A deep dive into Zoltan Pozsar’s Bretton Woods III world view

As an addendum to my original note about Zoltan Pozsar’s Friday note, here are my extended thoughts on his Bretton Woods III magnum opus.

On commodity basis:

Zoltan says:

Furthermore, like there is a “base” interest rate (EFFR and the OIS curve that springs from it) and a basis between that base rate and other interest rates, there are also bases between different sources of similar commodities (WTI, Brent, and Urals), and like harvesting money market bases uses balance sheet capacity, harvesting commodity bases uses “shipping balance sheet capacity” (vessels).

As someone who cut her finance teeth covering the world of commodities I always found it funny that what commodity traders would call “time spreads” or just “arbs” are described as basis trades everywhere else. A lot of the time  this linguistic variance is down to how sector-specific heuristics have evolved. So it’s nice to see it acknowledged as a thing.

And yes, all arbs are theoretically profitable to close. But as I mentioned in my piece about how commodity credit markets work they’re expensive to execute in the first place. This is especially the case for time spread trades (such as contango plays) which take up a hell of a lot of balance sheet.

As I also mentioned, sometimes — as with the covered Interest parity breakdown in money markets — there are less visible regulatory constraints that make it impossible to close arbs altogether. In those circumstances rates have to get totally out of whack before it is worthwhile to trade the arb out. And even then, the arb might only open to certain players. That is kind of the situation we are finding ourselves in now.

It could just be that many risk-related regulations brought in under Basel III will have to be unwound to allow for what was previously common trade to be conducted.

On commodity protection:

Zoltan says:

Protection is a conceptual counterpart to par. When you decide to take money out of a sight deposit, you expect the same amount back that you put in (par).

When you sail foreign cargo from port A to port B, you expect to unload the same amount of cargo that you onloaded. Banks can deliver par on deposits most of the time. When not, central banks step in to help. Commodity traders can deliver foreign cargo from port A to port B most of the time, but when not, the state intervenes again: not the monetary arm, but the military arm of the state. What central banks are to the protection of par promises, the military branch is to the protection of shipments: foreign cargo needs to sail on sea routes and through choke points like the Strait of Hormuz, and “par” in this context means being able to sail from here to there freely, safely, and without undue delays…

I’m really glad Zoltan brings this up because it is a much under appreciated point in high finance. No historian or classicist, however, will be surprised by the assertion that trade has to be protected. (Which reminds me, I will have to tell the story one day about how shipping protection and indemnity insurance clubs came about, as it’s a fab story.)

There’s a reason why the British East India Company became indistinguishable to a sovereign military force. Not only did it work on a Royal commission in many areas (sharing proceeds of its activities with the head of state) but developed its own naval force to protect certain trade routes for precisely these reasons. It’s why — by the way — we have British protectorates and so on.

The practice of giving out Royal commissions can also be seen as equivalent to today’s licensing regimes. It amounts to a de facto promise that the state will intervene and protect the business if anything goes wrong. Thus, if you messed with Britain’s Royally appointed merchant navy operators, you would inevitably feel the strong arm of marine law as enforced by the Royal Navy.

And it was Britain’s naval supremacy that really mattered in WW2.

In fact, in Paul Einzig’s 1941 Economic Warfare book there’s an entire chapter which focuses on how essential the Royal Navy was enforcing Britain’s blockade policies against Axis countries.

As Einzig wrote:

We saw in Chapters II and III that the blockade was never water-tight and that it was unable to prevent Germany altogether from importing essential materials or from replenishing her foreign exchange reserve by maintaining a certain amount of exports. Nevertheless the blockade, coupled with pre-emption, succeeded in preventing Germany from importing as much as she would like. For one thing, a large part of the goods which she bought overseas before the war or during the war never reached her ports. The ships carrying the cargoes were either captured by the Royal Navy or scuttled themselves or remained in neutral ports.

Meanwhile when Hitler tried to blockade Britain:

A feature of the German submarine warfare was the sinking of a large percentage of neutral ships. The United States, in order to avoid being involved in the conflict, stopped American ships from sailing to ports of the European war zone. On the other hand, a number of Scandinavian, Dutch, Belgian and even Japanese and Italian ships fell victims of the unrestricted submarine warfare.

The Admiralty, under the able leadership of Mr. Winston Churchill, was not slow in taking measures to cope with the situation. Convoys were speedily organised, and the percentage of ships sunk while in convoy was reduced to a negligible figure. A large number of submarines were destroyed, adn after a while Germany considered it advisable to relax the submarine warfare in order to avoid suffering further losses.

And sadly, by 1940, Britain had to call on American naval support to help it defend its trade routes:

In the circumstances it was not surprising that during the autumn and winter of 1940 the British shipping losses increased to an alarming degree. Even though the purchase of fifty American destroyers brought some relief, the situation gave cause nevertheless to grave concern. The almost complete loss of Great Britain’s Continental trade aggravated the British shipping position to no slight extent. A large percentage of the food and raw material imports, which until then were shipped from the Continent, had to be shipped henceforth from much more distant countries. The loss of the Mediterranean route necessitated the use of much longer sea routes, and the increased activities of German and Italian submarines, bombers and commerce raiders compelled convoys to pursue devious routes.

Einzig explains that a considerable amount of the merchant fleets of conquered countries were placed at the disposal of British authorities, with the British government actively chartering as much tonnage as it could to counteract the effects of the sinkings.

On how the rules of the game are changing:

Zoltan says:

We need to understand the details of commodity trading because the rules of the game are changing, and these changing rules will affect the price level, the level of interest rates (OIS), FX rates, and, in due course, OIS–OIS bases.

Zoltan frames this in the context of NATO supported protection for Western oil deals in Libya. Again, as a historian, what I find fascinating about these observations is what they reveal about how distanced finance has become — on account of decades worth of peacetime civility — from the fundamental realities it, as a simulacrum of the real world, powers.

It’s not the fact that finance people willfully ignore how much foreign policy and military action is conducted in the name of finance, trade supremacy and access to raw materials. It’s that the fundamental power structures involved have been muted in resonance due to how normalised this sort of activity has become in the mind set of those involved in the financing. Civility has compartmentalised everyone’s role in the great power game in such a way that nobody feels directly responsible for anything bad the system does. In fact, most people have no idea about the role they themselves play within the system, so sanitised everything is on the other side.

As a result, when John Pilger writes about how the Iraq war was motivated by access to oil, serious people in the finance world still tend to roll their eyes as if it’s a far fetched tale. They shouldn’t. It did. And unless we face up to the realpolitik, and our roles in it, nobody in finance will be able to protect their wealth let alone make more of it.

I suspect the learning curve we’re all about to go through will be significant. At the very least, it will force financial practitioners to face up to what it is they are really financing: western supremacy and the military industrial complex that supports it.

On foreign cargoes:

Zoltan says:

Russia is now invoicing its commodity exports to “non–friendly” nations in ruble, not U.S. dollars or euros and Saudi Arabia is open to China paying for oil in renminbi. It used to be as simple as “our currency, your problem”. Now it’s “our commodity, your problem”.

I do think this is a huge deal, even if I side with the notion that it’s mostly an FX intervention in disguise. The point that matters is that Russia is opting to shift the goal posts on how trade is conducted in the world, and who carries the exorbitant privilege as a result.

The problem Russia has is that coffers of its own currency are pretty useless unless foreign counterparts accept them for trade. And that is never going to happen.

The reason the move is important nonetheless, however, is because of the message it sends to the world about Putin’s desire for autarky, and what he and Russia are willing to sacrifice for the sake of protecting their own ideological standpoints. That makes it much more like a 1973 OPEC-style moment than anything else.

The analogy is Sheikh Zaki Yamani, the Saudi Oil minister, threatening to destroy his own oil supplies if the West doesn’t toe the line:

There’s another excellent clip of Yamani in the Adam Curtis documentary Bitter Lake that I can’t currently find, explaining the wider motivations.

The dialogue between Yamani and the BBC interviewer goes like this:

Yamani: What we want is the complete withdrawal of the Israeli forces from the occupied Arab territories. And then you’ll have the oil at the same level of September 73.

BBC: Is this demand absolutely rigid or is this just a negotiating position?

Yamani: Definitely. Definitely. We won’t give up any inch of these lands.

BBC: Doesn’t this new massive increase in the price of oil mean a change in the world balance of power between the developing nations like you the producers and us the developed industrialised nations.

Yamani: Yes it will.

BBC: What do you think arises from that?

Yamani: Well, a new type of relationship. You have to adjust yourself to the new circumstances. And I think you have to sit down and talk seriously with us about this new era.

What followed, of course, was the US-Saudi special relationship or concordia, and the begrudging acceptance of Saudi ideology and its way of doing things. The deal also included a huge transfer of wealth to the elites of all oil producing nations.

Finally, there was the deal struck between Nixon and Saudi in 1974, brokered by Kissinger, which would assure that the kingdom would sell the West its oil in dollar terms so that most of the wealth generated could be reinvested back in the Western system. But at the same time, as Adam Curtis likes to emphasise, this ended up funding a vast pool of petrodollar wealth which was highly removed from any political control whatsoever.

All of which was neatly incapsulated in this famous boardroom scene from the 1976 classic film Network (which also happens to deal nicely with the topic of press freedom):

What Putin is seemingly trying to do in that context, is meddle with the primal forces of multistakeholder capitalism and depoliticised “neutral” money — which he sees as ideological in its own right.

One could say he is purposefully politicising the money system so as to reassert political control and his own ideological perspectives on the international community.

VLCC shortages:

Zoltan says:

… a lack of VLCCs to move oil around (and other ships for other stuff) is the real–world equivalent of year–end G–SIB constraints in the financial system.

One aim of this dispatch is to hammer home the parallels between the (nominal) world of money and its four prices and the (real) world of commodities, and just as G–SIB constraints around year–end gum up the free flow of money, VLCC constraints during times of warcan gum up the free flow of commodities– can commodity prices spike like FX forward points when we run out of ships? We can’t QE oil (= reserves) or VLCCs (= balance sheet).

We can’t make the VLCCs quick enough. This is true. And it is also true that any bottlenecks could be life threatening to the stability of the system.

Another interesting observation is that Egypt, one of the biggest importers of Ukrainian wheat, has its own trump card to play if it becomes threatened with undersupply of wheat. It can shut down the Suez canal until other nations’ wheat supplies are diverted to it — an chaos-inducing experience we recently went through when the Ever Given got stuck in the canal.

On the return of piracy

Zoltan says:

Hungary lost to Russia in 1956 because the U.S. protected the Suez Canal…

Pirates need to eat too, and they will have an extra incentive to engage in acts of piracy when there is a bread shortage (a wheat shortage is a bread shortage).

Yep this is a thing. And again you only need to be a classicist to understand that piracy, the equivalent of wide-spread global insurgency, can never be settled militarily. Pompey the Great only managed to solve the Roman Republic’s pirate problem by paying the pirates off, effectively establishing the OPEC concordia of its day. This protected essential Roman trade routes from Egypt bearing wheat that the Roman civil system — and its dole system — depended on. It was the realpolitik of its day.

On the emergence of Bretton Woods III

Zoltan says:

Bretton Woods II served up a deflationary impulse (globalization, open trade, just–in–time supply chains, and only one supply chain [Foxconn], not many), and Bretton Woods III will serve up an inflationary impulse (de–globalization, autarky, just–in–case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left).

What will influence the foundations of the new BWIII system, Zoltan argues, is the reality that we no longer live in a unipolar world dominated by American military supremacy or the soft power of its cultural exports. In that context, “our commodity, your problem” becomes a meaningful threat, especially when it comes from nations which feel increasingly disenfranchised from the international community because their views on certain subjects simply won’t be tolerated in the “neutral” global order.

Perspectives and ideologies, we should add, that those countries are prepared to self-sabotage, die and sacrifice for — which may not be the case for the “spoiled” West. (Though, one would hope it would be.)

This is why I’ve argued we may (through our own arrogance) be inadvertently pursuing a policy of mutual assured economic destruction without even knowing it.

On which note Zoltan also says:

Don’t get me wrong – we need to tighten financial conditions, but it is now time to think about how to do QT such that we minimize the destruction of reserves while maximizing the amount of duration delivered into the bond market…
…to undo the mistake of believing that we can craft sanctions that maximize pain for Russia while minimizing financial and price stability risks for the West. Did OFAC coordinate with the FOMC and FSOC when crafting sanctions on Russia?

I think he’s quite right on that. Which is why I would be expecting this sort of thing from Biden soon: