Ukraine, US subprime and the erosion of US financial hegemony
Today is not going to be a themed post but a news flow analysis post like I generally write on Friday’s. But because I didn’t write on last Friday and because there is so much news flow, I am doing it today. Note that I will be out starting August 6 and unlike during prior holidays, I will not be posting (at the request of Mrs. Harrison!!) Now, on to the analysis.
- Ukraine will have global impact
- More sanctions are coming but will be somewhat limited
- The global financial system is moving away from the US
- US auto subprime is going to blow up
It’s hard to write about the global economy these days without leading off with Ukraine. Whereas the conflict in Iraq has no real global implications due to its muted impact on oil, the conflict in Ukraine is a more serious matter in my view. he geopolitical implications alone are going to have wide-reaching consequences for years or decades to come. For me, it is clear that the US – Russian bilateral relationship cannot recover from this episode. Perhaps before MH17 it was still possible. But in the wake of MH17, it is going to be very difficult. Russia has already started to pivot away from Europe and the US. The spy base agreement that Russia just made with Cuba can be seen in that vein. And it is a clear provocation, saying in effect, “we are no longer your ally in any way.”
From a geopolitical perspective, Russia’s trump card is oil, and more specifically, oil prices. Sanctions and embargoes can only work over the short-term in a global energy market. Russia will always find a buyer for its energy products. So, as long as prices remain high, Russia will do ok. Another political weapon in Russia’s arsenal is its position as a player in other crises via the UN, in Iran and in Syria. The potential for Iran to now increase Uranium enrichment is greater now. And it is unclear to me what the economic or military response would be. We can’t rule out a military response from Israel of course. So, when we are thinking about butterfly effects from Ukraine, one is Russia’s non-cooperation in Iran, Iranian enrichment and an Israeli strike. These are the kind of things we should expect as economic shocks going forward.
From an immediate economic perspective, I do not expect sanctions. I do expect sanctions in the near term however, say over the next two months. And I expect these sanctions to be punitive and not just cosmetic. Ambrose Evans-Pritchard pointed out on Twitter that the eurozone is better insulated to the natural gas weapon than one would believe.
The place where one sees dependence is in the former Eastern Bloc and in Turkey. The Turkey element makes the negotiating positions a bit harder. Turkey is in NATO and Turkey is vehemently opposed to what Israel is doing in Gaza right now. At the same time, Turkey has strong ties to Russia, particularly on natural gas. That is going to limit the kinds of economic sanctions we are likely to see. Let’s wait and see what the EU foreign ministers say today
When we talk about the post-Bretton Woods world and US financial hegemony, much of US power is related to the US dollar’s role as world reserve currency. The US is the largest economy with the largest capital markets and largest sovereign bond market in the world. It is that depth and liquidity which favours the US disproportionately in the currency arena. And I say disproportionately because liquidity matters so much that the depth of US markets will always mean the US share of currency transactions and reserve currency positions wii be out of proportion to U.S. share of the global economy.
Here’s the thing though. It is clear that the US has been engaged in financial warfare on numerous fronts. First, there are the multilateral institutions like the World Bank and the IMF that the US dominates with its European allies. The US and the EU have used this as a weapon to force countries to toe an economic line. We saw this in the Asian Crisis in the 1990s in particular. We saw it in Greece. We are seeing it now in Ukraine.
Then, there is the Argentine default judgment, something that the US has jurisdiction over by dint of use of the US dollar. The treatment of pari passu debt principles is problematic for future restructurings and potentially sets a bad precedent. Finally, there is the BNP Paribas judgment, which is a sign to everyone that the US is willing to use financial warfare to promote its foreign policy aims.
I think this is clear overreach, meaning the use of financial warfare so bluntly and aggressively will backfire such that a more multi-polar financial architecture becomes a priority outside of the US. The euro is a clear response to US hegemony and its resilience in the face of crisis is testament to Europe’s understanding that it helps Europe maintain relevance and power in the global financial system. The BRICS bank and credit facility are the latest responses to US hegemony. And while, these are not going to be huge vehicles that counterbalance the US, it is still early days.
Everyone who talks about this situation acknowledges there will be a shift in power. The question now is not whether US power wanes. The question is what will the speed of decline be. I believe we are now seeing that the speed of decline will be more rapid than previously thought. The Ukraine crisis only adds fuel to that fire. And note how the Chinese are in Latin America right now making deals with everyone including US pariah states Venezuela and Argentina (links here and here). We will see a lot more of this going forward.
I have written a lot about this segment of the market this year because it was clear to me excessive risk was building. My February post on inventory builds and the subpriming of the auto market showed “demand for cars is buoyed artificially by looser credit in the originate to distribute market. And the auto makers are sub-priming the market, preying on buyers by putting them into higher rate loans worth more than the price of the vehicle. If you are looking at auto asset-backed securities, you have to think this is a disaster waiting to happen.” That’s how I put it then.
Just recently, the New York Times did an exposé on the market that is a must-read piece of investigative journalism. What they found was predation and fraud like what we saw in mortgages during the housing bubble. This is a $145 billion market and it is emblematic of risks that people are taking everywhere to get an extra yield pickup. We see it in leveraged loans and in high yield as well. Janet Yellen would have you believe that easy money is not producing this type of behaviour. The reality, however, is that when nominal rates are low, nominal returns are low and investors are unable to hit yield targets. And the result is excessive risk. Caveat emptor.
I have run out of time today. Thanks for reading.