A War Update

and not the one between Russia and Ukraine

Fed Chairman Jerome Powell and European Central Bank (ECB) President Christine Legarde duke it out in the squared-circle.

There is an un-televised war going on between the ECB and the Fed. It has been simmering under the radar since 2012. In 2012, it was revealed that banks around the world had manipulated the London interbank offered rate (LIBOR). LIBOR is a benchmark interest rate used as the basis for bank lending, option contract pricing, mortgage rates, CDOs, and other consumer loans like car loans and student loans. LIBOR was sold to the public as the rate that major global banks lent money to one another. It was proven to be easily manipulated by the 17 foreign banks and 1 US Bank (JP Morgan) whose figures made up the basis for the rate. For John Williams and Jerome Powell, the LIBOR scandal brought to light how LIBOR was being used to effect monetary policy in the US.

What the Fed realized is that the LIBOR rate was controlling the flow of dollars into and out of the global banking system. The Fed’s hand was being forced. They had to lower interest rates and provide liquidity to failing European banks by LIBOR manipulation. When the Fed attempted to raise rates, it drained the liquidity of Euro-banks and put upward pressure on LIBOR. Once the LIBOR rate began to shoot higher, the products in the US that used LIBOR as a basis became unstable.

One of Powell’s first actions, once nominated to chair the Federal Reserve, was to raise interest rates. He had also announced a reduction in the Fed’s bloated balance sheet. This went on from 2018 until the LIBOR blow-out cause the market to breakdown in 2019. At that time, Powell reluctantly reversed course.

It’s important to note that Powell doesn’t come from the same ivory towers that Bernanke (Harvard, PhD MIT) and Yellen (PhD Yale) came from. Powell’s experience comes from years of work at investment banks (Davis Polk & Wardwell, Bankers Trust) and private equity/venture capital firms (Global Environment Fund, The Carlyle Group, Severn Capital Partners). This causes Powell to have an entirely different outlook on interest rates than Bernanke and Yellen.

To wrestle power back from the Europeans, Powell and Co introduced the Secured Overnight Financing Rate (SOFR). SOFR is a benchmark interest rate based on actual transaction costs in the overnight repo market and is calculated by the NY Fed (whose president is John Williams). SOFR breaks the link between the Fed and European banks. No longer when European banks get in trouble are they able to manipulate the Fed into lowering interest rates and supplying them with liquidity. This means the negative interest rates that the ECB was able to engineer will be coming to an end.

When John Williams announced that the repo facility was “working as planned” it signaled to me at the time that what the Fed was doing was purposeful. The picture is now coming into fuller view in light of SOFR. The repo market is working as planned because it is being used to create the SOFR rate which breaks the connection between the ECB’s and Fed’s policies. No longer does the Fed need to coordinate with other central banks. This allows them to chart their own monetary course, independent of what Europe, Japan, or China is doing. This leads straight to Jackson Hole.

The Federal Reserve Bank of Kansas City hosts the Jackson Hole Economic Symposium annually in August. It typically features prominent central bankers, finance ministers, academics, and financial market participants who discuss economic issues, policy implications, and policy options. This year the topic is “Reassessing Constraints on the Economy and Policy”.

This year’s symposium is going to be a direct look at the most recent policy of SOFR, interest rate increases, and what other constraints are holding the Fed back from the policy avenue of their choice. Many financial pundits have predicted that Jackson Hole would be the pivot point for the Fed. My opinion differs greatly here. For Powell, Jackson Hole is going to reaffirm that interest rate increases are going to be able to be sustained for a long period of time. It will also expose what other tools the central bank might be developing to strengthen their independence. The much talked about pivot is considerably further out in the distance than most anticipate. I believe the Fed is working to engineer a long period of stagnate growth and a slow deflation of the everything bubble. This brings me to gold.

The ECB needs a higher gold price. A much higher price. This is because of the enormous amount of government debt that is floating around on European bank and the European Central Bank balance sheets. The member states of the Euro have pledged their gold towards the central bank. The ECB has used this pledged gold to support their issuance of government debt. As the government debt has ballooned, the gold needed to support it grows. This is basic Exter’s Pyramid stuff.

From Wikipedia:

Exter is known for creating Exter's Pyramid (also known as Exter's Golden Pyramid and Exter's Inverted Pyramid) for visualizing the organization of asset classes in terms of risk and size. In Exter's scheme, gold forms the small base of most reliable value, and asset classes on progressively higher levels are more risky. The larger size of asset classes at higher levels is representative of the higher total worldwide notional value of those assets. While Exter's original pyramid placed Third World debt at the top, today derivatives hold this dubious honor.

The ECB needs the base of their pyramid to be larger in order to support the massive amount of government debt that they are burdened with. At the same time, the Fed wants the price of gold to stay steady or decline. By holding steady or declining, this signals to investors that the Fed is handling the inflation problem and are in control. At the same time, the ECB doesn’t want to see the euro currency drop any further against the dollar.

The challenges for the European Union are great and are getting more intense. At some point, the ECB is going to have to make a decision. Raise rates and allow sovereign debt to reprice in order to keep parity with the dollar or allow the euro to fall further against the dollar, see an increase the gold price in euros, and maintain their low government debt interest rates.

The odds that something breaks in Europe (or Asia for that matter) look much higher than the US. Expect the Fed to continue the battle for central bank dominance with increased interest rates and balance sheet tapering.