Odd Lots - Zoltan Pozsar on Russia, Gold, and a Turning Point for the U.S. Dollar

Episode Date: March 2, 2022

Even prior to Russia's attack on Ukraine, the global economy was facing an extraordinary moment. Now things have become massively more complex. In addition to the attack itself, rich Western governments have unveiled historically powerful sanctions against Russia, most notably by freezing much of the country's FX reserves. So what are the immediate and long term ramifications? On this episode, we speak with Credit Suisse short-term interest rate strategist Zoltan Pozsar on what this all means, how the Fed will react, why gold is important again, and how could this mark a turning point for the global dominance of the US dollar. See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. And welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Wisenthal. So, Joe, there is a lot going on at the moment. It is truly an extraordinary time. I would say kind of unprecedented. Already, I think, just the sort of like this economic. environment was pretty novel, not many people familiar with it. And now, of course, the start of Russia's war, the attack against Ukraine, making things potentially exponentially more complicated and difficult

to understand. Absolutely. And there are all sorts of impacts from what's going on in Ukraine with the Russian invasion. People have been talking at length about the commodities impact, what that's going to mean for inflation. But there is also this monetary impact. And we are starting to see shades of that now. So obviously, the ruble, I mean, if you look at a chart of the rubble right now, I think it lost another third just today on the day that we're recording, which is Monday, February 28th. It was down at an all-time low of, I think, about $109 rubles per dollar. But that is after the slide that it already encountered last week. So really extreme movements in FX. And at the same time, of course, we have the Western powers,

central banks across the world talking about excluding Russia from basically the global payment settlement system known as Swift. Yeah. So that's exactly right. And basically, at this point, there's no indication that other, you know, U.S. European powers are actually going to get involved. involved in combat directly. So in lieu of that, there's been a lot of attempts to use economic and financial penalties to go after Russia for its aggression. And so that includes both sort of traditional sanctions, but also, as we're seeing, some very extreme moves to cut off Russia from its own money, from its ability to conduct business, from its ability to engage in payments. That is a part what's caused the ruble to collapse. We've seen lines that. It's

ATMs in Russia, scramble for hard currency, and sort of this is a very new element of sort of economic and financial warfare of sorts against a relatively sophisticated and rich country. That's exactly right. It's something that we haven't really seen before. And so there are all sorts of questions around what this means for the broader financial system, how exactly it would work, what it means for the U.S. dollar. And we've already seen some signs of a scramble in money markets for people to get their hands on the safety of the world's reserve currency. There's a lot of uncertainty, a lot of questions around the mechanics. And I got to say, whenever we want to go deep into financial market mechanics or plumbing,

there is one person that we turn to. The most requested guest by far on odd lots. And somehow we have a tendency to speak with him at the start of almost every major crisis. This is true. All right. Well, we're going to be speaking with Zoltan Pozar. He is, of course, the global head of short-term interest rate strategy at Credit Swiss. So Zoltan, welcome to odd lots again. Thank you for having me. Nice to be back, guys. Yeah. Your timing is impeccable as always. I suppose, just to begin with, could you maybe give us a sense of Russia's place in the global financial system? So in your research, you've described it as a, a surplus agent in the financial system.

What does that mean exactly? The surplus agent means that you are a nation with a central bank, which has a lot of FX reserves. We are not talking about sudden stops. You know, we're not talking about a current account deficit country that needs to tap funding markets to import stuff. We're talking about a country that is exporting, you know, vests. amounts of commodities and has accumulated a lot of FX reserves on the back of that. And so,

you know, when you sanction the central bank of a country with a lot of FX reserves, naturally, I think one, you know, impact of that is that, you know, the central bank, the way it runs its portfolio is going to number one change. I mean, you know, the entity is a sanctioned entity. So if you have been lending those FX reserves in the FX swap market, you know, what's going to happen with all those trades, right? I mean, all the FX swap craves go through Western financial institutions. When you lend dollars in the FX swap market, you sell those dollars and then you get euros. You place those euros at the Bundesbank. You place them in various securities, which are all at euroclear.

So when all these things get frozen up, I think it's definitely going to have an impact. on funding markets. And also, you know, don't forget, you know, the FX reserves are partly used by the central bank to be able to provide dollars to the domestic financial system. And if all these balances are frozen, you know, one channel of dollars to help the local banking system dries up. So I think it's quite a complicated situation. The present situation has elements of a little bit of everything. I think it has, you know, definitely a local currency crisis, a local bank funding crisis, you know, a little bit of crisis of FX reserves, where typically we are used to situations where central banks that show they have something,

they don't have it, and then, you know, the market gets surprised by it, for example, you know, Southeast Asia in 1997. This time around, you know, the central bank did have a lot of reserves, but then these were seized. So I think it's, it's pretty uncharted territories and it's hard to tell which way this is going to go from here. But, you know, one day into it. We've had a big impact in the FX swap market, which has calmed considerably since the overnight session began. But again, I think it will take a couple of days to figure out where the bodies lie, because we're not just talking about the central bank getting sanctioned, but also some banks being excluded from Swift. We see the natural progression where, you know,

the sanctions were initially X and now they are 2x, and we don't know how the sanctions are going to evolve as the week progresses. But we know, for example, that energy-related payments are still excluded. What happens if energy-related payments get included as well? So I think it's quite a fluid situation as we speak still. So just to back up even a little bit further, you know, when we think about a country's FX reserves, maybe in our minds, you know, you think, okay, this is a war chest, this is a pile of money that's stashed away somewhere. But it's not literally a pile of money. It's liabilities of some foreign bankers.

You mentioned the Bundesbank, and it can be seized. It's not something that there just sits in a pile somewhere in Moscow. What are the numbers? What do we know about how much there is and where the money is right now? And how extraordinary is it to think that countries, FX, reserves, foreign central banks or foreign countries can just say, no, we're not going to give it. to. Okay. So, you know, to frame the discussion about this, you know, there is inside money and

outside money. You know, inside money is, are all the claims that are someone else's liability. And outside money is the type of money that is the liability of no one. And you're absolutely right. Most FX reserves that exist in the world today are all forms of inside money, i.e. they are the liabilities of someone. In the case of Russia, I mean, you know, the numbers are quite transparent. I mean, you know, they are subject to interpretation, but the IMF provides monthly data about the FX reserve composition of every country in the world. And so we know from that, that, you know, Russia has just rough numbers, you know, $500 billion of FX reserves, non-gold FX reserves.

About 200 billion of debt is in the form of securities. And about 100 some billion of it is central bank deposits. And then the rest of it is banked deposit. And so what this means in practical terms is that, you know, Russia's FX reserves are basically deposits at Western financial institutions. They are securities balances at Euroclear or wherever, you know, the custodian is for the securities that they hold. And they also have balances at central banks like the Bundesbank, obviously not the New York Fed, because they've sold out of all their treasuries.

So there's that. But again, I think when you look at the composition of the currency composition of these FX reserves, I think you require some careful interpretation there because, you know, the widely held assumption is that the dollar exposure is quite low. And the dollar exposure you will only be able to, the true dollar exposure, you will only be able to capture if you, if you think about things in the context of the FX spot market. If you have dollars and you lend those in the FX spot market, it's a spot sale of dollars today and then in some future point in time forward, you purchase those dollars back. But once you sold those dollars in the FX swap market, you would typically get Swiss francs or euros or yen. And then you

would take that local currency collateral and you would deposit at the local central bank. So in the case of euros, that would be the Bundesbank. Whether you hold the sovereign debt of a country or you keep a deposit at a central bank of a foreign country or if you keep deposits at Western financial institutions, these are all forms of inside money that you don't control. Someone owes it to you and these things can be sanctioned. Right. Outside money is something completely different. It's gold. And it so happens, I read it somewhere that all this gold that Russia has, for example, is in the vaults of the central bank in a basement in Moscow. So that's real money that they, so that they can, that no one can sanction.

Yes. Yes. So, you know, unlike France in a Second World War, you don't have to enlist, you know, the, the, the Navy to kind of rescue your gold bars somehow. And again, I think, I think, I think there is probably a medium to long-term lesson in all this, because this is precedent number two. I mean, we've seen what happened with the FX reserves of Afghanistan. Right. And we have seen with what happens with inside money type of FX reserves in the case of Russia.

And so what does this mean for gold as a monetary instrument going forward? You know, I've heard some, you know, clients, for example, what does it? Does this mean for dollars or for gold? Are they going to sell to get the dollars to help the domestic financial system? Far from it, I think, you know, gold can, it doesn't have to be sold. It can be repoed, just like any other financial instrument. So, you know, if you find a willing financial system and a willing central bank to, you know, reverse in gold in a repo transaction for you in exchange for dollars, you can use it

to raise dollars to make payments. But again, this inside versus outside reserves is something to think about because, you know, in the case of China, for example, it's the same setup. They have a lot of inside FX reserves. And what does that mean in situations like this? So the implication here is that if you have a lot of inside reserves, these are reserves that are tied up in other financial institutions or with other entities that can ultimately be tied up in times of conflict or war or, you know, what we saw in. Afghanistan, where the reserves were sort of frozen and the Taliban no longer has access to them. I want to ask a really basic question here. But what do central banks actually use reserves for? Like, what would Russia need these reserves for at the moment? I mean, obviously, they would want,

presumably, to stop the fall of the ruble, but are there other things that they might use this for? You know, reserves are reserves. I mean, we can go through the basics. You know, if your currency is too strong, you buy FX and print local currency. If your currency is in a freefall, you sell FX and you buy the local currency. If there's a dollar shortage in your local banking system and you don't have access to the FEMA repo facility and you don't have any treasuries you can repo with the Fed, if you don't have swap lines with the Fed, you tap into these reserves to provide dollars for the local banking system.

So it's basically there to buffer liquidity shortfalls and to be able to defend your currency. You don't have it. You don't have the ability to do any of these. So these are painful. I mean, again, in the grand scheme of things, energy-related flows, commodities and payments for commodities still continue. So we have not completely turned off the pipes yet. you know, this is the way you think about FX reserves. I mean, for example, if you go back to March 2020, I mean, we've seen a number of central banks, the Swedes, Brazil, for example,

you know, they were lending dollars to the domestic financial system without tapping the swap lines, even though they had access to the swap line. And again, the mechanism there was you turn into cash some of the inside FX reserves you have, and then you get that cash and you lend it on, you'll you lend those US dollars onto the domestic international institutions. But again, you need to be able to trade these instruments to do these types of things. I mean, you know, the fact that Russia, for example, restarted its gold purchases overnight from what I understand on the domestic market, I guess naturally since, because of all the sanctions, the central bank couldn't trade on international markets and buy gold there.

But I think it's just an interesting question, again, depending on. on how the geopolitical aspect of all this evolves. You know, if a central bank is in a situation like this and the currency is under pressure, would it ever come to having to re-anchor your currency to something like gold? I think these are all questions that should be top of mind. I don't know if it will come to that,

but if things get worse, you could basically re-anchor the rule to a pile of gold because you need an anchor in situations like this. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend.

I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations. about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world.

That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at the TV.

7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. You know, one of the questions that's come up in various forms is this idea of, okay, well, if Russia gets to shut off, it may seek totally alternative scenarios, or it may, you know, sort of develop something with China or use the Chinese UN more, or something like that, or maybe a new Swift will emerge, and we'll talk about Swift more. in a second. Is that realistic? Are there really alternatives to the existing system? I mean, I guess you just mentioned the idea of, okay, maybe the ruble could be gold-backed. But is there actually any realistic opportunity or ability to create sort of like a separate financial system?

Well, it's a big question. Yeah, that's an open-ended. Again, I think your imagination is the limit to how you can devise. alternative systems and then how realistic those are is another question. Obviously, I mean, we all know that there is, you know, transatlantic task forces that have been set up to check if anybody is helping sanctioned entities circumvent sanctions. That aside, you know, you have gold and you have commodities. And so it's possible to accumulate a new pile of surpluses. it's possible to still get U.S. dollars if you have a willing intermediary who's willing to give those dollars to you. And things can be, I'm sure there is ways to kind of structure these flows such that they don't really show up on balance sheets or if they show up, it's not very obvious what's going on.

Steins, you want to look for because there's a couple of things we, there's a couple of things we know is, you know, Russia doesn't have any more. treasuries because they sold all of it. It's in the tick data. Because they don't have treasuries, they have no ability to use the FEMA repo for services. You need treasuries for that. They also don't have a swap line, but they have gold. And so can you do gold repos between central banks? Yes. Can you provide U.S. dollars versus gold? Yes, you can. Are there some central banks that are so flush with FX reserves that they lend a lot of it in the FX swap market? So exactly if you don't send it on the world market, but you send those dollars to do another financial system, is it going to really show up? Not really.

Could it be a situation where some large central bank starts to pour collateral into the U.S. repo market to raise dollars and then, you know, take those? These are all possible. But I think the point here is that it is possible to do these in a way that no one's going to find out about them. because, you know, we are probably talking in orders of magnitude of like $100,200 billion, which is, you know, possible to hide on a balance sheet that's a couple trillion. Yeah, so I think these things, these things are all possible. But I think this is also, again, going back to the idea of, you know, Afghanistan and seizing inside reserves, this is probably going to leads to, you know, seeding financial centers in the east,

in friendlier jurisdictions because it's pretty obvious that FX reserves can be used against you. Currencies, I don't want to say dying, are born, but the prominence of currencies, I think, fades and rises in wartime, you know, stirring to dollar, dollar to R&B. I think it's situations like this that foments a lot of change. And these are definitely going to be catalysts in that type of a direction where you have us versus them and, you know, their financial system and our financial system and things change. So a related question on this point, but energy exports are excluded from a lot of these restrictions, it seems. And so one way for Russia to generate reserves at the moment is through energy exports. but are those reserves generated through energy exports?

Are those still going to be accessible to the central bank? Is it still going to find willing counterparties for those? As Perry Merlin would say, finance is hierarchical. So there is the central bank. There is the national wealth fund. And there is Gospram Bank, a bank entity, which is not sanctioned. I think the situation itself is extremely complex where Europe clearly needs the energy. Russia clearly needs the cash.

And some parts of this whole thing are just carved out and are untouched by sanctions. So again, for now, I think the exclusion of energy-related payments is making things a lot less severe than they otherwise would be. I mean, Gospon Bank, just like any other bank, can trade with domestic Russian banks, right? So if you think about the extreme scenarios of, okay, well, the Russian central banks can provide dollars to the local banks anymore, Gospon Bank can. So, again, depending on how tight the sanctions get and how wide the net of sanctions is cast and, you know, is Gospon Bank going to be a part of it, that is going to change things on the ground and that's going to change the way the rubal trades, the way funding markets paid.

I don't think we've seen everything yet. How prevalent is the dollar in the Russian economy? I mean, we've seen these stories. People scrambling for dollars. You mentioned Gazprom Bank would still be able to supply dollars. But how significant and how much dollarization is there in Russia? I mean, you know, Russia kind of insulated itself from FX liabilities somewhat, not totally. I don't have exact numbers at hand.

But I mean, I think any commodity exporter is going to trade them in a lot of dollars. I think it's just hard to, it's hard to kind of go down this path of figuring out the exact ramifications of all this. Because, again, I think, I think you're, you're meddling with these flows. And so we'll just see how tight the sanctions are going to get. So maybe we should talk a little bit more about what this. means for the wider financial system. So Russia, to some extent, is potentially a little bit insulated from, I guess, dollarization or dependence on dollars. But what we've seen so far in the

rest of the world is that all the uncertainty around the situation has sparked a scramble for greenbacks. So people are trying to get more dollars. We've seen, you know, some signs of this in money markets, in FX swaps, which you already mentioned. Where does it go from here? Is there going to be enough dollar liquidity to satisfy this demand? Make no mistake. There's a lot of dollar liquidity in the system, especially now. You know, FX swaps created, you know, 100 basis points wider a couple of hours ago that calm down considerably. So those spreads are much more normal. I mean, they are still wider but more normal as we speak. A frow YS widened.

I think the general posture of any bank in a situation like this is exactly what we're talking about. You don't know what the sanctions are going to look like tomorrow. You don't know what all this means. I think people are telling their exposures. Again, not to say that this is a Lehman moment, but some experienced hands that I spoke to last night, you know, reminded me. two people, actually, that when things like this happen, everybody's going to take time to

tell you up the true exposure and then you don't know where the bodies lie, but it's going to take at least a week to actually find out what all this means. So yes, there is a dash four dollars. There is also kind of unwillingness to part with your dollars. And so whatever excess liquidity you have, you're keeping it close to the vest of the Fed. And you don't trade it in the FX stock markets because, you know, you like to harvest, spread these locations where you know that, you know, someone just had a bad funding day and this money is likely to come back tomorrow. But, you know, these situations are the exact opposite of that. Dollars are tighter and, you know, we are learning. The last time I was on this call, we were talking about all the sex of liquidity

and funding being extremely boring for a while. You know, the year and turn wasn't that boring. I mean, the market did price some premium for a euro dollar basis. Despite all this liquidity in the system, the basis did cap as much as it did overnight. And so, you know, having a lot of money doesn't mean that you're going to be, you know, lending to harvest every basis point. You need to have confidence you're going to be able to get that money back. Another line of argument that I'm hearing, again, from experienced hands is, okay, well, if you freeze Russia's FX reserves, what does it mean?

they don't have access to it, but it's still with someone, and that someone is still probably going to be trading that money. I mean, not on behalf of Russia. And so the interest you earn on those FX reserves is not going to accrue back to the bank of Russia. But whatever custodian has that money or whatever dealer is stuck with the dollars of Russia, it's still going to kind of deploy that. Okay, interesting. But again, you know, what are the what are the, what are the legal aspects of all this. I mean, I think another theme that I've heard from a number of participants is that there is a lot of self-regulation in the marketplace at the moment, whether you are a Western financial institution or if you are a commodity trader, moving ships with

Russian oil, or processing payments for energy-related payments for Russia, which, again, are still not sanctioned. In the back of your mind, you are thinking about. whether it will be sanctioned by the end of this week. And do you want to deal with the headache of, you know, having deviled with, having moved Russian oil and Russian money and having traded that? And so what does that mean? So you just don't trade them and you don't, don't move oil around. So, so again, I think the self-regulation aspect of all this,

despite the fact that energy-related payments and flows are not excluded are making things difficult. So again, we will see. So at the beginning of that answer, or the very beginning of that answer, you said, it's not a layman moment, but then which is sort of ominous. What does that mean like, and then you say, okay, it's going to take a week before we see the true effects of that. So in other words, over the next several days, what are we going to be watching for? Who is maybe protect systemically or at least somewhat significant, who it turns out has big Russia, exposure in some way that we'll be taking huge losses? Like, is that what people are watching for

over the next several days? Well, I think the first thing we are going to watch for is how the war evolves. That is going to drive the severity of sanctions. So I don't think that we freeze in the moments in times of the package of sanctions. Let's see who gets hit. The sanctions are a moving goalpost. more and more entities can be added. So things can be ratcheted up. So it's dynamic, number one. Number two, we will tally up exposures. I mean, it's just basic things like,

okay, you know that we've seen headlines on Bloomberg, certain Russian-affiliated banks in Slovenia and Croatia, according to the ECB, are likely to go into difficulties. We know that you have a number of European banks with sizable Russian exposures, corporate exposures. I mean, I think anyone who claims to have a view that, you know, we are in the clear and this is as bad as it gets, is probably not right. You know, I probably overuse the Lehman analogy just to perhaps, you know, to shock ourselves into thinking. But, you know, let me just say that last week, we were not talking about Fra OIS widening and FXOIS blowing up a 100 basis points.

I mean, I think, you know, my first piece on this was Russia is a surplus agent. You will mess with these surpluses, and that's not going to have zero impact in funding markets. And now here we are in this situation, which is, I think, far worse than anyone thought we would be in last week. and I'm sure that there will be some some repercussions of this, not nearly as bad as Lehman, obviously, but still, an impact nonetheless. I mean, perhaps where I got the Lehman analogy from just kind of thinking things through, I mean, you guys know the plumbing quite well.

So, you know that Lehman at its heart was some clearing bank unwilling to unwind repos in the morning because if you give all that cash back to the money funds, you are stuck with the intraday exposure to Lehman. There is, I'm sure, some parallel at some level with Swift excluding certain banks from Swift, people being unable to make payments and the clearing bank decision to not unwind repos. And again, Lehman was not obvious the Monday after. It took the entire to kind of have a read on how bad damages. You know, Switzerland, Switzerland, for example, just adopted the EU sanctions. I mean, that's another new iteration. I don't know what that means, but there's a lot of commodity traders in Switzerland. So, I mean, we've been talking about

settlement risk all during this episode, but Russia certainly would not be the first financial institution or entity to encounter this. And there is a history of bank. that have been not just caught up in, but basically destroyed by settlement risk. Lehman is sort of one of them, if you think about the repo market. But there are a couple others that you've mentioned. What does history tell us about this kind of risk? Well, history tells us that the safety net around the world, whether it's the swap lines or standing repo facility or discount windows or, you know,

any central being able to provide local currency to the financial system is that, you know, there's obviously a solution for all these things. Again, I think the big context is Russia has its own problems, which we should talk about earlier. If there is a spillback from that onto Western financial institutions, there is all sorts of ways to kind of backstop, you know, settlement risk and liquidity hiccups that a bank experience is because the payments didn't. come from Russia. You know, the FX swap market, again, is a reflection of those types of fears and money getting gunged up. But I think the solution to all this is quite simple. The swap lines are there. And you should be ready to provide whatever currency needs to be provided in whatever

jurisdiction on a daily basis. So far, it wasn't necessary. If it comes to that, I think that liquidity will be forthcoming and from pretty obvious basis. This is Tom Keene, inviting you to join us for the Bloomberg Surveillance Podcast. It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of the U.S. market open. We cover stocks, bonds, commodities, even crypto, all the information you need to excel. And I'm Alexis Christophers. Bloomberg Surveillance also brings you the analysis behind the headlines.

We do that through conversations with the smartest names in economics, finance, investment, and international relations. We do all this live each and every weekday, then bring you the best analysis in our daily podcast. Search for Bloomberg Surveillance on Apple, Spotify, YouTube, or anywhere else you listen. On the East Coast, listen at lunch. And on the West Coast, listen as soon as you wake up. That's the Bloomberg Surveillance Podcast with Tom Keene, Paul Sweeney,

and me, Alexis Christophores. Subscribe today, wherever you get your podcasts. Bloomberg's Surveillance, Essential Listening, each and every business day. You know, one thing that we haven't fully touched on, but you mentioned we've been sort of talking around it, is Swift specifically. And there's a lot of, it's not a household name,

although everyone's sort of like trying to, you know, get up to speed on what it is. Not all of Russia is going to be disconnected. It appears, but there are going to be, it appears that at least some Russian banks will lose access. What does it mean specifically to lose access to Swift, which I understand as more a messaging system to make the payments happen? How much does that disconnection specifically? How disruptive and powerful is that?

It throws sands in the wheels. I mean, it's the messaging system for interbank payments. I think it is material. The more banks you exclude. And again, it's just your inability to, I mean, I don't even. You know, you take your email account and you can't communicate with the world. How is that? And so, again, you are freezing assets of banks.

You are making it harder, if not impossible, to alternative channels to wire money to various parts of the world. Central bank sanctions. So I think these are these things are cumulative. I think it's, you know, it's a quote unquote IT backbone. of the international payment system. So one thing we haven't spoken about is what this means specifically for the Federal Reserve. And before all of this happened,

you actually published a piece of research that got everyone on the street talking where you were discussing the idea of the Fed's exit strategy and what it actually needs to do to bring down inflation and things like that. And you argued that the Fed should perhaps engineer, or maybe not engineer, but allow a controlled correction in the market in order to reintroduce volatility. So I guess the point I'm trying to make is, you know, even before all of this happened,

we were at this very strange and interesting juncture for the central bank. And Joe and I have recorded a bunch of episodes on this. Now we have the Ukraine-Russia situation to throw into the mix, how difficult is it going to be for the Fed to actually raise interest rates and start winding down its balance sheet this year? So we will see. Let me take a step back with the whole notion of the basic idea of the piece was we need to inject volatility into the system mechanically by adding duration risk back into the system in a massive kind of, you know, surprise way. And so that's going to take some wind out of the sales of asset markets and, you know, asset price is correct. And, you know,

maybe that will bring about some increase in labor force participation. But, you know, this whole idea that we have this dynamic ever since Greenspan where we hike a little bit and be flattened, if not invert the curve. And so something's up with that, right? Because you're hiking, but that follow through, the real meaningful follow through in the back end is just not occurring. So that was two weeks ago today. What does it mean for inside FX reserves demand?

What does all this mean for that? It means you probably buy more gold and you diversify away from treasuries. So when you think about scenarios that can bring about surprise injections of duration and through that, you know, interest rate volatility in the back end of the market, you know, over the medium term, it's not just, you know, the Fed going from passive to active duty. It is now, I think, going to be decisions of FX Reserve managers as to how much money to keep where inside versus out. side. It is the threat of war. And, you know, there's no more peace dividend. I mean, I think what we've seen in Germany, but for the first time since the Second World War, you basically are talking about massive defense spending on the back of all this. It's also going to mean that in Europe, you will probably have a lot of fiscal spending on the back of this. I think the kind of theme

I touched on with, you know, let's do a whole core moment and go from passive to active Q3. at the end of the day is about injecting supply of long-term treasuries into the market. Whether that's going to come from the Fed or now in this brave new environment, FX reserves diversifying on the margin, the West increasing defense spending, and increasing issuance on the back of that, I don't know, but I think over the past two weeks since I've put out that piece, a lot of things have changed. And all of them are kind of pointing in the same direction, which is more supply and higher rates. And perhaps in the midst of all this, I think one of the most interesting things to me in watching the screens over the past week or so is, I mean, just for context, you know, if North Korea shut up a rocket without a warhead,

head. I think the 10-year, like, rallied massively in the past. Here we have open war in the heart of Europe, and the 10-year isn't really ready. I think that's huge, that there is this underlying kind of fear of inflation. And in addition to that, you know, what central bank's going to do about inflation, higher rates, potentially more issuance, potentially diversification away from inside FX reserves, perhaps in favor of outside FX reserves. I think the world is a very different place. My sense would be that there is a tremendous amount of pressure on long-term interest rates going higher from here than any time over the past 10, 15 years. So that's what I think all this means for central banks and long-term interest rates. I mean, it does,

feel like already, even prior to this particular moment, obviously we weren't getting the 10-year yield response that we normally get the market downturn. I mean, we had pretty intense selling and a lot of stuff really starting middle of November, not much of a flight to treasuries because of the elevated inflation. Does it change? I mean, it still seems like a tricky spot for the Fed setting aside the reintroduction of duration, whether they do it passively. or actively, this general effort to hike rates, normalize, fight inflation in general, wars or supply chain disruptions, increased commodities seems like going to be complicated that, just the rate hike part of normalization quite a bit.

Yeah, for sure. I mean, you know, everything that is happening is also highly inflationary, potentially even more, again, depending on how sanctions and energy-related stuff. of goes. And yes, I mean, I think these are, these are extremely complicated situations. I don't think that central banks are particularly able to do anything about any of this kind of inflation. But, you know, the markets and are kind of pricing in more inflation and more hikes on the back of this. I think, I think the situation is extremely complicated. I just want to go back to, you know, I thought one of the sort of more striking things you said was that,

In periods of war, we sometimes see a handoff from what, you know, currencies. And so you mentioned the end of the British pound, you know, amidst a war. You know, there's no immediate prospect as far as I can tell for a real, like, new global currency to replace the U.S. dollar. But can you talk about that a little bit further? Just this idea, it's like, okay, we're seeing essentially the weaponization of sorts. of FX reserves of central banks, and this idea what you said about, could this mark a sort of significant turning point

for the role of the US dollar on the international state? Yes, I mean, again, it's us versus them. You can probably imagine a response on the back of this where a lot of exporters of whatever, commodities and widgets, decides to invoice, things in a different currency. Because you know that all these dollars you're earning and all this money you keep in the West is at risk. Just to think out loud, you know, the one belt, one rope sphere of influence, I mean, should that all be invoiced in dollars or should it be invoiced in R&B?

I think, you know, these types of things are, because again, we are talking about seizing assets, you thought you had. So we know how to diversify away from that. Commodity reserves, gold reserves, what have you. Again, you can see new financial centers by invoicing a bunch of trade in a different dominant currency. And there's all sorts of reasons to do that now. So would you expect China to accelerate its own efforts of the internationalization of the RMB? Probably. I think, you know, two points make a straight line in geometry. So we had one example. We have another example. And so it will go like that. All the all the payments for all the all the gas, you know, what are some of the left field options? I mean, maybe you just don't accept payments for this gas in in euros and dollars. Please pay me in R&B. Right. I think that could be a very interesting variation on all this. And clearly, the, you know, year-old dollar market would probably feel that over time.

All right. Well, Zoltan, it's been great having you back on the show, as always. Really appreciate you coming on. That was great, Zolten. Thank you so much. Thank you for having me. So, Joe, there was so much in that conversation. And I feel infinitely smarter for having spoken with Zoltan.

But one of the things that struck me was he mentioned this idea of a lot of the financial institutions self-regulating before the sanctions even came into effect. And this kind of, and I wrote about it a little bit in the Oblots newsletter last Friday, but it kind of reminds me of the Federal Reserve when it started buying corporate bonds. And, you know, after it made the announcement, that was enough to settle the market and to backstop it. And it didn't even have to buy that much debt in the end. It's sort of a similar effect playing out right now. So because sanctions might be coming, a lot of financials. market counterparties have stepped away from Russian assets altogether. But I guess the tricky thing

in terms of inflation and financial stability is whether or not they, you know, decide to step away from everything, including commodities, even when those should be exempt, or whether they start stepping away from things in a disorderly manner. Yeah, I mean, I think that's a key thing. Financial conditions are going to tighten and or at least at least at the margin. And of course, there are the sanctions, there are the cutting off the banks, they're swift. And then, of course, there's the war. And nobody knows exactly how this is going to unfold. The fact that there is a war in Europe right now.

We don't know whether it's going to be short. We don't know that it's going to be long. We don't know anything about how it's going to end. You know, just think, as we were talking about, two weeks ago, the conversation is, you know, as Zoltan talking about introducing more duration into the market to introduce volatility. Well, now we have... Now we have volatility, yeah. Yeah.

And so even setting aside the financial restrictions, periods of a war are not typically when financial institutions, banks, et cetera, become sort of liberal with their lending. No, of course. And if you combine that with a central bank that is supposedly still on course for quantitative tightening and interest rate hikes, it's going to be... I know we overuse that word interesting, but I really don't know how else to describe it because of all the uncertainty involved, but it is certainly going to be an interesting moment. The other big thing in, you know, hearing Zoltan talk about like wars potentially are turning points for currency. And, you know, obviously one hopes that this war is short and somehow comes to a resolution, but the weaponization of FX reserves, the fact that it's like, okay, you have euros.

or you have dollars in a bank and now you don't have them and you thought you had this money and now you don't. And so do you want to trade or do you want to have a currency that's of the denomination or of the nation that's potentially going to be a rival or hostile towards you? And what does that mean for every other country that has FX reserves? Like, do you really want to hold dollars now that it's made clear? And I thought it was interesting that Zoltan brought up Afghanistan as well.

Oh, totally. as like, okay, the precedent is being set that what is your money may not be your money, hard to see how that wouldn't have affect the thinking of, as you mentioned, reserve managers all over the world. Totally. You could definitely see a rethink of reserves as a as a result of these two instances. And I suppose to some extent we have, we've seen shades of that already, right? Like the fact that Russia does hold so much of its. reserves in gold and that it sold down its treasuries and things like that. But definitely one to watch. And the gold conversation was also particularly, because gold I think for a while has felt, well, like a barbarous relic, but you think like, you know, Zoltan is one of the best and talking about the difference between inside and outside money. There's a big, a big demand for outside money at a time when like your inside money can just be a can just be shut off.

Absolutely. Shall we leave it there? Let's leave it there. All right. This has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthal.

You can follow me on Twitter at The Stallwart. Follow our producer, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca today. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening. This is Caroline Hyde. And I'm Ed Lodeman.

Lowe inviting you to join us for Bloomberg Tech, a daily podcast focusing exclusively on technology, innovation and the future of business. Every weekday, we bring you the top headlines from the world's biggest tech companies. From finance to defence, AI to entertainment and from startups to the magnificent seven. We highlight the latest stories of the people and companies pushing the tech sector to new frontiers and the politics that shape global tech markets. We do this all every weekday, then bring you the most important conversations and analysis. in our podcast.

Search for Bloomberg Tech on YouTube, Apple, Spotify, or anywhere else you listen. Join us every afternoon on your commute home and stay ahead of the tech news cycle. That's the Bloomberg Tech podcast. I'm Caroline Hyde in New York. And I'm Ed Ludlow in San Francisco. Subscribe today wherever you get your podcasts.