Weaponizing financial assets by sanctioning the Central Bank is an extraordinarily powerful tool against Russian aggression. However, we should be mindful of potential longer-term second-order effects. Nation states are likely to rethink their reserve strategies so that they have control of reserve assets. Digital assets provide direct ownership (your asset is no one else’s liability) even though they are easier to track and blacklist. The second order effects will be felt over the coming years rather than in the next weeks and months.
Stepping back, the events of the past week have significant economic and market implications. We assume that the conflict will be drawn out, but find ourselves ill equipped to anticipate Putin’s geopolitics. Markets are quickly pricing that he might be crazy but has not priced for a suicidal Putin. We don’t have the space to discuss the issues in detail, but the key changes follow.
- Global growth and inflation outlook has worsened materially. Bond yield curves further flattened, pointing to rising recession risks. Europe exposed far more than the US.
- Higher energy prices: Clear negative for energy consumers and businesses. Could second order effects include Europe halting carbon credit markets. Is it bullish for Uranium?
- Rising uncertainty is bullish for precious metals, which performed well this week.
- The current US administration may well pivot and unshackle domestic energy production. Such a move could curtail our bullish long-term view on energy.
Finally, this week illustrated the benefits of diversification with energy, bonds and precious metals buffering the weakness in most risk assets.
Dispatch #7 on March 4th, 2022, has the following line up of stories:
- Weaponizing financial assets could be negative longer-term
- $85m of crypto asset donations to Ukraine
- Wealth effect is unwinding
- Lamborghini destroyed to create NFTs!
- Bearish sentiment at an extreme
Weaponizing financial assets will have negative second-order effects
The threat to freeze Russia’s Central Bank reserves is a highly effective deterrent to push Russia to the negotiating table. However, The Dispatch sees potential negative repercussions for many years to come. We highlight the issues in a paragraph below from this WSJ article.
Many global macro analysts are pointing to a potential inflection point. Here’s famed stock investor Bill Miller’s one minute CNBC interview on the issue of reserve freeze and possible implications for bitcoin’s digital scarcity. The founder of Real Vision Raoul Pal has a similar.
Aren’t Russian reserves in Russia?
It’s worth digging into how Russian reserves can be seized or frozen by another country. That’s because Russian reserves are NOT in Russia, except for physical gold. Even some of that gold could be in a vault in a financial hub like London for ease of transacting. Since most of the assets are either currency or sovereign bonds, they are ledger entries at home-country institutions, often the central banks. Russia’s Euro reserves are likely a ledger entry (and liability) of one of the central banks in Europe. For even more background and thinking, we recommend Columbia Professor Adam Tooze’s “Are we on the brink of all out financial war with Russia?“ substack post from February 26th. It provides a chronological account of sanctions escalation last week, culminating with action to freeze Central Bank reserves.
As the chart illustrates, Russia has already aggressively diversified away from US$ assets. It is difficult to transact in gold, but not impossible. Despite that diversification, perhaps Russia thought Europe’s energy dependence would remove the risk of seizure. Instead, coordinated G7 action will put more than 40% of reserves at risk.
Zoltan Pozsar, a highly regard Credit Suisse strategist, recently wrote (report 1 and report 2) about how Russia’s reserves have moved and the negative implications from the sanctions. Removing Russia’s excess US$ liquidity from the global markets could have implications like the Lehman bankruptcy, he writes.
Could bitcoin become a broader central bank reserve asset?
All this brings us to Digital Assets that settle with finality on a decentralized ledger. One of the key factors is that the digital assets you own are no one else’s liability. Contrast that with owning a government bond (it’s a government liability) or cash in a bank (that cash is the bank’s liability). Even your Apple stock is the liability of a clearing house. It’s this liability aspect that’s allowing the G7 to freeze Russia’s assets. This lack of sovereignty over your own assets could drive global Central Banks’ interest in a scarce digital asset. However, moving digital value to Fiat currencies will remain a choke point as crypto assets can be easily tracked and blacklisted. Regardless, this week was an important long-term inflection point for digital assets, bitcoin in particular, The Dispatch believes.
The US recently froze $7bn of Afghan Central Bank’s reserves
This is not the first time the US has used its financial power. This WSJ article provides more details of how the US froze Afghan Central Bank assets recently.
The Dispatch fully supports efforts to stop Russia in Ukraine, including freezing Central Bank assets. We just need to acknowledge that this action will have far reaching long-term implications. Other countries will naturally seek to store their reserves in assets that can’t be seized by today’s global hegemon, the USA.
Digital Asset donations to Ukraine has hit $85m
The global crypto asset community has come together with impressive speed to support Ukraine. The country’s savvy digital media strategy has aided the cause. Here’s a dashboard providing live updates of the many crypto asset donation to Ukraine. One of the benefits of blockchains is that this data is available for all to see. We can see how much each wallet has received and which wallets contributed.
There are several entities that are raising money, but the largest share of donations has gone to Ukraine’s government wallet.
The important takeaway is the speed and lower friction mobilization of donations. The effort started with the tweet below from the Vice Premier of Ukraine on February 26th.
Crypto brings ease of use
Sure, he could just as easily have put bank account details there, but how many of us would have gone online and filled out the “new client” details or, worse still, gone to the bank branch to initiate a wire? Instead, a crypto asset transfer can be complete in under 30 seconds. Aren’t crypto asset transfer fees expensive you ask? Good question attentive reader! They have returned to reasonable levels compared to the excesses of the fall. The transfer fee to move $100 via stablecoins on the main Ethereum network is a competitive $9.90, in our example with the Metamask wallet shown below. The fee scale with size and a $1000 value transfer had $10.77 estimated fee. Moving value on other networks would be meaningfully lower cost. These fees are competitive vs. Citibank wire transfers that cost $17.50 to $25.00.
Source: Metamask wallet ~ 10.30am on 3/3/2022
It is great to see digital assets providing a new channel to fund needy causes. This ABC News article provides a list of traditional charities helping Ukraine. The Dispatch hopes this story illustrates the speed of mobilization allowed by digital assets.
“Wealth effect” is unwinding
Economic pundits have attributed 2021 economic strength to the “wealth effect”. This WSJ article says that the global value of crypto rose $1.5tn and S&P500 gained $10.5tn in 2021. That’s nearly 50% of US GDP, although not all those gains accrued to US consumers. One example of the wealth effect (we could easily phrase it as a wealth illusion!) is your “cash buyers” of high-end property. These cash buyers often obtain lines of credit against their investment portfolios. As asset prices decline, The Dispatch expects further headwinds on housing and other large ticket consumption items.
What about the money sitting on the side lines waiting to buy the markets?
You may have heard or seen reference “excess savings” or “money on the sidelines” in financial discussions. Yes, there’s been a surge in households’ cash reserves due to government stimulus payments, as the chart below illustrates. It didn’t matter if you were still employed and living comfortably, but you got the cash if your prior-year income was below some threshold. The chart below captures that jump, and the narrative goes that these deposits will be spent in the coming months and quarters.
Source: St. Louis Fed
Rising credit card balances offset cash balance argument
The Dispatch has a different interpretation of how these “excess savings” will behave. When stimulus payments started, credits card balances fell sharply, as the chart below shows. However, since mid-2021, credit card balances have started to rise again even though household deposit balances (chart above) have not changed. Our interpretation is that the remaining deposit balances are from households that have ample cashflow to support their needs. However, consumers with a gap between incomes and consumption have started using credit, as stimulus payments ended. As a result, we do not expect the “excess deposits” to bolster real consumption in the coming months.
Source: St. Louis Fed. Note: Billions of dollars seasonally adjusted
Furthermore, inflation has also robbed consumers of purchasing power. Real disposable income (DPI) is now below trend, as this chart to January 2022 shows.
This trend was already underway, and the Ukraine conflict has further aggravated inflationary pressure. Therefore, the Fed Put is dead, which the markets are grudgingly starting to realize. If an exogenous shock forced the Fed to inject liquidity while inflation sits above 7%, it would be a significant catalyst for scarce assets. For a worrying take on potential liquidity hiccups, read these two recent reports (report 1 and report 2) from former Fed staffer and current Credit Suisse strategist Zoltan Pozsar. He sees serious negative implications from removal of Russia’s US$ liquidity from the global markets.
Lamborghini destroyed to “create” NFTs
If you think the excess speculation in digital assets has dissipated, think again. As a financial analyst that enjoys automobiles, this makes absolutely no sense to The Dispatch. It is also a sign of froth in segments of digital assets.
Blow up a Lambo, and then sell videos of the destroyed parts as NFTs. Crypto currency excesses have moved to NFTs. We do not believe that NFTs will be immune from the wider decline in asset prices. Car website Jalopnik’s take is unsurprisingly salty. The NFT auction is still ongoing. Check the Twitter feed to follow the action!
Bearish sentiment is at extremes
We constantly look for arguments to counter to our held views. One of the factors to consider is that retail investor sentiment is at extremely bearish levels.
Here’s a 5-year chart of the AAII data. This is one more data point to keep in mind as we navigate a particularly difficult global macro and geopolitical picture.
Source: Ycharts
That’s it for this week. Nothing here is investment advice. Stay safe and do reach out if you have any questions or comments about the material in this Dispatch.
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