Zoltan Pozsar’s Fairy Tale

Zoltan Pozsar scarcely needs to exalt himself.

The financial media does that for him. In 2019, for example, Bloomberg’s Tracy Alloway accorded Pozsar the kind of respect the ancients reserved for the Delphic Oracle which, considering her unrivaled ability to secure interviews with Zoltan, makes her a modern day Pythia, I suppose. Zoltan linked to one such interview last month.

Although he doesn’t play it up, Pozsar does seem to revel in the almost mythical reputation he happened into. It helps that his first name is just one letter removed from the fortune-teller machine in one of American cinema’s most beloved family films. (“I wish I were big.”)

When the onset of hostilities in Ukraine drove up raw materials prices, fractured commodity markets and compelled the US and its allies to take unprecedented action aimed at cutting Russia off from the global financial system and freezing Vladimir Putin’s hard currency reserves, Pozsar busied himself constructing what he called “a new monetary world order.” If that sounds grandiose to you, you’re not wrong.

In his latest, Pozsar dropped all pretensions to modesty. “What Deutsche Bank’s Bretton Woods II framework was to the first decade of the new century, and what QE and Basel III then were to the second (post-GFC) decade of the new century, we believe that our Bretton Woods III framework will be to the third decade of the new century and potentially beyond,” he declared, in a new note.

Although Pozsar used “our” and “we” across his latest missive to refer to Credit Suisse, I don’t see much utility in skirting the obvious: It’s more like “my” and “I”. This is Zoltan’s framework. To the extent he’s right, and it is eventually enshrined in the annals of history, it’ll be identified with Pozsar more than his current employer.

Zoltan recapped the basics (if you’re unfamiliar with the thesis, the fourth linked article above is a good primer). “If we are right, our framework will be the right framework to think about how to trade interest rates in coming years: Inflation will be higher; the level of rates will be higher too; demand for commodity reserves will be higher, which will naturally replace demand for FX reserves (Treasurys and other G7 claims); demand for dollars will be lower too as more trade will be done in other currencies; and structurally then, the negative cross-currency basis (the dollar premium) will naturally fade away and potentially become a positive cross-currency basis,” he wrote.

Count me skeptical, or at least on some of those points. With the exception of gold, the historical track record of commodities as literal reserve assets is mixed, at best. Modern storage techniques mitigate the most basic problems with such systems, but at the end of the day, it’s cumbersome to transfer commodities, something Pozsar underscored in comically excruciating detail.

The idea that commodity reserves can “naturally replace” FX reserves rests, in part anyway, on a false equivalence. Generally speaking, you receive hard currency for any commodities you’re willing to part with, and you recycle those proceeds via G7 claims. “Demand” for commodity reserves is a matter of determining how much cushion you think you need to ensure food and energy security for your people, which in turn tends to be a function of the prevailing geopolitical landscape.

When tensions are running high, you might well determine (as China clearly has) that you need to take steps to shore up your reserves. That might mean cutting deals to fund the acquisition of things you don’t produce in sufficient quantities domestically in a currency you do, but the seller still gets FX in exchange. Depending on alliances, that could bring about an epochal shift in the composition and structure of FX reserves and give rise to a localized version of the eurodollar system, as Pozsar suggested last month. But the Kremlin, for example, isn’t going to trade Russian oil for Chinese tea. If China buys Russian energy, Moscow will get yuan and, once recycled (because Moscow isn’t going to open an inert FX trading account), CNY reserves.

That supports some parts of Pozsar’s thesis, but it undermines other aspects and, as he mentioned in passing in his latest, such a system can’t be established overnight. He described “the monetary arrangement of the new world order” (“Bretton Woods III,” as he calls it), as one in which “banks create eurorenminbi and where eurorenminbi balances are accumulated to buy Chinese Treasuries.” That will happen “inevitably, but not imminently,” he said.

Pozsar didn’t elaborate on this (certainly not because he lacks the wherewithal), but the CNY bond market isn’t anywhere near deep enough to support such a transition, and even if it was, exactly nobody would be excited about the prospect of holding a substantial portion of reserves in a currency that i) isn’t freely traded, and ii) is subject to the vagaries and whims of Party politics. As I put it last week, if you think the US Treasury is capricious, just wait until the fate of your accumulated national wealth rests with the Politburo.

Beyond that, a eurorenminbi system isn’t a “commodity reserves” system. Rather, it’s just the old system with CNY instead of USD (more on that below). Pozsar tried to square that circle by describing the new world order as a kind of amalgamation. Some G7 inside money would be replaced by the functional equivalent of Chinese inside money, with the balance shifted to outside money (i.e., gold) and physical commodities.

Such a system would be woefully ponderous, and inherently unwieldy, which was ultimately Pozsar’s point. Or one of his points, at least.

“Bretton Woods II served up a deflationary impulse (globalization, open trade, just-in-time supply chains and only one supply chain [Foxconn], not many),” he wrote, before describing Bretton Woods III as inflationary by way of “de-globalization, autarky, just-in-case hoarding of commodities and duplication of supply chains, and more military spending to be able to protect whatever seaborne trade is left.”

To the extent the system he posits would be ponderous, it’d be a model of efficiency compared to Zoltan’s efforts to explain it. With apologies to Delphi (I’d sacrifice a goat to appease Pythia, but the goatherd is demanding renminbi now, and I couldn’t secure any CNY financing), Pozsar’s latest is more jumble than genius.

In the obsequious profile piece linked here at the outset, Bloomberg quoted Perry Mehrling, who Pozsar describes as “my Keynes.” Mehrling returned the flattery, calling Zoltan “a spider in the middle of the web [who] has every short-term interest-rate trader in the world on his speed dial.” Suffice to say the webs this spider is now weaving are very tangled.

To say Pozsar is committed to explaining the world by way of Mehrling would be an early candidate for understatement of the year. If you haven’t read “Shadow Banking: The Money View,” you should. Mehrling comes up 29 times. Pozsar (and Credit Suisse’s James Sweeney) co-authored Mehrling’s “Bagehot was a Shadow Banker.” Most people view the world through their own lens and, in many cases, through the lenses of those who’ve influenced their work. There’s certainly nothing wrong with that, but Pozsar’s effort to stylize the global commodities trade by way of the four prices framework comes across as belabored, to put it generously.

To be fair, Zoltan predicted the cascade of margin calls that played out in the wake of Russia’s Ukraine “operation”, and his characterization of commodities in the post-invasion environment as bifurcated (“AAA” commodities versus “subprime” Russian commodities) proved exceptionally apt. But his attempts to extend various analogies come across as intentionally pedantic to the point of undermining an otherwise brilliant exposition. Put another way, Pozsar seems, at times, more concerned with living up to his encyclopedic reputation than he does with penning something that’s useful.

For the most part, he shines. But for someone in the habit of reminding readers what he isn’t, Pozsar certainly is ambitious (some might call it presumptuous) when it comes to connecting dots between things he’s unquestionably an expert on and things about which he disclaims any responsibility for knowing about. “I am no expert on geopolitics,” he wrote, several pages after penning these passages:

Protection is a conceptual counterpart to par. When you decide to take money out of a sight deposit, you expect the same amount back that you put in (par). When you sail foreign cargo from port A to port B, you expect to unload the same amount of cargo that you onloaded. Banks can deliver par on deposits most of the time. When not, central banks step in to help. Commodity traders can deliver foreign cargo from port A to port B most of the time, but when not, the state intervenes again: Not the monetary arm, but the military arm of the state. What central banks are to the protection of par promises, the military branch is to the protection of shipments: Foreign cargo needs to sail on sea routes and through choke points like the Strait of Hormuz, and “par” in this context means being able to sail from here to there freely, safely, and without undue delays. Protection applies more broadly. Not just to shipping, but to mining and oilfield interests, pipelines, et cetera, and protection for assets is not only military, but also legal and diplomatic. For colorful anecdotes, please refer to Chapter 21 (“Can’t the CIA and the Navy Solve This Problem”) in Steve Coll’s book, Private Empire: ExxonMobil and American Power, or the first page of the book, The World for Sale, by Javier Blas and Jack Farchy, recounting the descent of Vitol’s private jet with the legendary oil trader and CEO Ian Taylor a board under the protection of a NATO drone chaperoning its plane into war-torn Libya in order for him to negotiate with rebels to trade crude oil from fields controlled by the rebels for gasoline needed by the rebels to fight the forces of Gaddafi. All that trouble and protection to harvest crack spreads.

Protection we tend to take for granted, much like we take it for granted that currency, deposits and money fund shares are interchangeable always at par. Tankers pass through sea routes, and sea routes pass through straits, and straits must be open at all times and sea routes must be free of bottlenecks — bottlenecks engineered by states or pirates. Wheat and oil are connected. Egypt used to be a big importer of Ukrainian wheat. If much more oil is about to pass through the Suez Canal, Egypt might consider to introduce its own G-SIB surcharge: Raising the fee required to pass through the Suez Canal in order to raise more money for the state’s coffers, such that the Egyptian state can buy more wheat in the wheat market to feed its people. Hungary lost to Russia in 1956 because the US protected the Suez Canal. Pirates need to eat too, and they will have an extra incentive to engage in acts of piracy when there is a bread shortage (a wheat shortage is a bread shortage).

Is any of that wrong? Well, no. There’s nothing for him to be “wrong” about in those excerpts. But he’s pretty far afield for someone whose specialty is short-term funding markets.

And that’s precisely my point: Zoltan doesn’t think it’s far afield. In fact, he thinks the entire world can be conceptualized as the opposite side (tails) of the same coin, where heads is funding markets. There’s a very real sense in which such a world view is correct. One of my main arguments against Pozsar’s “new world monetary order” thesis is that such a system would effectively mean the world stops spinning for months, if not years or even decades. You can take that figuratively and literally — the demise of the dollar-based commodities trade would entail a disruption in “stuff” circling (spinning around) the globe.

Not only does Pozsar acknowledge as much, he makes the point better than I did, again by way of a torturously intricate journey through the logistics of shipping crude, all in an effort to suggest that VLCCs are bound up (possibly inextricably) with banks’ lowest comfortable level of reserves and, ultimately, the Fed’s oncoming effort to shrink its balance sheet.

Zoltan, seemingly bent on proving something about his capacity to deliver a more trenchant assessment of subjects about which he isn’t an expert than experts on those subjects, walked through every, single step of a theoretical diversion of Russian crude shipments from the Port of Primorsk or the Port of Ust Luga to China.

“Without pipelines, the only way Russian oil can be moved over to China will be through vessels [and] it’s uneconomical to transport crude on long-haul voyages on Aframax carriers,” he wrote, adding that “if Europe no longer wants Russian oil and Russian oil needs an outlet, and that outlet is a buyer in China, China will need more VLCC carriers to get oil from Primorsk and Ust Luga,” he explained.

He could’ve left it at that, but he didn’t. “Now, the details,” he said, before taking readers on a trip that’ll leave you more exhausted than you’d be if you picked up a barrel of Urals at Primorsk, put it on your back and walked it across Russia, through Mongolia and delivered it to Xi in Beijing personally. Pozsar’s point was as follows:

Oil transports will take four months to finance instead of two weeks, and because oil prices are up, it will take more money to fill up VLCCs — which means more notional borrowings for much longer terms. Our instinct says that as commodity price inflation and volatility drives the commodity world’s credit demand higher, banks’ LCLoRs will move higher too and banks’ willingness and ability to fulfill the commodity world’s credit needs will diminish. In 2019, o/n repo rates popped because banks got to LCLoR and they stopped lending reserves. In 2022, term credit to commodity traders may dry up because QT will soon begin in an environment where banks’ LCLoR needs are going up, not down. History never repeats itself, but it rhymes.

The implication is that the Fed’s QT efforts could exacerbate strains associated with higher commodity financing needs. For now, this isn’t a problem because banks are still flush with reserves. But it could become troublesome soon enough. Or at least according to Pozsar, who wrote that “banks’ LCLoRs are moving up as we speak because commodity and trade financing needs are growing too, and that cannot be good for banks’ demand for Treasurys on the eve of QT.”

Note that commodities traders lobbied the ECB last month for a funding backstop to guard against higher cash requirements (i.e., the margin calls Zoltan predicted), which some market participants contend will curtail trading, thereby driving up volatility. They were apparently unsuccessful.

In case it wasn’t clear (and it most assuredly was), Pozsar noted some six pages in that “one aim of this dispatch is to hammer home the parallels between the (nominal) world of money and its four prices and the (real) world of commodities.” Most readers are likely familiar with year-end funding stress as banks eye G-SIB requirements. If cargo ship capacity is tantamount to bank balance sheets (as Zoltan contends), then war is the equivalent of year-end. To wit:

Just as G-SIB constraints around year-end gum up the free flow of money, VLCC constraints during times of war can gum up the free flow of commodities — can commodity prices spike like FX forward points when we run out of ships ? We can’t QE oil (= reserves) or VLCCs (= balance sheet).

To the extent you’re still following along, you might be wondering whether this contradicts Zoltan’s widely-discussed contention that the Fed needs to engineer volatility in order to help bring down services sector inflation. The answer is “yes,” it does. But Pozsar isn’t someone who misses anything, so he had an answer.

The Fed does need to tighten financial conditions, he emphasized. It just needs to do so without draining reserves too quickly, while simultaneously preserving the tightening impulse from QT. Specifically, the Fed needs to “minimize the destruction of reserves while maximizing the amount of duration delivered into the bond market,” he said.

Zoltan then returned to Mehrling, incorporated Larry Fink, cited Ray Dalio and turned a “simplified” version of his expanded four prices framework “into a game of origami.” He included a flow chart and a 400-word explainer, some of which is excerpted above. The gist of it is just that there will be two systems anchored by two different currencies. The passage below exemplifies the Pepe Silvia–esque nature of Pozsar’s latest:

The top vertex of the second triangle is connected to the other two vertices by concepts of trade and time too: The left and top are connected by the concepts of commodity trade and time, and the right and top are connected by the concepts of currency trade and lending. But here, renminbi for other currencies instead of US dollars for other currencies, and between the bottom two nodes we have the monetary arrangement of the new world order.

The “magic number,” Zoltan said, is three. “The four prices of money are managed” via Basel III, there are four pillars of commodity trading, but they’re “shaped by war,” which he “hopes” isn’t World War III and then there’s the new monetary world order, which is Bretton Woods III.

In the old world, foreign cargo (i.e., commodities) was priced in dollars and euros. Now, Pozsar said, that’s changing. He cited the oil-for-yuan canard again. “It used to be as simple as ‘our currency, your problem’,” but now it’s “our commodity, your problem,” Zoltan contends.

That’s inflationary, and it won’t be as simple as Jerome Powell channeling Paul Volcker who, Zoltan said, “had it easy.” Powell needs more than the fortitude to hike rates. He needs a “strong helping hand,” Pozsar wrote, before posing the following as an interrogative: “A strongman to take on the (inflationary) mess caused by other strongmen?”

If all of this seems foreboding to you, Zoltan served up a helpful reminder. “Henry Kissinger is not Hans Christian Andersen and realpolitik isn’t a fairy tale.”

No, realpolitik isn’t a fairy tale. But fortunately, Pozsar’s “new monetary world order” probably is.

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