Why “safe assets” may not exist anymore

An interesting point comes by way of veteran fixed income market watcher, Marc Ostwald, of ADM Investor Services, in his latest quarterly publication “Ghost in the Machine“. It caught my eye because of how it aligns with my own thesis about the end of dollar neutrality.

As Ostwald notes:

If everything can be weaponised, as would appear now to be the case: e.g. food, energy and raw material supplies: and sanctions and asset seizures are not just reserved for the worst form of criminals (bt that rogue states, terrorists or murderers: people, drug or weapons traffickers), then there is in principle no such thing as a ‘safe asset’, and the underlying idea of free capital flows (which has long been an illusion) are exposed as a myth on which the world can no longer dine out.

This leads to what another notable financial analyst who prefers to stay anonymous has coined as the “know your supplier” framework.

Ostwald acknowledges, KYC and AML has been around for a while — so, it’s not like there wasn’t already a slow march toward the end of dollar neutrality.

Nonetheless, the whole thing will undoubtedly add even more bureaucratic cost to financial transactions. As Ostwald explains:

…the point is that all of this behoves risk, legal and compliance departments to be even more meticulous in conducting checks on all transactions, per se slowing up the process.

I would add that the difference this time is also the sweeping nature of the discrimination. At least with KYC and AML there was some semblance of individual-oriented action. You were discriminated against if you, the individual, were behaving badly. There was some sort of due process and a right of appeal. Current sanctions, however, are entirely broad brush and impact “good” Russians as much as “bad” Russians.

Ostwald sees it all as another variation of the counterparty risk phenomenon seen during the global financial crisis which also shrunk the pool of offshore US dollars. This is a smart observation, especially in the context of central banks that are intent on raising interest rates to reduce excess liquidity.

But he also sees some differences.

He says this new type of counterparty risk is likely to result in fragmentation that fractures global payment systems — which will in turn reduce demand for US dollars. This will then pave the way towards a greater accumulation of FX reserves not denominated in USD or EUR.

Another really important consequence of fewer dollars circulating through the international trade system is the impact it will have on the serviceability of existing dollar-denominated debt. The rationale for originating much of that debt will have been the expectation of continued dollar denominated inflows. Some of those flows, however, will have been linked to the recycling of commodity or petrodollar flows emanating from the Middle East or Russia through the international financial system. But fewer petrodollars means fewer dollar-denominated revenues to be depended on.

Those thinking dollar-denominated debt holders could just buy dollars on the FX market to overcome this issue completely miss the bigger picture. For every action in FX markets there is an equal and opposite reaction. If countries that were used to large dollar inflows are suddenly forced to buy-in those dollars instead, this would have an immediate effect on the strength of their own domestic countries.

The effect of this could be equivalent to a type of run on the domestic currency.

Think of that time Eastern Europe got stuck on the wrong side of the Swiss franc trade, and all its CHF-denominated debt couldn’t be paid off without destabilising local economies.

While I agree that this marks a potential end to the era of US-denominated safe assets, my personal hunch is that in the end most of these sanctions will go the way of lockdown regulations. Which is to say, the current almost hysterical response that is demanding ever more strenuous sanctions against Russia, will give way to sanctions fatigue as soon as the true effects of these actions are felt on domestic economies.

Unfortunately, before that happens we can expect Twitter and social media to continue to conjure the illusion of popular support for ever more extreme and self-destructive measures, putting pressure on government officials to follow suite. Support that is unlikely to be properly tested democratically, because even in France suggesting a vote for Macron is a vote in favour of sanctions is an absurd proposition. There are so many more reasons not to vote for Le Pen.

During this period anyone cautioning for a more measured stance or to think of the long term implications is likely to be dismissed as a traitor (an update on the original granny killer slur). Any person or corporation caught breaking sanctions — no matter how just the rationale or how oriented at saving lives — is likely to be met with the same sort of outrage and contempt that those breaking lockdown regulations were met with.

Until, of course, it slowly becomes obvious that our own comforts cannot be sustained with continued commitment to such policies. At which point, I suspect, we will sheepishly begin turning a blind eye to those breaking sanctions on a micro-level.

And then, just before the development of a major black market threatens to undermine government control entirely, politicians will see fit to about turn on sanctions policy entirely — likley citing some spurious change in Russian relations (when really nothing will have changed at all).

And then it will transpire that all sorts of secret “exceptional but not really exceptional” interstate backroom deals were being struck with Russia throughout the entire sanction period anyway.

Not that this will bring back the era of US-denominated safe assets. The damage by then will be too great.