Train Wreck
Doug Nolan
Wikipedia’s definition will suffice: “The term exorbitant privilege refers to the benefits the United States has due to its own currency (the US dollar) being the international reserve currency.
For example, the US would not face a balance of payments crisis, because their imports are purchased in their own currency.”
My first observation of “exorbitant privilege” dates back in 1986/87.
I was a Treasury Analyst falling head over heels for macro analysis at Toyota’s U.S. headquarters in Southern California.
It was a fascinatingly unstable environment, with company management alarmed by the growing backlash against the U.S.’s ballooning trade deficit with Japan (along with the rapidly inflating Japanese Bubble).
Offering U.S. consumers much higher quality and reliable automobiles, Toyota’s sales were booming.
Following the Volcker-led taming of the inflation beast, ten-year Treasury yields were below 7% in 1986, half the mid-1984 level.
In general, a significant loosening of financial conditions, huge “twin deficits” - large fiscal deficits (5% in 1986) and record trade ($170bn in 1986) and current account deficits, along with a strengthening lending boom, were stoking over-consumption, and heightened speculation that culminated in 1987’s speculative blowoff and subsequent “Black Monday” crash.
Rather than countering U.S. imbalances domestically (with tighter “money”), Washington imposed “exorbitant privilege” on our closest Asian ally.
Japanese officials were basically forced to aggressively loosen (supposedly to stimulate consumption and U.S. imports) already precariously loose conditions.
It was a fateful policy blunder, as Japan’s formidable Bubble (real estate, in particular) inflated in catastrophic “terminal phase excess.”
Japan suffers to this day.
Following Alan Greenspan’s post-crash assurances, U.S. and Japanese Bubble excess attained powerful momentum.
Japan’s Nikkei almost doubled from post-crash lows to end 1989 at 38,916 – a record high that would stand for almost 34 years (until last year).
In the U.S., the craziness would crystallize the “decade of greed.”
Bursting Bubbles then left Japan in tatters and the U.S. banking system severely impaired.
Greenspan’s aggressive early-nineties reflationary measures unleashed hedge fund speculative leverage, GSE balance sheets, securitizations, and Wall Street finance – the monumental shift to U.S. dominated market-based finance.
This highly unstable financial structure took on a life of its own.
Crushed by boom-and-bust dynamics on steroids, the emerging markets (i.e., Mexico, the “Asian Tigers,” Russia…) emerged from devastating collapses determined to buttress their currencies and systems with much larger Treasury holdings (solidifying U.S. exorbitant privilege).
In the U.S., policymakers overcame bouts of speculative excess and fragility (i.e., 1994 bond crash and 1998 LTCM implosion) ready to mitigate market dysfunction with aggressive (GSE) liquidity backstops and Fed-orchestrated bailouts.
Wall Street finance – with all its critical shortcomings – took on a life of ever bigger Bubbles, busts and policy reflations.
From the 1987 stock market crash to the culminating AI and “everything Bubble” - and everything in between.
Especially during recent peak mania excess, there has been a lot of focus on “American exceptionalism.”
I’m not dismissing U.S. technological prowess.
But there is a lack of appreciation for the financial and policymaking elements critical to our “exorbitant privilege.”
We’ve run perpetual trade and Current Account Deficits for decades, while enjoying myriad strong dollar benefits.
Our nation has been able to habitually trade IOUs for imported goods and services.
“Ripping us off”?
Our overheated Credit system floods the world with liquidity (electronic IOUs), a seemingly harmless dynamic with financial flows so easily recycled right back to U.S. Treasury/Agency Securities and American stocks/corporate bonds.
This recycling mechanism is integral to the unique latitude enjoyed by the Federal Reserve, affording essentially unlimited discretion to create the liquidity necessary to sustain Credit, asset, and economic Bubbles.
And it’s this Fed capacity for open-ended market support that has provided U.S. financial markets a decisive competitive advance versus all other nations – especially in the realm of leveraged speculation (so dependent on liquid and continuous markets).
Having witnessed this process for decades, I reject the thesis that everyone has screwed us.
We’ve all screwed each other.
Here at home, inflationism, a deeply flawed analytical framework, and imprudent policymaking basically frittered away decades of “exorbitant privilege.”
Over-consumption, resource misallocation and deindustrialization.
In exchange for trillions of inexpensive imports, we exported American inflationism, debt excess, asset Bubbles and instability.
Today’s world is one of unprecedented financial and economic imbalances and resulting geopolitical volatility.
Seeing it in their best interests, the world has tolerated our habitual borrowing and spending excesses.
The U.S. system was the bedrock for global free market capitalism and democracy – the epicenter of historic global development and prosperity.
We offered a security umbrella for allies and likeminded nations.
America was the driving force and linchpin for myriad international organizations promoting peace and prosperity.
Through thick and thin - and some major blunders - we were the glue that held the world together – the stabilizer - the guarantor of the post WWII “World Order.”
March 5 – Bloomberg (Christopher Anstey):
“Former Treasury Secretary Lawrence Summers said that volatile policy actions and rhetoric from President Donald Trump are posing the biggest risk to the dollar’s dominance in the world economy in half a century.
‘The broad approach we are taking to the rest of the world represents the biggest threat to the US dollar’s role as the central currency in the world economy we have had in the last five decades,’ Summers said…”
This has been materializing for a while now.
Pick your date: November 5th, January 20th, February 19th, or February 28th.
The disintegrating world order was overthrown – a New World of Disorder the conqueror.
Between the election and President Trump’s January 20th inauguration, the Dollar Index surged 5.7% - bolstered by manic market gains and “American exceptionalism” glorification.
The dollar declined 0.7% on the Munich Security Summit, and then another 0.8% on Zelenskyy the “dictator.”
Any doubts that the existing world order had been vanquished were answered in the Oval Office last Friday, February 28th.
The Dollar Index sank 3.4% this week.
The divisive domestic political debate is essentially irrelevant.
MAGA can disparage President Zelenskyy and be apologists for our President and vice president until they’re absolutely convinced it’s perfectly appropriate - common sense - to end military support and intelligence sharing with ungrateful, disrespectful, and delusional Ukraine.
It’s such a weird dynamic, but that’s where we are.
Importantly, the world saw it altogether differently; crystal clear; horrifying clarity.
Somehow, it all so quickly became much worse than even the worst fears stirred from the Munich Security Summit.
The new administration was no longer a reliable partner, alliance leader, member, beacon of hope, guarantor of global peace and prosperity…
America’s top leadership was unstable, untrustworthy, and, worse yet, no longer adhered to common values.
For posterity – and to emphasize the international perspective.
March 4 – Politico (Chris Lunday and Jurgen Klockner):
“Europe’s most powerful economy is poised to take a major step to bolster its defense capabilities, with Germany’s chancellor-in-waiting, Friedrich Merz, announcing a far-reaching plan to effectively exempt defense spending from the country’s constitutional fiscal restraints…
‘In view of the threats to our freedom and peace on our continent,’ Merz said…, the motto ‘whatever it takes’ must now apply to the country’s defense…
‘The political developments in Europe and the world are evolving faster than we anticipated just a week ago…
Germany and Europe must now undertake extraordinary efforts to ensure our defense capabilities’…
‘The challenge of investing in a strong and secure Europe,’ said SPD co-leader Lars Klingbeil, is ‘perhaps the most important task of my political generation, and with a view to the White House and the events that happened last Friday there in the Oval Office with President Zelenskyy, it has become all the more clear that we need a lot more money for our defense and for security in Europe.’”
March 5 - Bloomberg (Craig Stirling, Mark Schroers, and Alexander Weber):
“‘Events at the Munich Security Conference and in the Oval Office have clearly had a huge impact on the thinking of CDU leader Friedrich Merz,’ Greg Fuzesi, an economist at JPMorgan…
‘Germany is heading not only for a massive U-turn on fiscal policy but also for a very strong response to the new defense and security challenges.’”
March 3 – Politico (Marion Solletty):
“French Prime Minister François Bayrou… declared the alliance with the U.S. is seriously wounded and called President Donald Trump’s attitude toward Ukraine ‘an indecency.’
‘On Friday evening, a staggering scene unfolded, marked by brutality and a desire to humiliate, the aim of which was to threaten Ukrainian President Volodymyr Zelenskyy into surrendering to the demands of his aggressor,’ Bayrou said in a speech to the National Assembly…
‘There were two victims in this scene, the security of Ukraine, which is fighting for its survival,’ Bayrou said, and ‘a certain idea of the alliance we had with and around the United States…
We are being asked to accept standards we refuse… to abandon our concern for decency and accept the indecency they would like to impose on us.’”
March 3 – New York Times (Andrew Higgins):
“Lech Walesa, the leader of Poland’s Solidarity movement, which helped end Moscow’s grip on Eastern Europe at the end of the Cold War, joined with former Polish political prisoners… to send an impassioned letter to President Trump voicing ‘horror and disgust’ at his scolding of President Volodymyr Zelensky…, saying it reminded them of their encounters with bullying Communist-era officials.
They wrote… they were ‘terrified by the fact that the atmosphere in the Oval Office during this conversation reminded us of the one we remember well from interrogations by the Security Service and from courtrooms in Communist courts.’”
March 3 – Politico (Victor Goury-Laffont):
“French Foreign Affairs Minister Jean-Noël Barrot voiced his confusion over reports that the United States' Defense Secretary Pete Hegseth has ordered a halt of offensive cyber operations against Russia.
‘I have a bit of trouble understanding [Hegseth’s decision],’ Barrot told public radio France Inter...
The French minister said European Union countries ‘are constantly the targets’ of Russian cyberattacks.
Cybersecurity publication The Record on Friday reported that Hegseth had ordered U.S.
Cyber Command to stand down from planning offensive cyber operations against Russia.
The report was confirmed by other publications shortly after.”
March 6 – Financial Times (John Burn-Murdoch):
“In the realm of geopolitics, it was unthinkable that the US would suddenly suspend military support from a longtime ally fighting off an invasion — until it happened.
In economics, surely Trump and his team wouldn’t take action that could tank US stocks, let alone cause GDP to contract?
Think again.
But the series of shock decisions — not just the rhetoric — from Trump, vice-president JD Vance and Elon Musk are less brain-bendingly inexplicable once you realise this: their version of America is operating on an entirely different set of values from the rest of the western world…
The next four years and beyond will be a bumpy ride come what may, but it will be more navigable after accepting that the world has fundamentally changed.
For decades, the US was the champion of western values.
The America of Trump, Vance and Musk has left them behind.”
March 3 – Reuters (Kate Holton and Andrew MacAskill):
“Canadian Prime Minister Justin Trudeau said his priority in talks with King Charles on Monday will be protecting his country's sovereignty after U.S. President Donald Trump recently suggested making Canada the 51st U.S. state.
Trudeau said nothing is more important to his citizens than ‘standing up for our sovereignty and our independence’, ahead of the meeting with Charles, who is Canada's head of state…
‘I look forward to sitting down with His Majesty tomorrow, as always we will discuss matters of importance to Canada and Canadians, and I can tell you that nothing seems more important to Canadians than standing up for our sovereignty and our independence as a nation,’ Trudeau told reporters.”
Markets got through the week pretty well, considering the force of the earthquake.
Tsunami to follow.
“German Bonds Cap Worst Week Since Before Country’s Unification.”
Bund yields surged 43 bps to 2.84%.
Despite the historic yield spike, there was little indicating notable instability in the realm of levered speculation – i.e., “basis” and “carry trades.”
“Basis trades” (levered long cash bonds versus short futures) are largely immune to yield gyrations.
Importantly, the big peripheral European “carry trade” (short lower yielding German bunds to finance levered longs in higher-yielding periphery bonds) made it through the week unscathed.
Only Spanish yields (up 45bps) rose more than bunds, with Italian and Portuguese yields rising 42 bps, and French and Greek yields jumping 41 bps.
European bank and corporate debt CDS increased only moderately.
March 5 – Financial Times (Ian Smith, Mari Novik, Olaf Storbeck and Laura Pitel):
“German borrowing costs surged by the most in 28 years on Wednesday, as investors bet on a big boost to the country’s ailing economy from a historic deal to fund investment in the military and infrastructure…
Chancellor-in-waiting Friedrich Merz… agreed with the rival Social Democrats (SPD) to exempt defence spending above 1% of GDP from Germany’s strict constitutional borrowing limit, set up a €500bn off-balance sheet vehicle for debt-funded infrastructure investment and loosen debt rules for states.
Deutsche Bank economists described the deal as ‘one of the most historic paradigm shifts in German postwar history’, adding that both the ‘speed at which this is happening and the magnitude of the prospective fiscal expansion is reminiscent of German reunification’.”
Supporters will trumpet that there's a method to the madness.
President Trump will spur Europeans (and others) to shoulder more of their security responsibilities.
It certainly appears he has triggered what will become a historic global surge in militarization, nuclear proliferation, and debt growth.
With this week’s 25 bps (to 2.65%), the ECB has now cut rates 185 bps since June.
Meanwhile, bund yields have jumped 32 bps, French yields 57 bps, and Italian yields 13 bps.
Bond weakness was not isolated to Europe.
Yields jumped 13 bps in Canada and 11 bps in Australia and New Zealand.
Chinese yields rose seven bps (“worst slide this year”) to a three-month high of 1.85%.
Pain aplenty in European EM bonds.
Local currency yields surged 34 bps in Cyprus and Slovakia, 31 bps in Slovenia, 30 bps in Czech Republic, 24 bps in Latvia and 22 bps in Romania.
For the most part, dollar weakness underpinned EM currencies and equities.
The Hungarian forint jumped 5.6%, the Polish zloty 5.0%, the Czech koruna 4.9%, the Romanian leu 4.4%, the Bulgarian lev 4.4%, and the Chilean peso 3.7%.
The euro posted its best week (up 4.4%) since March 2009. Surging 6.8%, the Swedish krona’s advance was the strongest all the way back to the eighties.
Clearly, hedge fund strategies were poorly positioned for the week’s currency market fireworks.
The Bloomberg “MAG 7” index, having now given up the entire post-election rally, sank 4.5% this week, boosting its y-t-d decline to 10.7%.
Ominously, financial stocks were hammered.
The KBW Bank Index sank 8.8%, with the Broker/Dealers down 5.2% this week.
While financial conditions remain loose, the shock to consumer and business confidence portends economic and Credit vulnerability.
March 6 – Bloomberg (Tatiana Darie):
“Leveraged loan prices took a notable leg lower as growth fears rekindle credit risk concerns.
US loan prices… posted their biggest drop since August on Tuesday, showing how quickly the repricing in this asset class can be.
The loan market has been on fire in recent months, with prices rising to the highest since 2022 and year-to-date issuance swelling to the highest since Bloomberg began tracking the data in 2013.”
The historic U.S. speculative Bubble is faltering.
That, however, certainly doesn’t preclude the possibility of a short squeeze and unwind of hedges into March’s quarterly option expiration (March 21st).
Thus far, there has been de-risking, but little to suggest significant deleveraging.
Most financial conditions indicators suggest only modest tightening.
The recent drop in Treasury yields has supported speculative leverage (i.e., basis and carry trades), countering liquidity impacts from deleveraging in technology and related indices.
But Treasuries were caught up in this week’s rising global yield dynamic, and will confront tariff and inflation risks going forward.
March 4 – Financial Times (Katie Martin):
“Investors are starting to imagine a financial system without the US at its centre, handing Europe an opportunity that it simply must not miss.
This exercise in thinking the unthinkable comes despite a cacophony of noise in markets.
Mansoor Mohi-uddin, chief economist at Bank of Singapore, recently travelled to clients in Dubai and London.
To his surprise, not one of them asked him about short-term issues like tech stocks or tweaks to interest rates.
Instead, he says, ‘people were saying, ‘What’s going on?’
The free trade, free markets, globalisation era is over, and nobody knows what’s going to replace it.’
They refer, of course, to the new US administration.
Within a month of retaking his seat at the White House, Donald Trump & co had all but trashed the transatlantic alliance, and ridden roughshod over the key checks, balances and institutions on which true US exceptionalism is built.
‘It’s such a momentous change going on.
If it continues like this, capital allocators will wonder:
‘Do I want to stay allocated to the US?’ Mohi-uddin says.”
With a major deleveraging dynamic lurking, my thoughts this week returned to critical mortgage finance Bubble dynamics.
GSE (quasi-central) market liquidity support was instrumental in mitigating hedge fund deleveraging in 1994, 1998, 2000 and 2002.
The revelation of fraudulent accounting essentially abrogated Fannie Mae and Freddie Mac’s ability to aggressively expand their liabilities to orchestrate hedge fund and market bailouts.
Importantly, the loss of this key liquidity backstop was irrelevant, as leverage speculation created seemingly endless liquidity in Bubble “terminal phase” excess years 2005 through 2007.
But it mattered tremendously in 2008.
China and global central banks have significantly slowed Treasury purchases over recent years, altering the key dynamic of how dollar liquidity excess is recycled back into Treasuries and U.S. markets.
While momentous, this shift in EM central bank recycling has been irrelevant, as leveraged speculation created seemingly endless demand for dollar liquidity, Treasuries and U.S. equities.
But it will matter tremendously during the next bout of serious speculative deleveraging.
This week’s dollar weakness portends dollar and liquidity issues.
There has been a lot of talk of a modern day (dollar devaluation) Plaza Accord - the administration moving forward with a so-called “Mar-a-Largo Accord.”
What seemed like a long shot a couple weeks ago appears a pipedream after Munich, the Zelenskyy beat down, and the U.S. no-show at last week’s G20 meeting in South Africa.
It takes a fanciful imagination to envisage global leaders converging on Mar-a-Lago to negotiate a favorable deal for the U.S. In such a fragmented and divisive world, it’s frightening to contemplate how nations will respond to the next crisis.
Trust in the Trump administration has been irreparably broken.
March 7 – Wall Street Journal (Brian Spegele and Austin Ramzy):
“China’s top diplomat chided the Trump administration and said efforts to contain the country’s rise were destined to fail, presenting Beijing as a force for global stability in a rejection of U.S. policy under President Trump.
‘No country should harbor the illusion that it can suppress and contain China while simultaneously building good relations with China,’ Foreign Minister Wang Yi said...
‘Such two-faced methods are not only detrimental to the stability of bilateral ties but also make it impossible to build mutual trust.’
Wang’s strident comments reflected Beijing’s determination to stand up to U.S. pressure…”
If I were Xi Jinping preparing for a trade war, or worse with the U.S., I’d try to hit us where we’re today most vulnerable – AI and American technological exceptionalism.
I’d throw unlimited resources at AI, develop world class language models, offer them open source, and spread the technology globally for next to nothing.
Why not completely undercut “MAG seven,” stocks that dominate U.S. indices and companies that spend hundreds of billions.
I’d also see an opportunity to disrupt China’s leading adversary by advancing plans for Taiwan “unification”.
March 6 – Bloomberg (Catherine Thorbecke):
“More than anything, China’s embrace of open-source artificial intelligence systems will be what tips the scales in its favor in the heated tech race with the US. Washington and Silicon Valley now have a limited window to adapt and respond, or risk a future where Chinese AI overwhelmingly powers the products and applications used by the global industries of tomorrow.
The DeepSeek shock earlier this year provided the first wake-up call…
But the second came this week, in the closely read policy report released at the National People’s Congress in Beijing.”
March 6 – Bloomberg (Winnie Hsu):
“A $439 billion rally in Chinese tech megacaps this year has left their once-unbeatable US peers in the dust, an outperformance that many investors say has room to extend.
An equal-weighted basket of China’s seven tech heavyweights including Alibaba Group Holding Ltd. and Tencent Holdings Ltd. — dubbed the ‘7 titans’ by Societe Generale SA — has gained more than 40% this year.
That compares with an about 10% drop in an index of the Magnificent Seven stocks, whose slump has also pushed the Nasdaq 100 Index to the brink of a correction.”
March 5 - BBC (Laura Bicker):
“China has warned the US it is ready to fight ‘any type’ of war after hitting back against President Donald Trump's mounting trade tariffs.
The world’s top two economies have edged closer to a trade war after Trump slapped more tariffs on all Chinese goods.
China quickly retaliated imposing 10-15% tariffs on US farm products.
‘If war is what the US wants, be it a tariff war, a trade war or any other type of war, we’re ready to fight till the end,’ China’s embassy said…
It is some of the strongest rhetoric so far from China since Trump became president and comes as leaders gathered in Beijing for the annual National People's Congress.”
It's just an incredibly precarious environment.
I began the year emphasizing “character matters.”
I resorted to the pedestrian “Words matter.
Civility and respect matter.”
I worried out loud that the President’s power-obsessed shtick would play poorly internationally.
The stakes today couldn’t possibly be higher – an especially inauspicious juncture in history to experiment with a comprehensive tariff regime – to manhandle our friends and allies – to sabotage NATO and key security alliances.
I doubt the administration appreciates today’s acute Bubble fragilities.
They seemingly couldn’t care less about international ramifications for their words and actions.
They relish blowing things up.
In my eyes, this is looking less like a disruption and more like a train wreck.
We're throwing so much away.
It’s worth repeating: this is no environment for aggressive leverage.
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