TINA to the US dollar as the reserve currency

Crude oil’s price surge has historically been associated with recessions

Nothing works better than a historical chart to illustrate my point here. A 47% price surge in Brent and a 48% increase in WTI this year alone will become a substantial drag on the US and global economy this year. Have a look at this chart from Pictet, using the real oil price:

And if you have any doubts, look at this historical chart from Goldman Sachs, noting the recessions are shaded below the price line for crude oil (I hope that you can see the shading):

Also, as we know, Russian oil sales are increasingly under an embargo in all but name, threatening a vital source of global crude supply. While there are currently no sanctions in place preventing companies from purchasing the nation’s crude, buyers are refusing to take it, and tanker companies are unwilling to ship it. Refineries are racing to secure alternative supplies from other markets, pushing some gauges in the futures market to the strongest in years, such as the front futures spreads.

In fact, Brent and WTI timespreads surged to unprecedented levels yesterday and remain so today, with most gauges over the next 12 months the strongest since at least 2007. The market has moved into ‘super-backwardation’ with M1-M6 spreads trading above $15 today. Options markets were sent into a frenzy amid the huge price gyrations. Brent prices passed through $100 for June, bringing almost 40k contracts into the money, while call skews were some of the biggest on record.

While equities rally, investment grade corporates CDS spreads keep widening

I know which side I choose to take!

TINA to the US dollar as the reserve currency

If the last dozen years or so has taught us anything about markets and the economy, it’s that anything can happen, no matter how unlikely. The US housing market was considered as solid an investment as there ever was because prices never fell nationally — until the subprime crisis came along. The idea that the European Union would ever come close to breaking apart and taking the euro with it was unthinkable — until Greece defaulted. And everyone knew that inflation like that of the late 1970s was never coming back — until the pandemic snarled supply chains worldwide.

So it’s natural that a sort of cottage industry has sprung up in the last decade or so trying to anticipate the next so-called black swan event that could upend the global economy and markets. Right on cue, there is a growing concern that perhaps Russia’s invasion of Ukraine could mark the beginning of a turning point for the US dollar, and not for the good, as recently espoused by Credit Suisse’s Zoltan Pozsar. The thinking is that the US has “weaponized” the dollar through heavy financial sanctions imposed on Russia, including preventing that country’s central bank from accessing its foreign currency reserves.  As such, so the thought process goes, it may make less and less sense for global reserve managers to hold dollars for safety, given that they could be taken away right when they’re most needed.

Make no mistake, any such move away from the dollar would have earth-shattering consequences. The dollar has been the world’s reserve currency since the US and its allies agreed at the 1944 Bretton Woods conference to peg it to a rate of $35 per ounce of gold. According to the IMF, the dollar’s share of global reserves stands at 59%, far above the euro at 20.5%. After the euro, there’s a steep drop to the No. 3 slot, which is occupied by Japan’s yen at 5.83%. As the world’s primary reserve currency, the US enjoys the “exorbitant privilege” that goes along with that, such as interest rates that are lower than they might otherwise be and the government being able to fund budget deficits in perpetuity. (See footnote on Triffin’s dilemma at the end of this article)

To consider how difficult it is to come up with a viable alternative to the dollar, consider China’s yuan. (The euro doesn’t count, given how close the European Union came to breaking up over its debt crisis a decade ago. Plus, it’s more of a monetary union than a fiscal one.) The Asian nation, which has the world’s second-largest economy after the US, has spent a lot of time and effort over the past decade trying to make the yuan a viable alternative to the dollar. And, yet, less than 3% of the world’s foreign-exchange reserves are denominated in yuan. On top of that, only about 3% of global transactions are conducted in yuan, compared with 40% for the dollar, according to SWIFT, the messaging service that facilitates the vast majority of money transfers globally.

The benefit to holding reserves in dollars is that US markets are so much deeper and more liquid than any other. At $23 trillion, the US Treasury market is more than double the size of Japan’s government bond market. And even if you wanted to buy JGBs, you probably couldn’t because the Bank of Japan owns a vast majority of them, so much so, that no trading is done in the JGB market on some days. As for Europe, the UK, France, Italian and German bond markets are all less than $3 trillion in size. Foreign holdings of U. Treasuries have soared to $7.74 trillion from around $1 trillion at the start of the century, according to the US Treasury Department.

And while America’s politics and brand of democracy can seem messy at times, especially lately, foreign investors do take comfort in the country’s strict adherence to the rule of law that draws capital from all around the world in good times and bad. Although global foreign-direct investment flows surged 77% to an estimated $1.65 trillion in 2021, the US experienced an even bigger jump of 114% to $323 billion, according to the UN Conference on Trade and Development.

The dollar’s share of global currency reserves has slowly eroded over the years, dropping from around 73% in 2001, but the current level is still up from the low of around 45% going back to the early 1960s. And although the rise in cryptocurrencies offers bad actors another option to park their money out of the reach of regulators and other authorities, no country of consequence is going to attempt to park their reserves in Bitcoin. Indeed, that is the point. As long as the world does not suddenly see a string of bad actors launch megalomaniacal attacks on their neighbors, they don’t really have to worry about having their dollar assets frozen. The sanctions on Russia are extraordinary because Russia’s misbehavior under Vladimir Putin is extraordinary.

Of course, nothing is forever, but it can sure seem like it in the Forex market. Before the dollar, the British pound was the world’s dominant currency, having held the crown throughout the 1800s until World War II. By that measure, the dollar has a long way to go before being toppled. The simple fact is, there is no alternative – TINA.

Footnote:

The economist Robert Triffin gained enormous influence by reviving the interwar story that gold scarcity threatened deflation. In particular, he held that central banks needed to accumulate claims on the US to back money growth. But the claims would eventually surpass the US gold stock and then central banks would inevitably stage a run on it. He feared that the resulting high US interest rates would cause global deflation. However, the US gold position after WWII was no worse than the UK position in 1900. Yet it took WWI to break sterling’s gold link. And better and feasible US policies could have kept Bretton Woods going.

This history serves as a backdrop to two later extensions of Triffin. One holds that the dollar’s reserve role required US current account deficits. This current account Triffin is popular, but anachronistic, and flawed in logic and fact. Nevertheless, it pops up in debates over the euro’s and the yuan’s reserve roles. A fiscal Triffin holds that global demand for safe assets will either remain dangerously unsatisfied, or force excessive US fiscal debt. Less flawed, this story posits implausibly inflexible demand for and supply of safe assets. Thus, these stories do not convince in their own terms. Moreover, each lacks Triffin’s clear cross-over point from a stable system to an unstable one.

Triffin’s seeming predictive success leads economists to wrap his brand around dissimilar stories. Yet Triffin’s dilemma in its most general form correctly points to the conflicts and difficulties that arise when a national currency plays a role as an international public good.

Rates market volatility is at unsustainable levels, being headline driven

I have regularly mentioned how the Fed can no longer suppress volatility, given the shift to a tightening bias, and what should be a significant one at that. Given my macro background, I was referring to all markets, not just the VIX. So, let’s look at the interest rate market, using yesterday’s closing levels.

The risk reward has worsened for owning rates volatility, which is at elevated levels that are unsustainable over time. The timing for vol to decline remains tricky, given the geopolitical threats and uncertainty around the outlook, which can support realized volatility, coupled with poor liquidity conditions.

While I expect this year to be more volatile, it may be less than what is currently priced when viewed on a terminal basis. The vol surface is dislocated, with the term structure inverted across tenors and imbalance, with the left side (short tenors) much higher than the right side. While the Fed seems to be sticking to the playbook for now, policy uncertainty remains high, which isn’t a good environment for vol sellers in short tenors. Clarity on the path through a time series of economic data is needed to bring confidence.

The 6m2y straddle is pricing a terminal breakeven range of 128bps wide, and the 6m10y at 106bps.

Expiry Term Structure Inversion

Swaption Skew Still Positive, Isn’t Pricing Severe Risk-Off

Macro Hedging Reflected in Demand for TLT Call Options

Changes in TY Call Option Open Interest since Feb 23

TLT Skew at Lower End of Range on Russia’s Invasion of Ukraine

In the near term, the market appears relatively well-hedged for a geopolitically driven move lower in yields. Looking further out, there’s $10.9 billion notional of 10-year (TY) call option open interest at the $130 calls, which implies a futures-equivalent yield of about 1.56%.

The market is less hedged for a larger move. Let’s look at the futures-equivalent forward yield of the current cheapest-to-deliver bond (the 2.625% of Feb 15, 2029). The expiration for the April Options is March 25.

1-Month Vols Screening Relatively Expensive to Gamma Grid on PCA

PCA Swaption Surface (2y Horizon)

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