One of the penalties for refusing to participate in politics is that you end up being governed by your inferiors – Plato
We are at the end of many long economic, market, geostrategic, political, and social cycles. As a result, we are forced to look objectively at beliefs that we have long held to prepare for a new set of cycles that are starting.
People and institutions are self-immolating as they attempt to hold onto the old cycle even as the world starts to see them for who they are and what they represent. The Federal Reserve is one of those institutions that is destroying itself. Later this year when the global economic downturn hits in full force, we’re going to see that the specially constructed façade of omniscience at the Fed is merely a Potemkin village behind which hides a politically motivated Wizard of Oz.
The Fed has far less power than we ascribe to it. Modern financial markets that are largely controlled by robotic trading and massive index funds have made the Fed’s role of injecting/extracting money into/from the banking system, at the margin, less impactful. I’ve come to believe that the Fed’s main task these days is to orchestrate levitation of asset markets to ensure that the commoditized national banking system remains solvent on paper.
Their primary role is keeper of the economic narration and not the lender of last resort because the system is far too large for them to maintain that function. The Fed created a Frankenstein’s Monster and when it breaks loose from its restraints later this year, the Fed is going to be on the hook for the damage.
People keep looking for historical analogs to predict what is going to happen to the dollar and the financial system. Don’t bother; there has NEVER been a time in history that resembles the current situation. We’re walking on the moon and we have no idea what is going to happen. The best we can do is own assets that are relatively scarce and necessary under every scenario.
Interest Rates
If you do not change direction, you may end up where you are heading – Lao Tzu
The Fed is capable of setting rates at the short end of the yield curve in the US, essentially setting a bench-mark for the rest of the world. But I’ve always wondered how much they influence rates in the Eurodollar market, dollars held in banks outside the US, or whether they follow the Eurodollar market?
It seems a ridiculous question until you consider that the Fed has no discretion over the Eurodollar market; the Fed’s mandate doesn’t cover anything outside the US banking system. In practice, we know that the Fed influences international markets through currency swaps and probably other areas that are not open to scrutiny. Still, it’s not the same as their direct influence on the Fed Funds market and Discount Window where they can be one side of the transaction.
It’s an important question because influencing the Eurodollar market would require a massive increase in the Fed’s balance sheet, which they have been trying to reduce. It may also require a new funding mechanism that effectively bails out the global Eurodollar market, something that would be politically untenable with the current White House. As such, I wonder if borrowing costs in dollars are being priced in the Eurodollar market and that our interest rates are set high due to relative scarcity outside the US? Is the Fed following rather than leading?
When you consider that the Eurodollar market is believed to be roughly the same size as our domestic dollar market, yet is unregulated, the question becomes meaningful. Unregulated markets offer true market prices and since the Eurodollar market is as large as our domestic market, it is entirely possible that the Eurodollar market has usurped the price setting function from the Fed outside the US.
If correct, the tariff war, which will result in fewer US dollars exported in trade, could finally indicate that the Eurodollar market has separated from the domestic US dollar market. This would reveal what I have long suspected which is the US Federal Reserve has far less power than people realize. The result would initially be a two-tiered market for dollar assets with the Eurodollar rates trending higher due to scarcity plus a risk-premium.
The global dollar system only works if the US economy exports increasing numbers of US dollar to become Eurodollars in the global banking system. This happens through trade. But the US consumer has been clobbered by the inflationary policies of the past four years as shown in my last piece. https://geovestadvisors.com/inflation-fountainhead/ In addition, shale oil and gas have destroyed the Petrodollar trade which was an enormous source of Eurodollar liquidity from the 1970’s through the 1990’s. In short, the global dollar system is starved for liquidity. The Fed has reduced its balance sheet from $9 trillion in 2022 to $6.7 trillion today as they attempt to off-load assets following the Covid catastrophe. This has worsened dollar scarcity, forcing global central bank reserve managers to sell their Treasury positions to create enough liquidity to purchase food and energy in global markets. The tariff war has exacerbated these issues because foreign banks generally have dollars coming into their commercial banks from trade. Liquidating US Treasuries indicates a decline in trade flows and NOT anti-US policy directives.
Instead of fighting inflation, Jay Powell is creating dollar scarcity in Eurodollar markets such that global asset deflation is now a certainty. The combination of tariff war and Fed parsimony is destroying the global economy and will ultimately force the world into a new currency regime. Powell is reading the tariff war completely wrong; it’s deflationary, not inflationary.
Fed interest rate policy is also destroying the housing market in the US where the combination of high interest rates and high housing prices has shut young families out of the market. I have little doubt the Trump Administration is going to force that message across media daily such that the Fed is going to be the scapegoat for all global economic ills when the real volatility starts. The Fed has a great PR department but they’re going against a master salesman in Donald Trump.
Interest rates are headed to 0% and it’s going to be clear that the Fed waited too long to cut interest rates in the US. Jerome Powell is self-immolating.
Pulling Back the Curtain
The Fed employs more PhD’s than I can count but they have no idea of how many US dollars and Eurodollars exist. The dollar system has become far too complex for anyone to adequately understand which is why the idea that the Fed’s army of statisticians are making informed science-like decisions is a joke.
As such, you would expect the Fed to show some humility but they can’t because they’re trapped in their own narrative of omnipotence and omniscience. You could say that they are the foundation of the global asset-value expansion of the past 25 years. Alas, the foundation is not as solid as advertised.
Their power lies in knowing the risk positions of everyone in our domestic markets plus a posse of very large agent-institutions that can be coordinated to take the other side of a trade in seconds. This is how they were able to snuff out the selling pressure during the Great Financial Crisis, even as they created the conditions for a grotesque misallocation of capital.
We can see this today in Europe where western Europe is a hot mess financially, economically, and most of all, politically. I have little doubt that the Fed, ECB, BoJ, and Bank of England, collectively, know who is long and short in the currency markets. I’ve been watching this for years where it seems that every time the euro gets close to parity with the dollar (1.00), it spikes.
There are two ways to move dollars to Europe. The first is trade, which is on the decline. The second is from investment flows, which are responsible for this move from 1.02 to 1.14. It seems that too many investors were betting against the euro and for the nth time since 2009, short sellers got squeezed out of their positions by investment flows to Europe. This is what global central banks have devolved in to – Confidence Men. At this point, if you don’t know they are in the game, you shouldn’t be at the table.
Global Deflation
Every serious deflation I’ve looked into is preceded by an asset bubble, and then it bursts – Stanley Druckenmiller
Central bank manipulation in the markets is now so obvious that only the most obtuse among us can ignore it. If they’re betting against central banks today, it’s likely that they will be out of capital (and out of the markets) before much longer. When this happens, when the last short has been squeezed, the Fed will be powerless just when the global economy picks up velocity to the downside.
The Fed is ensuring this happens thanks to excessively tight interest rate policy. I don’t know whether the Fed or the Eurodollar markets lead but simply asking the questions reveals insights and factors to explore. In particular, the Fed is behind the curve in a serious way and they’ll be forced to slash interest rates aggressively later this year. It also reveals that the dollar system will prove untenable going forward.
Here’s a chart of the TED spread, or 3 month US Treasury minus 3 month Eurodollar rate, using SOFR, or Secured Overnight Funding Rate, which replaced LIBOR. SOFR is a repo rate with Treasuries as collateral and can be subject to tumult in the repo market.
The critical thing to understand about this chart is that it has lost much of its value when they switched from LIBOR to SOFR because a US Treasury index versus a repo index that measures paper fully backed by US Treasuries is basically the same thing, until the markets go haywire…
We’ve witnessed this market going crazy on a few occasions, most recently October of 2024. Given what’s being measured, we keep getting a stark warning about the fragility of the system when apples stop equaling apples.
The most critical variation in the spread came in 2022 when the Eurodollar markets, as measured by SOFR, were slow in responding to Fed rate hikes. Presumably, this was because the global financial system received a boost in dollar exports when the US Treasury sent out Covid checks to consumers, unable to purchase services due to lockdowns. The result was a one-time boost in imports, temporarily flooding the Eurodollar markets with new dollars.
LIBOR was a better system for investors because it gave us insights into the Eurodollar money desks in London, particularly what they were prepared to pay for excess dollars versus to lend for excess dollars. In times of extreme uncertainty, these desks sought to hold onto their dollars and would only lend at much higher rates. The Fed has effectively closed the curtain so we non-insiders can no longer see the Wizard pulling levers.
The Fed didn’t pull the curtains to help investors understand the system nor did they stop publishing the monetary aggregates in their old form to help us make sense of this complexity. Instead, the Fed is purposely trying to make things as opaque as possible. This suggests that people are in for a very unpleasant surprise later this year when the Fed loses control of the monster.
As Druckenmiller opined in the quote above, deflation follows bubbles like night follows days. If we’ve learned anything from the past five years, it’s that US government spending, particularly transfer payments, is the primary driver of US consumer inflation. This driver is presently off-line; there’s one less lever to throw when the deflationary downturn hits.
Timing
You win battles by knowing the enemy’s timing, and using a timing which the enemy does not expect – Miyamoto Musashi
Things can get ugly very quickly and we always need to be cognizant of an unexpected event but absent the unforecastable, I suspect it’s going to be messy trading until the global economy starts to crater. This is why I’ve spent 20 years understanding China. China is the weakest link in the chain followed by the emerging markets and western Europe.
The chain is going to fracture sometime this year and it will probably start with China. We’re going to know it’s time to don black suits for China’s economic funeral when the price of copper drops and the price of the US dollar jumps. When this happens, the deflationary downturn will start in earnest. For me, everything else is just noise.
Copper is rallying and the US dollar is trading lower on the year. When we add in the recent strength in Europe, it tells me that central banks know where they are vulnerable and are moving to prevent the inevitable.
Why else would the pacifists in Europe suddenly bang the war drums? They’re trying to distract their population from the fact that they’ve screwed up the continental economy beyond repair. Unless they can create a crisis, we’re going to see wholesale political change and social unrest within months.
The Chinese may invade Taiwan, not because they are confident they can win, but because they desperately need to distract the people from Xi Jinping’s many bone-headed mistakes. Those mistakes have undone 30 years of effort. Meanwhile, Trump’s tariffs are going to clobber everyone outside the US.
Conclusion
Oh, what a tangled web we weave, when first we practice to deceive – Sir Walter Scott
Like the great Carthaginian general Hannibal Barca, the Fed has won every battle in the markets but is destined to lose the war. By creating a casino where players never lose, we’re facing the mother of all moral hazards. It’s not just equity markets, it’s real estate, fixed income, commodities, crypto, and especially private equity where excess financial leverage is the norm.
Some will be tempted to ride the wave down, believing that the Fed will be able to transit the Alps once more to fall upon short-sellers from some unexpected direction. Perhaps, but there is a sense of finality to a lot of cycles such that I believe the Fed is out of magic tricks. Alas, I expect Jay Powell to prove a tragic figure, one who is easy to scapegoat.
The Federal Reserve started on December 23, 1913. If they survive this coming downturn, their power will be drastically reduced. The Fed amassed tremendous power over the past 30 years by creating a profitable but ultimately destructive system. Their job is to regulate money supply in the banking system yet they have no idea how many dollars exist.
The inflation thesis is built on observing money creation but misses money destruction. Thanks to grotesque misallocation of capital, money destruction will overwhelm the inflation thesis. It has already started in China.
Despite what’s coming, I’m optimistic. The United States has every advantage a nation could want and Americans can turn on a dime towards opportunity. I’m less sanguine about the rest of the world but that’s a tale for another day.
If you’re interested in learning more, visit us at https://geovestadvisors.com/ and contact Paul Hurley.
Philip M. Byrne, CFA
