Collateral Chains Are the Real Tightening

Saudi Crown Prince Mohammed bin Salman (R) greets U.S. President Joe Biden with a fist bump after his arrival in Jeddah, Saudi Arabia, on July 15, 2022. Bandar Aljaloud/Saudi Royal Palace via AP

Commentary 

It was barely a month ago when OPEC+, the group of major oil-exporting nations, had announced a small increase in production. The world economy was suffering under extreme oil price pressure. President Joe Biden traveled to Saudi Arabia, one of OPEC’s largest producing members, to personally deliver his plea for relief on behalf of pretty much everyone. All he extracted from the Saudis was a measly increase of 100,000 barrel per day (bpd).

Partisan politics aside, the reason Biden didn’t get any more than this symbolic gesture was widespread concern on the part of producers over the same economy. Fears of recession have been growing for good reason, as oil prices swing wildly, unsettling the market.

The small output increase was a compromise, ironically, between acknowledging the potential for demand destruction high oil prices represent, Biden’s plea, and the very real possibility that price destruction is already happening as crude benchmarks sink.

In response, the OPEC+ cabal just backed out of even providing 100,000 bpd, unwilling to commit to any supply reduction. Demand concerns have now completely overridden the serious production constraints that had provoked Biden’s pleas in the first place, and the lack of oil worldwide still remains unsolved (especially in the United States itself).

We see this very clearly, as I wrote in my last column, in the reshaping of the domestic oil futures market curve. Gasoline use (demand) domestically is thought (by the government) to be right now, on average, as dismal as it had been during the summer of 2020, when much of the country was still unwisely imprisoned by pandemic politics.

The West Texas Intermediate (WTI) market, therefore, inches closer and closer to contango—that is, when the futures price of a commodity is higher than the spot price—flattening out on its front end, representing greater fears over future demand trouble yet to come.

While this is relatively straightforward, recession isn’t the only factor weighing on this curve and many others.

Crude oil futures are the nexus between the real world and the monetary, the physical needs of supply balancing demand set against global liquidity. What had sent oil prices surging originally from 2020 was entirely supply related—that is, too little of it. Since around February and March 2022, the balance (or imbalance) has flipped, though not just toward demand fears.

From early June until mid-July, it was the other of those fundamental forces, liquidity (meaning money), which had set crude oil prices on their initial plummet, the one which gave OPEC so much pause upon Biden’s plea that they’d only offer him a tiny token. Since mid-July, both lack of liquidity and all-too-reasonable worries about falling demand have contributed to bending the curve and sending prices across the whole of it much lower.

Shouldn’t the president have visited Federal Reserve Chairman Jerome Powell instead of the Saudi crown prince?

Had Biden done so, it would’ve been just as much a waste of everyone’s time. By mainstream convention, we’re told that if something happens in markets or the economy, the Federal Reserve must be behind it. This “don’t fight the Fed” myth persists, despite decades of experience having long ago overthrown it (in fact, the myth was never really established by anything apart from unsubstantiated claims, including those for quantitative easing).

In the case of monetary tightening, this sounds exactly like what Chairman Powell has the Fed up to. Not only that, Powell has been raising benchmark interest rates primarily because of the president’s prior demand (the pair did visit with each other not long ago, at the end of May) that Powell “do something” about inflation.

But like OPEC’s brief production increase, rate hikes are just as symbolic (and still heavily priced to be brief). Effective monetary tightening is just not something the Federal Reserve actually does. Instead, we can easily establish the real U.S. money conditions punishing the WTI curve by starting in … Italy.

Unbeknownst to most people, which includes those working at the Fed or European Central Bank (ECB), Italian governments are a huge source of useful currency for the entire global system. How do bonds become currency? As collateral in all kinds of monetary transactions, from repos to derivatives to collateral-for-collateral swaps and transformations.

In short, since the Germans are notorious for being fiscally prudent, there just isn’t a lot of “pristine” German government bonds issued, particularly of the short-run maturities coveted by global money participants engaging in securities financing transactions. As a result, the fiscally profligate Italian government has, sadly, filled this crucial monetary void.

This, of course, introduces a potential fracture point—the same exact one which had already been the primary source of the second global monetary crisis more than a decade ago, in 2010 and 2011. Any real prospect for recession in Europe is a bad combination, with Italian bonds already trading on shaky grounds because the Italian economy never recovers from any of the previous contractions.

Growing concerns about Italy’s situation, which always features an unhealthy dose of related political instability, spill right over into volatility in Italian bonds. There is nothing collateral-takers in repos despise more than price volatility and uncertainty. We can see this pressure rising in the dangerously growing spread between Italian bonds and their German counterparts.

And as it becomes more difficult for Italian debt to fill its role as a primary European interbank currency, the ripples of instability and illiquidity spread out around the rest of the world, leading to second-order effects like in crude oil since mid-June.

The ECB, aware of at least the politics surrounding Italy’s precarious position, promised more than two months ago to do something about it. Announcing a frankly ridiculous “anti-fragmentation” idea (to buy more Italian bonds while selling German bonds, theoretically narrowing the spread between them, it quickly lost favor in the marketplace because it was the usual central banking nonsense (which the financial media ate right up, the policy’s true aim).

Despite the ECB’s promise, or because it isn’t a useful solution, Italian spreads are once more blowing out.

We can observe the consequences in metrics such as U.S. dollar repo fails using U.S. Treasury collateral. These fails are an indirect measure of collateral shortfalls, or worse, rising, at times precipitously, indicating significant collateral trouble across the global monetary system.

Thus, as Italian government spreads surge, this instability forces the system to scramble for other forms of more usable collateral, creating an imbalance in demand for alternatives, such as U.S. Treasuries, to the point that it leads to more and more of those repo failures.

As the collateral squeeze spreads, it also leads to the more visible warning signs of dangerously tightening global money supplies—a rising U.S. dollar exchange value (also incorrectly assumed to be a result of whatever the Fed is doing). With the dollar having surged to multi-decade highs against many major currencies, this is actually a systemic monetary warning!

In that respect, OPEC+ and the Fed, the president or any politician, are all running around merely pretending to have a clue.

The real clue, however, is the dollar’s surge, because collateral and its fingerprints are all over the current state of the world. And that is our biggest problem.