UPDATE ON BRETTON WOODS 3 CONCEPT / MACLEOD FINANCE

Update on Bretton Woods 3 concept

You will have to prepare for your currency to buy less and interest rates to rise: how will your portfolio fare, and will you afford your mortgage?

MACLEODFINANCE

In recent days, some commentators have begun to fear that interest rates will not decline materially for the foreseeable future. 

They had pinned their hopes on the Fed having no option but to ease monetary conditions, given mounting debt problems for the federal government, commercial real estate values, and the regional banking system. 

Declining consumer price inflation appeared to have created favourable conditions for lowering interest rates, but month by month, the US’s CPI has actually been increasing gradually since October.

That causes some alarm, as does the yield performance of US Treasuries, shown in the chart below. 

The magnified insert shows that technically the price and moving averages are in bullish sequence (i.e. yields are set to rise).

Clearly, the monthly inflation trend and what’s happening to T-bonds conflicts with current expectations for lower interest rates.

All the hopium about lower interest rates has been pushed by an investing establishment which actually knows next to nothing about the legal and commercial principles behind the colossal system of credit. 

This ignorance is not new. 

But it stems from the fact that economics and investing textbooks never properly address the topic. 

And while your broker or investment manager is highly qualified in financial matters on paper, their learning is entirely textbook based. 

Ill-prepared, they work their way up to managing your affairs in ignorance of practical elements which are crucial to protecting your wealth.

Never forget that only dead fish swim with the stream. 

The large majority of portfolio managers and investment advisers swim with the stream. It’s a mistake to get carried along with them.

Consequently, the experts miss the sea-change in the basics behind credit values. 

But occasionally, an astute individual alights on a theme which some people can grasp but without a full appreciation of the implications. 

Poorly understood, it then becomes forgotten because it is not immediately relevant. 

And it has little or no effect on your investments, until it does. 

The theme that emerged over two years ago was that of Bretton Woods 3 promoted by Zoltan Pozsar, at that time an expert in dollar-based short-term credit for the now defunct Credit Suisse.

Pozsar’s followers sat up and took notice, trying to unpick his Delphic pronouncements. 

With his Bretton Woods 3 concept, he prophesised that the era of declining and ultra-low interest rates was over, and that many of the economic benefits enjoyed from the fifty years under fiat currencies would be reversed. 

Geopolitical shifts away from pax Americana would undermine the use and value of the dollar, and the stagflationary conditions of the 1970s would return.

Now that over two years have passed since Pozsar introduced his BW3 theme, we can begin to see its relevance and why we should worry. 

Hence, the opening question to this article: how will your portfolio fare and will you still afford your mortgage? 

While the investing mainstream believes that the Fed controls interest rates and will make them fall to support government finances, the banking system, and the values of all their investments investors ignore one of the first things they are taught in high-school economics: that supply and demand are matched by means of the price mechanism. 

It is not only true of goods and services, but also credit.

The Fed has now only two paths it can follow, both leading to the destruction of the currency. 

If it does what the dead-fish investors wish by reducing interest rates, the dollar’s decline in purchasing power will accelerate. 

Foreign holders of dollars and then domestic American institutions will refuse to buy US Treasury debt, forcing bond yields to rise to a level high enough to stimulate demand. 

But then the problem is that the higher the cost of funding, the worse the position becomes. 

Classic debt trap.

Alternatively, if the Fed takes the other option, taking a hard line on interest rates in an attempt to protect the dollar’s purchasing power, it will also accelerate the US Treasury’s slide into its debt trap, because debt interest continues to be rolled up into new debt, and the politicians show no restraint in their spending. 

In a debt trap, debt interest accumulates at a faster pace than the growth of GDP, which is clearly now the case.

So, one way or another, bond yields will continue to rise: what the Fed does is simply a distraction because it cannot change the outcome. 

The chart below says it all.

From a peak yield of 15.75% on 1 October 1981, a multi-point downtrend became firmly established, finally broken in mid-2022 when the yield soared through the 2.8% level. 

More than anything, this was manifest evidence that economic conditions which led to continually declining interest rates without surging inflation were over, and that we should revisit Pozsar’s BW3 concept.

Dollar’s demise is baked in the cake

Another plainly ridiculous anticipation is that inflation is licked. 

Inflation is basically the outcome of currency dilution and/or loss of faith in a fiat currency (more on which follows). 

As new units of currency enter the economy, their purchasing power dilutes, reflected in rising prices. 

This dilution is still accelerating because the budget deficit feeds into nominal GDP. 

Non-interest costs, such as welfare, pensions, and healthcare feed directly into the GDP economy, while interest payments feed initially into the financial non-GDP economy, from whence they leak over time through spending into GDP by private sector pension payments, insurance claims, and declines in the savings rate.

I estimate that this fiscal year the US budget deficit to GDP ratio will be about 12%, half of which is interest. 

It is this which drives the dilution of the dollar’s purchasing power, not the Fed’s interest rate policy. 

And there is still significant inflationary pressure in the pipeline and will be for many years.

The deficit also conceals economic deterioration. 

US nominal GDP is expected by the OECD to grow by 4%. 

Yet net of interest, the government’s deficit contribution will amount to about 6% (assuming that debt interest in fiscal 2024 is about half the deficit). 

In very approximate terms, we can say that the nominal growth in GDP can be accounted for by direct government spending, which by its nature is non-productive, and indirect spending through interest payments. 

And we can go even further and say that government spending is masking economic contraction.

From his public statements, Jay Powell, Fed Chairman, mistakes this artificial boost to GDP for a robust economy. 

But if he does understand the truth of the matter he just cannot admit it; then either way monetary policy is a failure.

Loss of faith in fiat currencies doom their existence

The reason that gold is money and all else is credit, and that it is so important not to confuse the two, is that credit must take its anchor in value from gold. 

Only then are the consequences of credit expansion contained. 

And if a currency is to continue to act as a gold substitute, then the issuing government must impose strict fiscal and economic discipline on its activities.

That is why countries experienced the greatest advances in economic history under gold standards which allowed for the free expansion of credit for productive means. 

But since the end of Bretton Woods when the world adopted the fiat dollar as its currency reference point, all currency values have been progressively eroded. 

The next chart shows how the dollar and other major currencies have fared since.

Against true money, dollar credit has fallen by 98.5%. 

And the fate of the other currencies has been similar. 

Much of this has been down to central banks targeting an inflation rate of 2%, but the consequences have been an uneven redistribution of wealth with the savers and the poor robbed, while those with wealth in the form of property and equity have seen valuation benefits. 

But the habit of valuing equity in property in nominal currency has disguised the true position which should be adjusted for loss of purchasing power. 

And speculators who use financial leverage have had a ball.

The devaluation of savings and the taxes imposed upon them, coupled with welfarism has destroyed the structure of the US economy, disadvantaging the vast majority of the population. 

Even those with 401k shelters are discouraged from saving by the inexorable destruction of the dollar’s purchasing power. 

In short, the public faith in the fiat dollar is probably closer to being seriously undermined than you might think.

This particularly matters on the foreign exchanges. 

The table below estimates total foreign interests in dollars and dollar-denominated financial assets.

Compared with US GDP at about $28 trillion, foreign ownership of onshore short and long-term securities at $32 trillion exceeds it by a fair margin. 

This represents two levels of credit obligations: the first is in bank deposits, bonds, and equities (yes, equities are also a credit obligation) and the second is in the dollar currency itself, which contrary to what modern economists will tell you is credit, a debt obligation of the central bank as counterparty.

There are therefore two aspects which could undermine faith in the dollar for foreign creditors. 

The first is the bad debts arising from an economic slump, rising interest rates, or a combination of the two. 

The second is the US Government’s credit standing with respect to the Fed’s handling of the situation. 

We can summarise this from the foreigner’s viewpoint: In a bear market and with rising interest rates, is it sufficient to liquidate credit and hang onto dollar cash, or do we sell dollars as well for something else?

In addition to this problem is the offshore dollar position. 

The $85 trillion of short-term securities (i.e. credit) is the notional bank deposit value of constantly rotating dollars intermediating between foreign currency transactions. 

When you sell your euros for yen, you sell euros to buy dollars and then sell dollars to buy yen. 

That is the way it works, and why it is that the BIS comes up with such a large figure, being the temporary balances thrown up on international bank balance sheets.  

Offshore long-term securities refer to the size of the Eurodollar market. 

Altogether, the total of these obligations at nearly $128 trillion is over four and a half times US GDP, representing a potentially unstable mountain of dollar credit whose value resides in the collective faith of foreigners.

Finally, from US Treasury TIC figures, we see that US interests in credit denominated in foreign currencies is only $730 billion, 1/175th of foreign dollar interests. 

It is this small because international debt obligations tend to be in dollars, and listings of foreign securities in American equity markets are in dollar ADR form. 

And it represents a potentially catastrophic mismatch in the event of a dollar crisis and could become the trigger point for a collapse of the entire dollar-based credit structure.

The foreigners’ escape route

With the dollar so obviously exposed to the consequences of a federal government debt trap, foreign holders in particular are likely to seek alternatives to holding dollar credit and dollars themselves. 

The problem they face is that all other currencies take their value from the dollar, so swapping out of dollars and into, say, euros or yen can never be more than a temporary solution and more likely would put them in an even worse position.

Increasingly, the solution for central banks is to reduce their dollar reserves in favour of gold, which they still recognise as a monetary asset, but crucially without counterparty risk. 

The solution for governments outside the western alliance is to covertly accumulate gold off-balance sheet, along with stockpiles of key commodities. 

China, for example, is driving up the copper price by building its strategic reserves and has been stockpiling silver for the last decade at least as well as stockpiling gold. 

Russia has no need to stockpile commodities, being a substantial exporter of them and can always acquire what she needs in exchange for oil and gas. 

Nevertheless, as well as accumulating gold on the central bank’s balance sheet, it operates two sovereign wealth funds which observers believe could bring her total gold holdings to over 12,000 tonnes.

Both Russia and China are able to protect their currencies by putting them back on gold standards. 

Meanwhile, in their common sphere of influence they have accumulated economic allies totalling about 60% of the world’s population, outnumbering the western alliance (basically our past-their-prime economies) by nearly five to one. 

By global GDP, the western alliance still leads by 54% to the Asian axis’s 30%. 

But on a purchasing power parity basis, the Asians are a lot closer, with China’s economy alone estimated to be greater than that of the US.

While a collapse of the dollar-based fiat currency system is going to be painful for everyone, we can see that over the next few decades the majority of the world by population plans to industrialise freed from pax Americana. 

The demand for commodities will accelerate, forcing prices higher measured in our declining fiat currencies. 

The condition whereby this Asian-led economic progress can flourish requires ample credit, whose value must be stabilised in commodity values. 

And that can only be achieved under gold standards for participating currencies.

That is what Bretton Woods 3 really refers to.