Plumbing Notes: War & Plumbing

U.S. monetary statecraft is about to snowball

— the Warsh Ultimatum will (depending on newsflow) follow this note

The Middle Eastern “Not War”¹ is creating fragmentation in dollar funding markets. Onshore, conditions remain lax. Money funds have received hefty flight-to-safety inflows, pressuring bill yields and o/n (overnight) rates lower. Offshore, meanwhile, an unwind of low volatility and increased demand for dollar hedging have pressured cross-currency bases wider². A return to a Global Compression where onshore and offshore $ rates converge will thus only materialize when the Board of Peace earns its title. The duration of the Not War, whether TACOed (i.e. short) or prolonged, has now become key to where dollar funding and rates markets trade.

in the right-hand chart, a flatter curve (more negative) suggests more UST frictions, such as from deficit fears. in the left-hand chart, a more negative value implies more $ demand

The geopolitical chessboard, however, suggests the latter. Trump had been widely depicted as the first U.S. leader, perhaps in a century, to attempt a transition away from a longstanding unipolar U.S. order. Instead, as shown by capturing Maduro, increasing arms sales, and seeking to annex multiple islands, Trump has turned out to be a unipolar hawk. Instead of ushering in a multipolar world, POTUS has upheld America’s global “security pact”, in which the developed world, ex-Iran and Russia³, “employs” the U.S. empire to enforce clear waters and airways, enabling free trade. Enemies of this security pact face the reality that damaging global trade, financial markets, and the U.S. dollar hurts them more than they hurt America and its allies. Inflicting substantial harm to the U.S. empire must (and has) come from within. Nevertheless, attempts to destabilize the U.S. security pact — such as imposing sky-high tariffs — have illustrated that even the most disruptive U.S. leader ultimately defends the unipolar status quo.

Unable to contest such a power structure, Iran must resort to undermining the U.S. Yet Iran’s recent activities have spurred Trump to embark on another Middle Eastern foray. Most disputes, even during the Trump presidency, have died down quickly. But after eliminating Iran’s Supreme Leader, POTUS can’t simply pack his bags and leave. This looks to be the first “happening” that could take weeks, months, or years to resolve.

Unfortunately for markets, this war will inflict a slow burn on asset prices, with neither the Fed nor the U.S. govt supplying fuel for risk-taking. No sudden market move, not even a spike in Crude, should trigger the U.S. admin’s (low) tolerance level for market instability, one that would trigger the next TACO.