:02)
Well the other thing I thought was really interesting was this idea of maybe outsourcing more dealer functions to the central banks. And if you were to do that, it could potentially solve some of the concerns that you just outlined, but also free up some balance sheet for big banks to do other types of activities. Maybe more non-market making activities, more loans, things like that. I hadn't really considered that.
Joe: (50:29)
Yeah, it's a really interesting point and no one else has really talked about that. But you know, we do sort of live in this era in which sort of state capitalism, state-directed capitalism is such a big thing. Right? And so the extent to which central banks become bigger sort of active dealers rather than just sort of behind the scenes supporters of private banks is something to take seriously. And maybe there is a context there in which sort of the CBDC or digital currencies could sort of have a natural fit in that framework. We need a new map.
Tracy: (51:05)
Yeah. We really do, don't we? Well, maybe Zoltan will publish one at his new research firm. Shall we leave it there?
Joe: (51:11)
Let's leave it there.
As discussed, Zoltan isn’t on Twitter but you can reach him at his new home of: zp@exunoplures.hu