After the US took the dollar off the gold standard, we entered a regime where free-floating currencies were the release valve for economic warfare and financial imbalances. A free-floating currency regime means that the market decides the price of a currency instead of a government unilaterally controlling it, as the US did under the gold standard. A currency is the gateway for accessing a country's goods, services, and assets, which means that the market determines HOW MUCH of a premium you should pay for access.
This change in rules for free-floating currencies has been one of THE major drivers in every credit cycle melt-up and financial crisis over the last 40 years, but it is the most misunderstood. The focus in the media has been on “dollar devaluation” as if that is the magic solution for risk assets to go up over time and a crisis to be avoided. The misunderstanding about how free-floating currencies function in the modern world of globalization has created an environment where anyone can jump onto the narrative and promote any asset that they want.
I have already explained HOW China is utilizing the market forces of free floating currencies to tip the odds of global power in their favor. The relationship between the US and China will define the next crisis but this time it won’t look like anything we have seen in the past.
The seductive lie that governments can print their way out of any crisis and that devaluation of currencies means risk assets can go up forever is coming to a day of reckoning as countries are being pushed into a corner.
I will remind everyone: policymakers AND everyone in the media industrial complex are responsible for the crisis that is coming one day. On one side of the spectrum, you have doomers who refuse to be part of the solution because they don’t understand the problem and on the other side you have naive optimists who think that the devaluation of the currency can go on forever without any consequences. These narratives are used as platforms to monetize attention instead of injecting accountability into the system.
This is why systemic risks build in the system and we are on the edge of seeing them materialize. Europe is leading the US in their complacency because they have allowed China to hollow out their industrial base. As a result, the government is being forced to spend more than they make in order to keep the economy propped up. There is no turning back for Europe from the path they have gone down, there is only limiting the damage through difficult decisions. France is the first to send a signal about the lie about “devaluation solves all problems.”
French policymakers and investors who foolishly believed the lie about “dollar devaluation” are now paying the price for their sins. Yields in France are blowing out vs. German yields and Euro swaps showing that if France wants to borrow, the market is going to charge them in alignment with the actual risks that reflect their incompetence.
Equities are not immune to the consequences that are materializing. The French stock market (CAC 40) is down considerably as investors are realizing that the promises of “money printer go brrrr” are empty, and they believed a lie instead of conducting a counterattack against Chinese currency manipulation. The French stock market is already illustrating this dynamic but Eurostoxx (blue) are underperforming US stocks as the systemic risks for Europe growth and higher crude prices hurt Europe the most.
Traders believe it is virtuous to keep politics out of markets despite policymakers being THE largest driver of interest rates and FX. Many traders turn to quantitative methods to extract alpha because they can’t separate their desire for how they want the world to be politically from how it actually functions.
Politics and regulation are such important factors to understand when trading interest rates and FX when the time horizon is greater than a few days. In today’s world, everyone has become a short term momentum trader which is why we continue to see quant shops have significant alpha decay and constraints to scale. On the flip side, all of the real macro traders have retreated into the shadows because the way that the world actually functions isn’t palatable to the public. The world would rather have a shot of dopamine than a hard conversation that brings accountability.
I explained the structural factors for WHERE we find ourselves in the United States today here. What I am going to expand on today is HOW to think about US interest rates and WHY the recent price action in French OATs (government bonds in France): Please read yesterday’s report so you understand the context
