Pozsar: QE, YCC needed to "keep wheels on the [USD] cart"
Zoltan Pozsar’s War and Peace:
- Part 1: The Cause: What the East is Doing
- Part 2: The Effect: BRICking the Dollar
Part 3: How the Fed will Counter the Brics
Next Zoltan focuses on what the West likely will do to combat the risks associated with a shrinking global reliance on dollars as the sole settlement medium for world trade.
Zoltan's 4 Definitions/Prices of Money Restated...
This is core to the plumber’s-delight part—where he handicaps the path of least resistance for the markets’ next potential crises.
Using examples of each of the four prices of money (renamed: Spot, Equity, Rates, FX) he quickly diagnoses the risks to each type as things currently stand. The SHTF when Rates markets (Bonds) start to fall apart. Let's fast forward to the good stuff
In the domain of the second price (interest rates), spreads around OIS have been fairly quiet to date: only credit spreads had blowouts, but not swap spreads. But with Treasuries, I see a conceptual problem brewing …
Right here we should note the RATES concept is not tied to inflation as he describes it. He is focused on the lack of offshore demand coming to meet the growing supply needed to be launched from QT combined with the increased fiscal policy spending we now have. Who will step into the demand gap to keep rates/bonds stable?
WHO WILL BUY OUR BONDS NOW?
He quickly runs through the list of likely classic marginal sources/buyers to offset the lack of foreign demand for treasuries.
- RRP Cash: will help but not at current prices relative to OIS
- Relative Value funds: good for only $25BB each
- Banks: not likely given their underwater “held to maturity” portfolios
- FX hedgers: nope, they’ve pulled in reins since the BOJ priced them out
If noone steps up, then we will start to see increased tailings at Treasury auctions. If that happens too much, then nasty selloffs in risk assets follow bond selloffs. And If that happens the Fed is forced to act:
[M}y sense is that this [too many tailings] is a “checkmate -like ” situation: the Fed won’t be [able to] pivot and the terminal rate may have to go higher still , neither of which augurs well for either risk assets… or Treasuries …
If this were to happen that would be the end of QT. In it’s place would effectively be QE6 but “under the guise of yield curve control, which my instinct says will come by the end of 2023 to control where U.S. Treasuries trade versus OIS.” he says. That sounds to us that he feels the RRP will be tapped out by December of this year.
Forget stocks, we’d need to support the Treasury market. if we don't then that risks acceleration into mistrust of all FIAT. Thus: if all this were to happen the “put” we enjoyed under stocks all these years would need to be under bonds.
The put under risk assets is dead…The put under government bonds is about to be born.
Citing a May 2022 paper from the BIS he labels this the conception of the Fed reserve as backstop to dysfunctional bond markets. The birth of the bond put, if you will. We would note that if the fed is putting an “put under bond prices, then the Bond market becomes by its use a risk asset as the EXTER pyramid begins to wobble at the top. Which means cash and gold are all that’s left as safe havens. This is bad, but if this doesn’t work.. it gets way worse and the dollar will no longer be a safe haven.
The Fed will move its "Put" from Equities to Bonds as it pulls back USD defenses...
POWELL’S LAST STAND
This is the therefore the Last Stand. If the Fed cant defend bonds, they certainly can't defend other nations' FX.. and that means the Dollar is done as global reserve. Then you get massive real economic deflation from reduced global dollar velocity (financial leverage) fought by the Fed with very risky hyperinflationary policy just to stop a depression. If less people are using dollars, then by necessity dollar velocity will shrink despite the big float. If that happens, you get economic deflation bordering on depression. Then the Fed will try to get velocity back up by printing even more money.
This is what the BOE had to deal with in panic mode, and what the BOJ is currently massaging with YCC.
Also, please note, the moving of the put from stocks to bonds is being discussed as if it’s a lateral move. It is not. It is a vertical move from a risk asset to a supposedly safe haven asset much closer to the core of money itself. This should be a massive concern if a central bank has to do that. Which could translate to a massive exodus from US bonds into cash, as the government buys all of them. Far worse, than the bank of Japan. Because we bet you the bank of Japan is being helped by the US fed on this. Who is going to help the US fed when it is our turn?
ENTER YIELD CURVE CONTROL
Keeping the YCC part clean and hopefully clear for purposes of this write-up: Yield curve control is effectively an interest-rate peg. Interest-rate pegs theoretically affect financial conditions and the economy in many of the same ways as traditional monetary policy (namely QE which hardly was traditional until recently): capped interest rates on Treasury securities would feed through to capped interest rates on mortgages, car loans, and corporate debt, and ultimately filter through to higher stock prices and a cheaper dollar.
YCC has been famously memorialized in how the BOJ used it to push rates to zero in order to spur inflation. Now they are using it to keep a lid on RATES as inflation works its way through their FX market.
One advantage of YCC vs QE is that by targeting rates as opposed to volumes of bonds it is reactionary and therefore almost guarantees less balance sheet bloat from too many bonds being bought.
One major disadvantage not discussed enough is that in using a rate peg, this can take much much longer to quell the various uprisings that will attack the peg. The acute problem is traded off for a more chronic one and that could be dangerous7. Confidence can in normalcy ever being returned to can be destroyed and with it the CB credibility.
CONTROLLED DEMOLITION OF THE LONG BOND
While YCC is currently associated with QE because the Fed would be keeping a cap on rates by buying bonds, and therefore is associated with risk assets like stocks being beneficiaries— what if the Fed is buying bonds not to push rates lower and incentivize stock purchases, but to keep RATES from exploding and destroying SPOT, The focus is not the EQUITY part of the pyramid at all then.
On this Zoltan says:
…don’t expect the put under government debt to prop up risk assets: unlike QE in the context of low interest rates and a risk asset put, the coming QE will be in the context of Treasury market disfunction (sic).… The next round of QE will aim to “keep the wheels on the cart” amid high inflation, growing geopolitical tension, and an ugly financial divorce between the West and the global East and South.
Then what you have is a controlled demolition of both bonds (partially) and stocks, with a slowly increasing rate peg like a dog being given a little more leash hoping it tires out.
The idea being to prevent wholesale panic out of both bonds and stocks as opposed to directing money to come into them.
Now we see the path from BRICS actions to Fed Policy as Pozsar assesses, and can put it into a flowchart:
- IF: Treasuries Tail
- THEN: RRP gets drained to handle it and marginal players are called in
- IF: that fails (RRP empties end of 2023?)
- THEN: YCC starts in 2024
- RESULTING IN: Bonds (and presumably commodities) benefit, stocks less so
One thing to mention is Pozsar strongly asserted months ago that part of this would entail long tern yields going up when he said 'You can fight inflation by raising short term rates, or letting long term rates rise. here is the quote: From Cure Inflation "By Forcing Long Term Rates Higher"- Zoltan Pozsar in April.
Since Volcker, the Fed has sought to actually keep long term rates lower by raising short term rates. The second way to lower inflation Pozser says, is “by forcing long-term interest rates higher”.
We understand this somewhat and described that the long end bond yields must rise as the yield curve uninverts at higher levels in the back, as opposed to lower levels in the front. YCC is how they will control the rate assent is our guess while they titrate the short end with fed funds.
Here's an updated version of what it looks like from our post The Broken Bond ladder
The End of The End of History
Pozsar next transitions to the nitty gritty of portfolio management with the following:
But my message to readers [ PMs and clients] is that war is deeply personal, and it naturally forces you to take sides. But taking sides can’t blind your objectivity and judgement when it comes to your portfolio. Don’t be Tolstoy’s “intelligent man” who “knows” that today’s world order is the only possible world order because Francis Fukuyama said so, and, similarly, that U.S. dollar hegemony is the end of financial history.
Zoltan asks macromanagers to know their own biases and to understand that beyond macro there are structural forces at work here. "Don’t be Tolstoy’s “intelligent man” who “knows” that today’s world order is the only possible world order." If he is reading this.... we would add corroborating: Even Francis Fukuyama renounced being a Fukuyama-ist by rescinding his “End of History” thesis a few years ago.
Tomorrow: Zoltan’s portfolios for the next 10 years in Part 4
Full Analysis here.
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