What’s The Warsh That Could Happen?

By Benjamin Picton, Senior Market Strategist at Rabobank

The DXY is dealing firmer this morning and precious metals continue to be flogged like the family silver after Donald Trump confirmed the nomination of Kevin Warsh as incoming Fed Chair. In defiance of the President’s oft-stated preference, markets are convinced that Warsh is a hawk. Consequently, zero-yield risk is taking a beating (bitcoin, ouch), equities are offered and US 5y5y inflation swaps have fallen by ~2bps since Wednesday of last week.

The Financial Times marked the occasion of Warsh’s nomination by saying ‘wish for a lower Fed Funds rate, this might be the best shot of the administration to move the fiscal needle. Indeed, in an era of fiscal dominance, the incoming Fed Chair may have little choice but to keep short rates low.

Along with moves to pressure mortgage relates lower through MBS purchases, threats of price caps (on credit card interest, for instance) and attempts to use tariffs as leverage to extract investment pledges from other countries, these sorts of measures veer into the realm of financial repression, where real interest rates are held negative and private savers carry the can for the government largesse.

Of course, some of these policy options are only available to the United States due to its status as the issuer of the global reserve currency. Abusing the “exorbitant privilege” of being the reserve currency issuer through erratic trade practices, financial repression and strategic currency devaluation is a high stakes gamble that could backfire spectacularly.

Xi Jinping is evidently well aware of the contradictions faced by the United States in attempting to leverage its position as reserve currency issuer without losing it. The FT yesterday reported on comments from Xi calling for the Chinese renminbi to become a global reserve currency by creating a “powerful (read: politicized) central bank” that would ensure a “strong currency” used widely in international trade, investment and foreign exchange markets.

The renminbi has been steadily strengthening against the dollar since Liberation Day last year, and the PBOC has accelerated its run stronger daily fixings from late November onwards. Xi was clear at the Shanghai Cooperation Organization summit last year that he wished to internationalize the role of the CNY and China has begun using its monopsony market power in commodities like iron ore to drive wider acceptance of its currency for trade settlement. Expect more of this in markets where China is the only buyer, or the only buyer of scale.

CNY is starting from a low base and still faces the Triffin Dilemma of not meeting the requirements of a reserve currency so long as China insists on running trade surpluses (there’s no sign of a change of heart on that score), but by boosting its adoption Xi could chip away at the reserve currency status of the dollar right at the moment when many other players in financial markets and the world economy are openly questioning whether the dollar’s writ still runs.

Though it still seems unlikely at this stage, if the reserve status of the dollar was genuinely threatened it would dramatically reduce the freedom to manoeuvre of US policy makers grappling with that “unsustainable” fiscal trajectory.

For the public finances of the United States, that might be the Warsh that could happen.