War Finance

Americans, Beijing, Washington and the Fed are reacting to developments in the trade war as they come. But these reactions are best understood as responses to an emerging world order, in particular one where the financial flows of the previous world order are, or soon will be, no longer reliable due to geopolitical fragmentation. This sets the stage for Zoltan Pozsar's War Finance, which is already underway, to be fully realized.

War Finance includes but goes beyond the Fed's balance sheet policy (QE) and the Treasury's fiscal policy (stimulus) - it encompasses structural changes in how capital is allocated, how reserves are managed and when intervention in markets is due. Its focus is less on supporting a global financial empire and more about securing the onshore credit needs of private industry, be it semiconductor lithography, energy production or steel manufacturing.

In this regime, the lines between fiscal and monetary policy begin to blur. War Finance would call for the Fed and the Treasury to officially fuse into a single framework, where policy is most powerful, which was the case during World War II when the former explicitly supported the latter.

The US is not currently outfitted for War Finance, as fiscal and monetary policy continue to diverge due to obvious political differences, but the Trump administration clearly recognizes the necessity. It will take an implosion before both recognize with absolute clarity that the old paradigm can no longer be relied on, and with that implosion will follow better choreography, as it always does in a crisis.

- DeathTaxesandQE

Following last week's Liberation Day announcement of official reciprocal tariff rates, I couldn't help but notice a question that seemed to linger everywhere: what is the Fed supposed to do?

If you're somewhat familiar with what I write about, you'll probably notice how I rarely think about the "what should they do" and instead focus on the "what will they do." Should the Fed have made four rate cuts over three meetings last year? Probably not. But, by early summer, it soon became clear that they were going to anyway.

That said, what will the Fed do? Cut? Pause?? Hike???

Whatever it is, surely, it will be meaningful.

Zerohedge echoed this on X, asking whether the stimulus will first come from rate cuts (Fed) or fiscal expansion (Treasury).

There's at least one person in high finance whose reputation I believe will reach legendary status, if it hasn't already, as the Trump administration gets under way. After a couple years of mockery for holding such bold and contrarian views, many of the things he wrote about are finally unfolding: tariffs, reshoring, FX reserve managers at Asian central banks buying gold, US sovereign wealth funds, stockpiling commodities & rare earth minerals... the list goes on...

... but that's only a fraction of the list. Each of these things are part of a bigger theme. And understanding what that theme is will give the current environment much better context.

He had been advising Treasury secretary Scott Bessent in the months leading up to Trump's November election victory, and probably has been since, so it should come as no surprise that the new administration appears to be embracing what he warned the financial world of years ago, namely about a reversal in global financial flows as a result of geopolitical fragmentation. At times I've personally doubted him and even questioned his credibility, but his calls appear to be growing more and more relevant each day, so it would seem like a good time to get familiar with what he's written, if you aren't already.

In fact, I suggested as much to the zerohedge audience last week.

In the second half of 2022, while still employed by Credit Suisse as an interest rate strategist, Zoltan Pozsar published his famous War series:

1. War and Interest Rates, July 31, 2022

2. War and Industrial Policy, August 23, 2022

3. War and Commodity Encumbrance, December 26, 2022

4. War and Currency Statecraft, December 28, 2022

5. War and Peace, January 5, 2023

By "war", Pozsar speaks of full-spectrum geopolitical rivalry - a cold war fought on economic, financial, technological, and hard resource fronts between Great Powers. In his framework, war is as much about semiconductors, deep sea cables, swap line access and rare earth minerals as it is about troops, missiles, ships and military hardware. This cold war, however, is much different from the cold war of the 20th century as, this time, each adversary has incredible financial infrastructure that they aren't reluctant to weaponize. Therefore, financial policy must be outfitted to serve national security goals.

Pozsar's use of the phrase War Finance dates before 2022, and is best described as a response to a shift, what he calls a response to a crisis: a slow motion financial divorce between the global South and the West.

War cuts new financial channels, he says:

What are G7 policymakers, rates traders, and strategists to do when threats to the unipolar world order are coming from every angle. They should definitely not ignore the threats, but they still do. How could they not? For two generations, we did not have to discount geopolitical risks. Since the end of WWII, the only Great Power conflict investors really had to deal with was the Cold War, and since the conclusion of the Cold War, the world enjoyed a unipolar “moment” – the U.S. was the undisputed hegemon, globalization was the economic order, and the U.S. dollar was the currency of choice. But today, geopolitics has reared its ugly head again: for the first time since WWII, there is a formidable challenger to the existing world order, and for the first time in its young history, the U.S. is facing off against an economically equal or, by some measures, superior adversary.

The American Paradigm

For decades, we had an undisputed, unipolar world order - a global system where foreign nations running a trade surplus would trade goods for dollars and recycle those earned dollars into Treasuries, giving them a parking spot in the US financial system that backstopped their banks. Treasuries could easily be monetized (sold) for cash or pledged as collateral for dollar loans in the repo market. In some ways, foreign banking systems came to rely on this setup even more than the US banking system did.

The classic example is of the petrodollar, but today it's become a much bigger system encompassing more goods than simply oil.

For a while, it was a "heavenly match": offshore nations would be able to upscale their economies and their firms could easily obtain dollar credit (including dollar credit from non-US banks), all while backstopping their banking system. Having a foothold in the US financial system also afforded them a spot under the American security umbrella. Across the ocean, this meant the US would be able to finance and support its "exorbitant privilege" that relied on ample demand for Treasuries. Ample demand for Treasuries and supply chain security meant inflation was reasonable. China, and any trade partner, dutifully recycling their earnings back into our debt claims was the bedrock of the calm, low inflation world.

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.

When trust is gone, everything is gone, which, to quote Zoltan, is "a scary conclusion."

Pozsar's instinct was that the seizure of Russia's FX reserves in response to the invasion of Ukraine meant this trust had broken, ended the "heavenly match" and thus signaled those foreign capital flows, one of the pillars that kept the world stable, would necessarily begin to go into reverse. It wasn't necessarily that the seizure of Russian FX reserves caused this trust to break, but was, at least, a manifestation that it had already been broken.

He would say that, one of the pillars in the visual example above, foreign demand for US Treasuries, slowed long before tariffs came in to slow the export of dollars. In that sense, tariffs are catching up with this new paradigm. The US was still running historically-large trade deficits over the last year, but it was not met with foreign official sector accumulation of Treasuries, or at least certainly not to any reciprocal extent. In a financially unipolar world, this would not happen:

As I showed last August, the gross uptick in foreign US Treasury demand over the last year came from the non-official sector (which means any financial entity that's not a government or central bank) on the margin. Many of which were probably foreign hedge funds, since foreign pensions, banks and life insurers would FX-hedge their Treasuries. Those foreign non-official bond purchases were basically speculative, not funded with the dollars recycled from trade surplus.

You would not realize that this is what's going on just by looking at the results for Treasury auctions: one day can have "stellar" foreign demand, and the next day you might see the weakest in years. I mean, literally, the next day...:

Auctions are pretty technical (here's a good piece on the nitty gritty), and reading too deeply into the individual results can be misleading. Countries will buy and sell Treasuries to weaken and strengthen their FX, respectively, like what the Japanese did repeatedly last year as they defended a weaker yen. They could buy something else, but most assets are just not liquid enough for FX interventions, and liquidity is crucial if you want to avoid realizing big losses unnecessarily.

In any case, it's hard to make sense of this disconnect - after all, if a foreign nation is running a large trade surplus with the US, but isn't recycling that surplus back into Treasuries, where are those dollars going? Sticking with the example of China, Brad Setser has showed that total Chinese dollar reserves are virtually unchanged, but its composition includes less Treasuries. Instead, those dollars are recycled into other USD assets, like mortgage-backed securities (Agency MBS) and equities:

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