Energy, Currency, and Deglobalization

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Part I

The world is at war. While at first this statement may sound hyperbolic, it has become increasingly obvious that the world is in the midst of an economic war that is at the risk of turning “hot.”

Before diving into the complex elements of global geopolitics, let’s first evaluate why as market participants it is even worth our time to analyze. The most important thing to understand as an investor (more broadly a global citizen at large) is that the previous three decades were a total anomaly in the span of global history.

Following the collapse of the Soviet Union, trade mobilized on a global scale unlike anything ever seen before, as the U.S. played peacemaker patrolling trade routes with their navy. This contributed to what many now refer to as The Great Moderation.

To quote Federal Reserve History,

What Caused the Great Moderation?

“Reducing inflation and establishing basic price stability laid the foundation for the Great Moderation. But, in looking for deeper reasons, economists have generally proposed three reasons: changes in the structure of the economy, good luck, and good policy.

“Changes in the structure of the economy can reduce volatility. For example, since manufacturing tends to be volatile, the shift that occurred from manufacturing to services would tend to reduce volatility. Another structural change would be the adoption of ‘just-in-time’ inventory practices, which reduces the volatility of the inventory cycle. Similarly, advances in information technology and communications may have allowed firms to produce more efficiently and monitor their production processes more effectively, thereby reducing volatility in production—and thus in real GDP. Deregulation of many industries may have contributed to the increasing flexibility of the economy and thereby allow the economy to adjust more smoothly to shocks of various kinds, thus leading to its greater stability. Finally, more open international trade and capital flows may have helped make the economy more stable.”

To summarize, one can broadly think of The Great Moderation as a synonym for globalization on a scale never seen before. Particularly, the disinflationary environment of the previous three decades allowed for real growth to persist, and for U.S. financial assets to go parabolic off the backs of low interest rate policy and seemingly never-ending quantitative easing programs post the Great Financial Crisis.

Ever-lower levels of inflation allowed for ever-lower discount rates, supporting ever higher levels of indebtedness and leading to ever-higher asset prices. Year-over-year inflation rate in the United States and the 10-year Treasury yield are shown below to visualize this dynamic:

To quote Credit Suisse strategist Zoltan Pozsar’s latest dispatch,

“The low inflation world had three pillars: cheap immigrant labor keeping nominal wage growth ‘stagnant’ in the U.S., cheap Chinese goods raising real wages amid stagnant nominal wages, and cheap Russian natural gas fueling German industry and Europe more broadly. Implicit in this ‘trinity’ were two giant geo-strategic and geo-economic blocks: Niall Ferguson called the first one ‘Chimerica.’ I will call the other one ‘Eurussia.’

“Both unions were a ‘heavenly match’: the EU paid euros for cheap Russian gas, the U.S. paid U.S. dollars for cheap Chinese imports, and Russia and China dutifully recycled their earnings into G7 claims. All sides were entangled commercially as well as financially, and as the old wisdom goes, if we trade, everyone benefits and so we won’t fight. But like in any marriage, that’s true only if there is harmony. Harmony is built on trust, and occasional disagreements can only be resolved peacefully provided there is trust. But when trust is gone, everything is gone.”

There are a couple massive points made here that are absolutely vital for readers to understand. The first, is that the conditions which enabled the disinflationary world of the last three decades are violently changing. The second is that in the previous world order, the major exporters of the world, namely China and Russia would recycle their earnings back into G7 claims. Particularly, because of dollar-denominated oil trade that is key to the petrodollar system, nations would “recycle” their dollars back into U.S. Treasurys.

Treasury securities, which are merely claims on future dollars with an attached interest rate, allowed for nations to store their economic surplus. This system benefited sovereign stakeholders so long as dollars, and subsequently treasuries, held their purchasing power in real terms.

Let’s revisit how the USD became linked to the energy trade and earned the nickname the petrodollar in the first place.

In Alex Gladstein’s, Uncovering the Hidden Costs of the Petrodollar, he explained how it came to be:

“Nixon floated the dollar in order to pay for the cost of a war in which he ordered more than four million tons of explosives and incendiaries dropped on cities and villages across Indochina… the debt crisis was a direct result of the need to pay for the bombs, or, to be more precise, the vast military infrastructure needed to deliver them. This was what was causing such an enormous strain on U.S. gold reserves.
“For the first time in history, the world was in a pure fiat standard. The dollars held by central banks across the globe lost their backing, and there was a geopolitical moment where U.S. dominance was called into question and where a multipolar financial world was a distinct possibility. Adding even more pressure, in 1973 the Arab petroleum exporters of OPEC decided to quadruple the price of world oil and embargo the U.S. in response to its support for Israel during the Yom Kippur War. In just a few years, a barrel of oil rose from less than $2 to nearly $12. Faced with double-digit inflation and declining global faith in the dollar, Nixon and his Secretary of State and National Security Advisor Henry Kissinger came up with an idea that would allow them to keep ‘guns and butter’ going in the post-gold standard era and alter the fate of the world.
“In 1974, they sent new Treasury Secretary William Simon to Saudi Arabia ‘to find a way to persuade a hostile kingdom to finance America’s widening deficit with its newfound petrodollar wealth.’ Simply put, a petrodollar is a U.S. dollar paid to a petroleum exporter in exchange for oil. As a Bloomberg report says, the basic framework was ‘strikingly simple.’ The U.S. would ‘buy oil from Saudi Arabia and provide the kingdom military aid and equipment. In return, the Saudis would plow billions of their petrodollar revenue back into Treasurys and finance America’s spending.’ This was the moment that the U.S. dollar was officially married to oil.”

Transitioning back to the pillars of a globalized world, participation from Russia and China was obviously a must. However, following the Great Financial Crisis, it became clear that some of the key stakeholders began to make a fuss over U.S. hegemony, which was a necessity for the system to exist, and is a necessity for the system to persist.

In 2011, Russian Prime Minister Vladimir Putin said the following about the U.S. and the dollar in regards to its role as the global reserve currency:

“They are living beyond their means and shifting a part of the weight of their problems to the world economy …
“They are living like parasites off the global economy and their monopoly of the dollar.”

This can be assumed to be one of the dominant reasons Russia began to rid itself of dollar-denominated assets (and liabilities) throughout the 2010s.

Following the invasion of Ukraine in February, G7 nations announced the freezing of Russian Central Bank assets. Remember, sovereign debt is nothing other than a promise of future payment from another nation; a liability of your counterparty.

With this move, a clear precedent was set. In our February monthly report, we said the following.

“The move essentially told all sovereign nations, especially China, ‘Your foreign exchange reserves might not be yours if you make a wrong step.’”

As geopolitical tensions heat up between nations, lines are being drawn and alliances are being formed. To further quote Pozsar’s latest piece

“Wars are also about alliances. In today’s complex conflict between the U.S. on the one hand and Russia and China on the other, the world is best described by “the enemy of my enemy is my friend”: Russia and China hold naval exercises with Iran around the Strait of Hormuz; Iran has recently hosted talks between Russia and Turkey regarding grain shipments through the Bosporus Strait; not surprisingly, the first shipment sailed to the Syrian port of Tartus, which hosts a technical support point (not a base) of the Russian Navy; even more recently, Turkey and Russia agreed to clear bilateral trade flows, including gas, in rubles.
“In this complex web of geostrategic hotspots around the Eurasian landmass, the noose is tightening for the ‘friends of my enemy’: Ukraine is under attack; Taiwan was effectively subject to a weeklong sea and air blockade recently; and South Korea is being pressured by China to uphold the ‘Three Nos’ policy, the essence of which is to end all forms of military cooperation with the U.S., while at the same time North Korea says the peninsula is on the ‘brink of war’ – the checkmate like position that Seoul finds itself in is so hard to navigate that President Yoon didn’t meet Speaker Pelosi on her stop in South Korea and opted for theater instead (‘strategic ambiguity’; ‘Our commodities, your problem’ is branching into ‘chips from our backyard, your problem’ and might also branch into ‘our straits, your problem’: the U.S. threatening Turkey with secondary sanctions for financial cooperation with Russia should be understood in light of the inconvenient geographic fact that NATO’s access to the Black Sea goes through Turkey’s Bosporus Strait.”

While speculating on the potential for hot war to break out is no exciting task, it is clear for those paying attention that geopolitical tensions are continuing to heat up, and history tells us that conflicts are rarely anything but inflationary. Not only due to the protectionist trade policies that nations take on, but also due to the supply and demand imbalance that a massive industrialization towards war requires.  

“That’s why forecasts of a rapid deceleration of inflation are naively optimistic: if Pax Americana enabled globalization and globalization underwrote lowflation, the TRICKs (Turkey, Russia, Iran, China, and North Korea) trying to poke holes in the Pax means that inflation is a big risk. To understand the path of inflation from here, we will have to read more history and think about trust, trade, and Dale Copeland’s theory of trade expectations: if trust drove globalization, and globalization drove ‘The Great Moderation,’ distrust will drive de -globalization, and de -globalization ‘The Great Reflation
“First, how do you wage wars on multiple fronts when a single front in Ukraine showed how quickly stockpiles can deplete in a war of attrition, and how slow the replacement is.”

We have already witnessed the devastating effects of the economic war being played by Putin’s Russia in a mere six months. As Russia has shut down its natural gas pipelines into Germany, Europe has been rocked to its core.

Germany, which we referred to earlier as one of the drivers of the globalization trend, with particular reliance on Russia, has seen its manufacturing sector collapse as a result of skyrocketing energy prices. Germany Producer Price (PPI) year-over-year is now at an astronomical 37.2%.

This has caused the trade balance of Germany, dubbed “The Powerhouse of Europe,” the fall below zero, meaning that Germany has become a net importer of goods for the first time since 1990.

This has sent Europe’s trade balance into its largest deficit in recorded history, as the euro has collapsed below dollar parity.

If you recall at the beginning of this piece, we referred to the conditions that gave way to The Great Moderation.

“Reducing inflation and establishing basic price stability laid the foundation for the Great Moderation.”

Similar to how excessive leverage in the financial system around mortgage-backed securities in 2008 nearly caused the global economy to implode, we are now seeing a similar dynamic play out today; however instead of financial leverage, we are dealing with the world’s “just-in-time” supply chains, a previously highlighted pillar of The Great Moderation (otherwise known as globalization).

“…Another structural change would be the adoption of ‘just-in-time’ inventory practices, which reduces the volatility of the inventory cycle.” - The Great Moderation

However, the illusion of stability and lack of volatility that these practices gave the world are coming back to rear their head.

Quoting Zoltan,

“Inventory for supply chains is what liquidity is for banks. In 2007-08, big banks ran on ‘just-in-time’ liquidity: the dominant form of liquidity was market liquidity, for which you could always sell assets into a deep market without moving prices, so you did not have to have liquidity reserves at the central bank. Similarly, big corporations today run ‘just-in-time’ supply chains for which they assume that they can always source what they need without moving the price.
“…Minsky moments (a sudden, major collapse of asset values) are triggered by excessive financial leverage, and in the context of supply chains, leverage means excessive operating leverage: in Germany, $2 trillion of value added depends on $20 billion of gas from Russia… that’s 100x leverage - more than Lehman’s.”

As shown in the chart below, just $27 billion worth of Russian natural gas exports served as an input for approximately $2 trillion worth of German manufacturing production:


That’s leverage. A mere six months later, and consumer confidence in the EU is at an all-time record low dating back to 1985:

Households and corporations alike are being pummeled by the rise in energy costs, and it's not just the Germans who are feeling the pain. The United Kingdom is also feeling the effects:

Published today, a Bloomberg piece titled Energy Crisis May Have Bigger Impact on Households Than 2008 Crash detailed how households in the United Kingdom are being affected by the energy shortage.

A senior executive for a lead U.K. power generator also shared a grim view, “more than half of U.K. households will likely be in fuel poverty by January.”

The supply side energy shortage has significant knock-on effects, not only for households feeling the pain but also for sovereign debt markets. One possible “resolution” is for the end of conflict in Ukraine and some peace deal to be made between Russia and Europe. But according to reputable sources on the ground, don't expect truths between the sides anytime soon.

“Business leaders speaking privately at the World Economic Forum’s annual meeting in Davos in May suggested a ceasefire with Russia. Giving Putin an ‘off-ramp’ to end the war, restoring relations and bringing plentiful supplies of Russian gas back to Europe would halt the energy crisis in its tracks.
“But it would leave Russia’s military closer to the heart of Europe and destabilize the security of Poland and Hungary, pillars of the Western alliance.
“Politically, there seems little chance of détente. This week, Gennady Gatilov, Russia’s permanent representative to the UN, said Moscow expected a protracted conflict. Europe and the US are also bedding in.
“A dismal winter for Europe economically and military stagnation for Russia could force a reset in relations, though.”

Part II

As we covered the brewing geopolitical tensions and developing energy crises in Europe in yesterday’s issue, let's cover some of the possible second order effects, as well as outline our short-term and long-term market outlook, with quotes from the ever-insightful Zoltan Poszar from his latest piece “War and Industrial Policy.”

Before diving back into the big ideas from Poszar, let’s review the market moves today following Federal Reserve Chairman Jerome Powell’s speech at Jackson Hole.

As Powell began to speak, global markets began to sell off sharply, with equities quickly making new lows, as bitcoin followed in tandem while the dollar rallied. Shown below are the three respective charts (with DXY inverted). For now, it’s all one trade (more on this later).

Among the most interesting developments in recent weeks has been the divergence between the bond market and the equities market, as yields across the curve continued to push higher in tandem with equities, which is not a relationship that is expected to last.

All else being equal, higher yields equal higher discount rates and borrowing costs, and when the largest market in the world (bonds) is selling off significantly, equities can only swim against the tide for so long.

The repricing in yields was in part due to the rise in Fed Funds expectations in 2023, with a significant amount of repricing taking place over the course of recent weeks towards higher rates for longer. In fact, that was one of the key talking points in Powell’s speech today.

The Fed has been fairly transparent about their intent to raise interest rates to combat inflation, and today was no different.

Powell even went further today, so much as to admit “pain” is likely to be felt by households and businesses,

"While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses” - Jerome Powell

As said in our July Monthly Report: “Long Live Macro,”

“The story of 2022 has been the inflation-induced monetary tightening that has occurred across financial markets. In an attempt to fulfill their dual mandate of price stability and full employment (more on this later), the Federal Reserve has embarked upon one of the fastest hiking cycles in history.”

The combination of tightening monetary policy globally coupled with a structural energy shortage has led to the dollar strengthening against other fiat currencies materially.

“A strong dollar is in the process of completely upending the global economy. While there are certainly exogenous factors that are causing the economic pain points such as shattered supply chains following COVID-19 economic lockdowns (which were incredibly strained following unprecedented levels of monetary and fiscal stimulus in 2020/2021) and the Russia/Ukraine conflict which has thrown global energy and commodity markets in flux, a strong dollar only increases pressure on foreign nations in terms of meeting their dollar-denominated liabilities, while increasingly harming U.S. domestic industry.” - “Dollar Go Up: Global Macro Headwinds Intensify, 7/15/22

Let’s return to the excellent work of Zoltan Pozsar before further examining the likely path for financial markets and Fed policy:

“Globalization is not a bank in need of a bailout. It’s in need of a hegemon to maintain order. The systemic event is someone challenging the hegemon, and today, Russia and China are challenging the U.S. hegemony. For the current world order and its trade arrangements and network of global supply chains to survive the challenge, the challenge must be squashed quickly and decisively, in the spirit of the Powell Doctrine.
“But Ukraine and Taiwan aren’t Kuwait, Russia and China aren’t Iraq, and ‘Top Gun 2’ isn’t the same movie as ‘Top Gun’ … Think about what Tim Geithner said about how to deal with crises like the Asian financial crisis or a herd of short sellers questioning the solvency of the U.S. banking system. In today’s context, Russia and China are basically the ‘short sellers.’”

To be able to attempt to outcompete Russia and China, the U.S. desperately needs to reshore domestic manufacturing. This not only takes time, but plenty of raw materials and infrastructure, all of which are inflationary. Yes, the Fed is attempting to destroy demand (at the margin) to combat inflation, but during “wartime,” industrial policy and economic sovereignty take importance.

“I get it why the U.S. wants to invert time. But we can’t win by slowing progress. We’ll also have to progress by building, and that’s where industrial policy comes in: as an investor, you care about the inflationary consequences of Russia and China challenging the U.S. hegemon. Where inflation goes, policy rates go, or if not, financial repression is an issue.”
“Either way, you care, especially if you are a bond house or if you depend on fixed income. These are the scary times when the ‘euthanasia of the rentier’ is a risk. To ensure that the West wins the economic war – to overcome the risks posed by ‘our commodities, your problem’; ‘chips from our backyard, your problem’; and ‘our straits, your problem’ - the West will have to pour trillions into four types of projects starting ‘yesterday’:
(1) re-arm (to defend the world order)
(2) re-shore (to get around blockades)
(3) re-stock and invest (commodities)
(4) re-wire the grid (energy transition)
“I think that the above four themes (re-arm, re-shore, re-stock, and re-wire the electric grid) will be the defining aims of industrial policy over the next five years. How much the G7 will spend on these items is an open question, but given that the global order is at stake, they will likely not be penny pinching. If Tim Geithner were in charge, he’d put ‘a lot of money in the window’ to show who’s in charge.
“And hopefully it will be like that … and if so, any investor will have to be mindful that the above to-do-list is:
  1. commodity intensive
  2. capital intensive
  3. interest rate insensitive
  4. uninvestable for the East
“Commodity intensity means that inflation will be a nagging problem as the West executes on the above list. Re-arming, re-shoring, re-stocking, and re-wiring need a lot of commodities – it’s a demand shock. It’s a demand shock in a macro environment in which the commodities sector is woefully underinvested – a legacy of a decade of ESG policies.
“Capital intensity means that governments and also the private sector will have to borrow long-term to execute the to-dos. Re-arming and re-stocking are the domains of the government, and re-shoring and re-wiring the grid will involve public-private partnerships. Private firms will have to issue debt and raise equity to build things: ships, F-35s, factories, commodity warehouses, and wind turbines. Insensitivity to interest rates means that the to-do-list will have to be executed regardless of whether the Fed hikes rates to 3.5% or 7%. Hell or high water, executing on the to-do-list is imperative.
Finally, uninvestability means that for certain large countries in the global East, it makes absolutely and categorically no logical sense to roll their investments in G7 debt claims. Not just because of what happened to Russia’s FX reserves, but also because rolling a $1 trillion portfolio of U.S. Treasury securities means that you will fund the West’s effort to re-arm, re-shore, re-stock, and re-wire … against the East.”

You don’t think it's a coincidence that China is persistently selling its stash of U.S. Treasurys, do you? After seeing what happened to Russia, and the latest military operations off the coast of Taiwan, China looks to be preparing for increased hostility with the West. This isn’t a call nor even a prediction of war, but rather observations that likely are too aligned to be merely coincidental.


Let's go over what we’ve covered so far:

  • An economic crisis is developing in Europe, with energy rationing a likely outcome for many this winter as shortages are prevalent.
  • Energy importer nations are facing rapid currency devaluation
  • Yields on global debt are skyrocketing across the board as central banks attempt to fight supply side inflationary pressures with demand destruction
  • As weak currencies depreciate against the dollar and trade slows due to skyrocketing energy prices, dollars are increasingly hard to come by to fulfill denominated liabilities, leading to further dollar strengthening
  • The conditions and sovereign cooperation which enabled the disinflationary environment of the last three decades is rapidly reversing, and the left tail risk of escalating geopolitical tension is real
  • Due to a matter of national security, the U.S. government will likely need to spend/invest massive amounts of money to reshore domestic manufacturing, during a time where finance costs have rapidly risen
  • As a result, the market is likely pricing in a near best case scenario outcome of softening inflationary pressures

As Powell and the Federal Reserve are emboldened to tighten policy into a global slowdown, with the dollar strengthening to new highs on a weekly basis and energy prices skyrocketing around the world, we view it as increasingly likely that something breaks in a massive way over the next six months. Six months may even be too generous of a timeline.

Given the Fed plans to begin quantitative tightening next month, reducing its balance sheet to the tune of $95 billion per month, we expect something under the surface will crack in financial markets.

Remember the last time the Fed attempted to strategically reduce its balance sheet, in 2019?

As the Fed rolled off its balance sheet, overnight money markets seized up and SOFR (secured overnight financing rate), a measure of borrowing costs for borrowing against treasuries skyrocketed far above the target rate set by the Fed.

The repo market broke.

The Fed responded by once again expanding its balance sheet, and notoriously emphasizing that the expansion should not be thought of as “quantitative easing.”

While liquidity conditions are entirely different today, the macro headwinds faced today are nearly an order of magnitude more complex and challenging than those faced back in 2019.

As covered extensively in our July Monthly Report, the Fed is tightening policy while the U.S. Treasury spends more than 140% of tax receipts on necessities. Not to mention the fact that during recessionary periods, tax receipts fall markedly (as a result of falling asset prices).

With this being said, we think what “breaks” is liquidity in the U.S. Treasury market, as a soaring dollar, skyrocketing energy prices and subsequently contracting global productivity lead to a sell-off in dollar-denominated assets.

There still is a massive implicit short dollar position around the world (USD-denominated debt).

We still have yet to see the blow-off top short squeeze in the USD. In that environment only two places are safe, volatility (as an asset class) and dollars. Everything else sells.

Bitcoin won't be insulated, nothing will.

When that time comes, the Fed will be forced to print into an inflation spike.

This is when bitcoin comes back with a vengeance.

Content Provided By:

Dylan LeClair (@DylanLeClair_) and Sam Rule (@samjrule)