Re: Inflation/Geopolitics-Geopolitical Mosh Pits & Sovereign Debt Endgames.

Recent developments in the world have introduced an “Every Man For Himself” dynamic not just between adversaries but also between allies. Welcome to the Geopolitical Mosh Pit.

I am not just talking about the obvious geopolitical conflicts like Russia/Ukraine or China/Taiwan/US. I am talking about conflicting ECONOMIC incentives between regions even among traditionally allied economic/geopolitical blocs.

STRUCTURAL INFLATION is at the HEART of the matter, not just from an energy/resource scarcity dynamic, but also from the CONFLICTING REMEDIES to combat Inflation from different CBs (Central Banks).

Let’s examine the BOJ’s quandary first. The Impossible Trinity lies at the heart of it; this chart explains it.

BOJ knows that pursuing YCC while the Fed is hiking will devalue JPY, so it allegedly looked for an “out-of-the-box” solution in July when JPY first approached the 140 level:

Ask the Fed for help.

Supposedly the Fed enabled the BOJ to buy UST 10yrs to “to paint a picture” of impending Fed Pivot to stymie the USD Wrecking Ball. No idea if the rumors were true, but the charts seem to corroborate this possibility:

Here’s the problem: the Fed simply can’t afford to keep doing “stealth QE” to benefit other countries when it’s fighting our own Inflation problem with aggressive rate hikes.

As you can see by the charts, this “intervention” lasted for ~2 weeks before JPY/UST 10yrs/Equities all resumed their respective dirt naps.

By mid-September as JPY approached 145, BOJ got desperate and directly intervened on 9/22/22 by expending $20B to prop up JPY. This time, the intervention last all of 2 DAYS.

As of this writing, JPY is at 145.33.

Let’s move on to the BOE’s quandary:

Like most CBs in RoW (Rest of World), the BOE needs to keep up with the Fed in its rate hikes if it wants a hope at keeping the USD Wrecking Ball at bay. If it doesn’t, the market reprices its yield curve and its currency.

By now, we all know why BOE had to intervene in the Gilt market: to save its pension system.

My friend Jim has a great thread that explains what happened:

But now that the BOE has tipped its hand to where the fragility lies, it too is BOXED like the BOJ. Because of the Impossible Trinity, IT CANNOT DEFEND BOTH GILTS AND GBP.

This is why I think the GBP is bound to revisit if not slice through the lows.

The BOE’s range of choices DIFFER from the Fed’s range of choices. Here are the BOE’s:

Here are the Fed’s:

BECAUSE OF STRUCTURAL INFLATION AND ECONOMIC DIVERGENCES, CB INCENTIVES DIFFER; DON’T COUNT ON THE FED TO BAIL OUT THE WORLD.

Last week, Williams came right out and said as much:

So far, we’ve talked about CONFLICTS BETWEEN ALLIES.
What about Frenemies or outright Adversaries?
In case you haven't noticed, OPEC+ has now entered the Geopolitical Mosh Pit last week:

PRIOR to this escalation, my base case for the next several years was an ASYNCHRONOUS CORE/ENERGY TAG TEAM that could potentially lure the Fed into the same “stop-n-go” monetary policies of the 70’s.

With OPEC+’s move, that ASYNCHRONOUS TAG TEAM becomes a SYNCHRONOUS WALLOP:

I can see a tit-for-tat battle emerging between the Fed trying to engineer DEMAND DESTRUCTION and OPEC+ compensating with SUPPLY WITHDRAWAL.

With “Every Man For Himself,” where does this all end?

Many believe that the Fed will have no choice but to pivot and once again paper over the coming crisis the same way it’s papered over every crisis of the last 4 decades, BUT:

Here’s the Fed Pivot argument I hear a lot:

“This wasn’t a monetary inflation, so why bother hiking? The Fed can’t print Oil or fix supply-driven inflation. The Fed is making a mistake and is looking at lagging indicators.”

My counter: “Alas, what you're seeing is the REMEDY to the REAL MISTAKE: Fed allowing Oil/Energy Inflation to leap/embed into far STICKIER components leading to a full-blown Inflation Conflagration."

Fed Pivot argument: “Besides, a debt-driven fiat monetary system MUST continue to grow, and the only way out is Growth/Inflation. Why bother trying to stop/slow it?”

My counter: “Lack of STRUCTURAL INFLATION have made us all forget that there are BUSINESS CYCLES. If 9% Inflation isn’t an excuse for reigning in the Liquidity Lottery and instilling for austerity for a change, what is the ENDGAME?”

This Recursive Debt Loop that Fed Pivoters say is inevitable reminds me of the Positive Feedback Loop that can only end ONE WAY: EVENTUAL COLLAPSE OF THE ENTIRE SYSTEM.

I likened it to the Tacoma Narrows Bridge collapsing due to RESONANCE in this thread from last year:

Just like the way Resonance created larger and larger oscillations in the bridge that eventually overcame the mechanical limitations of the system, forever increasing sovereign debt loads will result in larger and larger defaults/losses when they eventually happen.

Interestingly, when I studied the history of sovereign defaults/debt restructurings (there literally have been HUNDREDS since the early 19th century), the vast preponderance involve maturity extensions along with coupon haircuts – in other words, MORE CAN- KICKING.

Which brings us to an interesting thought experiment. Can endless Can-Kicking result in a Free Lunch?

Specifically, let’s consider the BOJ’s endless YCC policy and take it to the limit:

Can an Ourobouros ever be sated?

To me, in this hypothetical scenario, the markets would assume that a country that is so profligate in its spending that its own CB winds up buying all of its own debt would require CONTINUED ACCESS TO GLOBAL MARKETS.

Result: JPY would likely be worthless and Japan would experience a Weimar-style collapse.

I don’t believe in Free Lunches or Perpetual Motion Machines. Eventually, the piper has to be paid, and one must apply a CORPORATE RESTRUCTURING playbook (as I did for many years when I ran my fund) and consider the ASSET-SIDE OF SOVEREIGN BALANCE SHEETS.

In corporate reorganizations, Defaulted Bonds are typically converted into Post-Reorg Equity depending on where in the capital stack the Bonds reside. The more levered the company, the more Post-Reorg Equity component that results.

What then is the SOVEREIGN EQUIVALENT OF POST-REORG EQUITY? Here are some proxies.

After WWI, a sizable number of sovereign restructurings involved transfers of income streams (taxes, customs, rents, railway concessions, etc.). In the 80’s, debt-for-equity swaps and discount bonds with options on privatized government enterprises were prevalent.

If this is the kind of Sovereign Debt Crisis Endgame that results from constant Can-Kicking that “breaks the system,” note that countries endowed with the BEST GEOPOLITICAL ASSETS / RESOURCES WIN.

I wrote this thread to illustrate that CURRENCIES REFLECT NOT JUST METRICS LIKE DEBT/GDP OR EVEN INTEREST RATE DIFFERENTIALS BUT ALSO RELATIVE GEOPOLITICAL STRENGTHS:

In summary, this thread makes several Key Points:

1. The Presence of Structural Inflation presents an “Every Man For Himself” dynamic among world CBs.

2. Can-Kicking was easy when there was no Structural Inflation; now, not so much.

3. The winners of the Endgame when Can-Kicking comes to an inevitable end will be those countries with the best GEOPOLITICAL ASSETS.

I end this thread with a provocative question:

When you consider the unparalleled mix of geographic assets and hard/soft power of the United States, does realpolitik now also influence the Fed’s policy with respect to the USD Wrecking Ball?

END OF ORIGINAL THREAD.

Some updates follow:

Uh huh, BOE. Your move.

Riffing on the realpolitik theme, @PeterZeihan once mentioned that the establishment of the EUR has a COMPETITOR to USD hegemony would not exactly be viewed kindly by the US as gratitude for the Marshall Plan.

Unpopular Question:

Would the US be that unhappy about the USD Wrecking Ball fracturing the EUR? Bye-bye GBP.