Breaking The Dollar System | Freya Beamish
01:11:47 Share

The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Thank you. Let's close the door. Very pleased today to be speaking to Freya Beamish, Chief Economist at TS Lombard. Freya, welcome to Monetary Matters. Thank you. Pleasure to be here. Freya.

We got a lot to talk about today. You just had a note out to clients talking about how the problem is that the post-1973 international monetary system is broken. Tell us your thoughts on the international monetary system, the dollar, and how they correlate to the ongoing tariff announcements from the United States.

So I think the tariff announcements are sort of a catalyst for a longer term rebalancing towards a multipolar currency. I almost hesitate to use the word system because I think that sort of implies some degree of order. I think it's not necessarily going to be a very ordered transition from sort of one system to another. But I think the tariffs certainly feed into that.

And I think kind of critically, there's a couple of things that could trigger a much more perhaps disorderly transition to something new that's not that sort of dollar standard that has pervaded for so many years.

decades now. And I think those triggers are anything to do with the US administration tampering with the capital flows and tampering with the Fed. And I actually see, you know, both of those things, the likelihood of those has risen. And I think that's why we're seeing a bit of a shift in the correlations that we saw in

towards the end of last week that's a little bit worrying, which is, I think, partly what prompted me to put that note out. But more broadly, I think it's really important. There's some very clear distinctions that we have to make. And the first is,

the reason for the US dollar being the international reserve currency and the center of the global financial system versus the fact that it is right now. And that it remains that the center of the global financial system at this moment in time.

And that actually gives you the potential for sort of shorter term shifts into the dollar still if there's sort of financial stress. I don't see that at this moment in time. I see like basis trades unwinding and that's kind of like very painful for the segments of the financial sector. But sort of hedge funds going through that sort of

potentially severe correction is not a financial crisis. The sort of the issues that we see at the moment are about the asset involved is US government debt. It's very different from the type of asset that would be involved in a sort of a global financial crisis or something like that. So

The potential in this environment for the dollar to start spiking as a result of financial stress seems to me to be a little bit lower. And that actually gives me the impression that we can move away from the dollar more rapidly, which seems a little bit counterintuitive. But that's, I think, where we are in the sense that what's being undermined here is

is the long-term desire to hold US assets. And that can give us weakness in the dollar over the short term. It's not a sort of a financial crisis. I keep getting asked, is this a financial crisis? It's a genuine sort of rebalancing in people's appreciation of the relative returns of the US versus the rest of the world.

And because that is the fundamental reason for the US being the world's reserve currency, I think that's at the root of almost everything with regards to that dollar system. That puts the US dollar system at risk.

And there doesn't seem to be anything to me looking at the fact that it is the center of the global financial system. There doesn't seem to be sort of financial stress that could cause the dollar to spike and therefore prevent this transition away from the dollar and towards a multipolar currency world.

So most of the time when there's a financial crisis or even there's a steep sell-off in risk assets, the US dollar appreciates against other currencies. That is not happening. The US dollar has weakened as risk assets have sold off this time. Exactly why is it that

foreign countries are reconsidering their holdings of US dollars? I mean, do you think they were outright selling or do you think the marginal reserve is actually just going to a more diversified basket that includes other currencies as well as perhaps gold? And you mentioned one reason, which is expectations of fewer, lower risk adjusted returns in US assets.

Is that because of tariffs? Is it also because of if the US has a lower trade deficit with the rest of the world, they have a lower financial surplus with the rest of the world and therefore less money will be flowing into US assets? Explain why you think what's going on right now is causing other countries to reassess their holdings of US dollars.

A lot of different points here. So there's the issue with regards to the VIX. And I think that's why a lot of people initially were worried that this is a more sort of financial crisis type of an event. We have the VIX spiking. And yet initially, when the VIX started to rise, the dollar was selling off. And I think that gave people a lot of sort of heart palpitations, because that's sort of not what you would typically expect. But actually, if we look at sort of correlations within different regimes, so sort of

low volatility regime and a high volatility regime. It's not always the case that the dollar spikes when the dollar appreciates when you have high volatility. I think the reason why we had high volatility in the wake of Liberation Day was because people were reassessing the long-term reasons for holding US assets, which is another part of your question.

And so it was actually much more about the real economy than the financial economy. And that's why we had this big spike in kind of volatility, but you didn't necessarily have the appreciation of the dollar. You would have the appreciation of the dollar if VIX was spiking because there's some kind of stress in short-term funding markets.

If you have stress in short-term funding markets, so many different investors and people are exposed to that short-term dollar funding. And so actually, that's an environment in which the dollar rallies. That's when you get this positive correlation between VIX and...

and the dollar, and that's not what was happening. There was a period of time, sort of the beginning of last week in response to payrolls and the more kind of hawkish, relatively hawkish stance that Powell kind of put out there, which made people think a little bit more about the interest rate differential rather than just the sort of the decrease in the growth differential over the short term that was implied by the imposition of tariffs.

And when we started to see people thinking a bit more about the interest rate and realizing that the Fed wouldn't necessarily be able to cut, then we saw a little bit of the dollar coming back and a little bit of dollar strength. But again, that was sort of on the real economy. It was trading on the real economy.

I think what started to shift towards the end of last week was that we started to see yields rising and the dollar selling off at the same time. And that's a kind of more Liz Trust type moment type of a correlation, right? Up until that point, we've been saying, actually, this is just like genuine rebalancing of people's expectations of the US versus the rest of the world.

Whereas when you start to get the currency depreciating and yields rising, that's more of a kind of a trust type of a dynamic. So I think that's the rough game plan of what's happened or the order of play of what's happened since 2020.

since tariff day. And then you've asked about is it kind of marginal selling? Is it just at the margin or was it sort of, was it outright selling? Yeah, I think it is partly selling, but I want to just lean back a little bit against some of the narratives that have arisen around that particular idea.

the idea that sort of China is able to punish the US by selling its treasuries. I think, yeah, certainly in a short-term sense, that kind of feeds into the wider sort of market dynamics that have...

that have played out over this period of time. But in the long term, and this is a really important point in terms of how the currency system might start to bed down over time, China is very exposed to the dollar. So I don't see it as China having leverage over the US. I see it as China being tied into the dollar system in a way that it can't quickly

escape from. And the big sort of difference here, the big sort of the big comparison would be between the US and the UK back in the 40s and the 50s versus the relationship between China and the US just now. Back in the 40s and 50s, it was the US that was the surplus nation and the UK that was the deficit nation.

But when we think about what's the leverage, what's the balance of power there between those two parties, there's a couple of really key differences between what we see in that 40s and 50s period compared with what we see right now. One is that the US economy was already sort of there and champing at the bit and sort of ready to be that point of highest pressurization in the global economy. And China is by no stretch of the imagination ready to do that. It's about to go through or is going through

kind of secular deleveraging cycle, which is a disinflationary cycle and not the type of environment where you'd be able to sort of step up and be that point of highest pressure, which I think is intimately related with the ability to be the world's reserve currency. And the second difference is that at that point in time, US holdings of sterling back in the 40s and 50s were trivial on a per capita basis.

And so when the US, I always use this example, but when the US wanted the UK to get out of Suez in 1956, they just turned around and said, get out or we'll cause a sterling crisis. That was a credible threat because they didn't hold sterling in any kind of relevant level.

And so the UK just said, okay, we're gone. Whereas this at this moment in time, if the, if China was to continue trying to, I'm not saying this is what they're trying to do, but this is the narrative out there. If China was to try to sell treasuries to spike, to spike the, to spike treasuries yields, then, then that would, would harm them and harm, harm their state owned banks.

way more than it would have harmed the US in the 40s and 50s. So that's a sort of a key difference there. I think, however, that on a short-term basis, Chinese selling along with selling by other major sort of global players is,

has been a part of the reason why we've seen those increases in US yields, which has been a big part of, I think, what has caused Trump to turn around. And so in that sense, it is an effective short-term policy. He sort of revealed his reaction function over the course of the past two weeks or so. And that reaction function is intimately related with the term premium, essentially. It's intimately related with the

the sell-off in yields and the sell-off in treasuries at the same time, when you've got both of those things happening, then there's no way for you to profit from the chaos effectively. The capital is just being destroyed. And so that seems to be his reaction function. And that plays very much into your other part of your question, which is why are returns being destroyed in the US and why are we

Why are we having these worries? And there's a sort of a broader, softer, but still very important part to that, which is just undermining of the rule of law and then kind of risk adjusted returns. We had this ruling being handed down, I think, on the 9th of April 2020.

from Chief Justice John Roberts with regards to the ability of Trump to fire independent officials. And those officials, he overturned a lower court ruling. Those officials appear to be on the same standing as officials on the FOMC governors, which is just the lowering of the barrier between the government and the Federal Reserve. So these things are all there. They're all sort of, there's a great deal of sort of

perception that there's an undermining of the rule of law in the US, and that plays into risk-adjusted returns. I think in terms of what I'd be worried about in a macroeconomic sense, more directly macroeconomic sense, is the greater instance of negative supply shock.

So the big difference between what we're seeing right now and the period that has pervaded most of the time in which the dollar has been the center of the global financial system is that through most of that time, you had a sort of slow burn. If you can have a shock that slow burn, but a slow burn positive supply shock.

Lots and lots of labor was coming online. You had sort of digitalization, you had automation. There were all these different things that were causing profits to rise as a percentage of GDP. And because the US is sort of uniquely positioned with its capitalist economy, it was the best position to take advantage of those shocks, which were intimately related with hyperglobalization.

And I think that's where the strength of, that's US exceptionalism, that's where the strength of, you know, on a kind of a super cycle basis, where the strength of US returns and outperformance came from. We're now turning around and saying, or the US administration is now turning around and saying tariffs, deportations, these are negative supply shocks.

and negative supply shocks are just fundamentally destructive of capital in the sense that they create inflation, which then destroys growth. And so it's bad for bonds and bad for equities at the same time. And if that shock is big enough, the way that plays out in the 10 year is through a recognition by investors that they want to be compensated more for holding debt, for holding the government debt,

because the hedging capacity of the bond for equities has depreciated. So that means higher term premium. And if you want to see how that plays out in the equity market, we're going from, as I said, the increase of profits as a percentage of GDP decade after decade since the 80s,

to a situation where now profits are very high as a percentage of GDP and almost in direct parallel to that, labour income is very low as a percentage of GDP.

And so the sort of the political thrust is towards labor share of income increasing and profit share of income decreasing. But also that kind of flip from positive supply shock to negative supply shock is one which is sort of destructive of profits as a percentage of GDP, I think, and also is destructive of growth, of real growth.

and pushes up the term premium, which makes it more difficult to get these positive synergies between private consumption and capex. That's probably enough talking for one breath. Thank you, Freya. You talked about the balance of power between the United States and China.

I'll ask you about that in a moment. But just you said that in the Suez crisis, the U.S. could exert control over Britain because the U.S. didn't have sterling holdings, the currency of Britain, and therefore it wouldn't have been hurt. I would have thought intuitively it would be the opposite, that actually because China holds a ton of U.S. treasuries, they can sell treasuries and spike yields.

and therefore they can exert control. But you said the opposite, that because they own it, they would be hurting themselves. Can you just explain why you think that is? So one way we can think about this is just to think about how quickly the gold price is spiking as China is trying to get out of treasuries. So there's sort of two effects. If they're going to sell treasuries, they're going to exert losses on themselves because the flow effect is going to damage their stock.

And then the second is that there's just nothing big enough to get out of the dollar quickly enough that you don't end up spiking the price of the thing that you're trying to buy and make it much more difficult to actually kind of rebalance away. So I think it's the opposite of what I think most people intuitively believe. You see these big stocks.

Chinese dollar holdings. And you think, oh, China must have a lot of leverage over over the US. I mean, to a certain extent, as I explained, there's a short term effect there where they've played into triggering the Trump reaction function as the term premium has risen and as sort of yields have risen, and that seems to antagonize him as somebody that has a background in real estate. So there's a short term ability to sort of affect things and kind of trigger that reaction function. But in the bigger picture,

I think what happened in Suez was that they, or in the Suez crisis, was that the US threatened to create a crisis in sterling. And that's credible only if you don't have great exposure to it yourself, if you don't have great exposure to that currency yourself. And that's certainly just not the case for China at this moment in time.

And how do you think the Trump reaction function you mentioned, it's towards currencies, the dollar towards bonds, bond yields and the stock market. Definitely the Trump administration does not like the fact that the interest rates are rising, the 10-year yield, the 30-year yield.

are rising. I don't think they are happy that the stock market has gone down, although maybe they're not as concerned about that at current levels. And then also the dollar, are they actually happy that the dollar is going down? Because the weaker the dollar is, the more competitive US exports are and therefore

that helps if you want to narrow the trade deficit, although it also will be inflationary. And for example, when Treasury Secretary Scott Besson was testifying for Congress to be approved, he said part of the reason tariffs wouldn't be so inflationary is because the dollar would strengthen. And if it's weakened, obviously, you get the opposite effect. Right. So everyone at the beginning was sort of saying that tariffs are sort of pro-dollar, that that's a sort of dollar strengthener. And certainly there's sort of renminbi weakness that's playing out at this moment in time because China is the sort of

bearing the brunt of the Trumpian wrath at this moment in time. But I think, yes, certainly within the US administration, there's a lot of key players that see the strength of the dollar as a real problem for the wider aims of tariffs, which is to reshore production and get that CapEx

back online in the United States. So to some degree, I think there's, and my colleague calls this cake-ism, you want to sort of have your cake and eat it. There's a whole different bunch of ways in which they certainly can be accused of cake-ism. Like whenever anyone, whenever any EM turns around and says, oh, I'd like to use another type of cryptocurrency or some other currency that's outside of the dollar, then Trump's reaction has been

oh no, you don't dump the dollar, we're at the center, we're the world's reserve currency. And that seems to be very much at odds with the need for the currency to come off of its sort of longer term strength. And similarly, people like sort of J.D. Vance, when they're questioning Powell, they will draw a direct relationship between the U.S. dollar currency

at this and its role as the reserve currency and the loss of people's jobs in Ohio, that people that that's how he sees it. And I think I don't see the mechanisms in the same way as the US administration does. But I think there's this there's there's a case to be made for the conjunction of hyperglobalization and the role that the US dollar plays in the global financial system and its role as a reserve currency.

to that that has has a great deal to answer for with regards to the hollowing out of middle income in in the United States. I don't think you can disentangle those effects of hyperglobalization, US domestic policy with regards to globalization, policies that created kind of wage depression in Eurasia, and Europe and China that

Those policies that have created sort of excess supply in the rest of the world are part of the hyperglobalization and the US acceptance of the cheaper goods is part of that hyperglobalization. And I think that can't be separated from the role of the US dollar in global financial markets as well. I think they all kind of go together.

to explain not just the increasing inequality in the US system, but the increasing inequality globally in all of the major economies that are sort of important at this moment in time as drivers of how the solutions might arise. When I think about

Again, there's a few sort of critical distinctions to make here. There's the policy that's required to maintain the dollar at the center of the global financial system. And then there's the sort of the actual genuine effects of the dollar being at the center of the global financial system. And there's a few things here. If I think about how those policies that are required to maintain the dollar in its place

They're sort of the things that create high risk adjusted returns. They're the things that create the willingness to borrow in the US economy. They're the things that create the willingness to run strong dollar policy. And then there are policies that sort of support those three elements to why the dollar is at the center of the global financial system. So if we run through sort of those elements, and then we can sort of also think about what are the effects

of the dollar being at the center of the currency system, which are further ways in which you can get this increase in inequality. So what are they? What are the preconditions for being the currency

the global reserve currency there's as we said high risk adjusted returns relative to elsewhere the willingness to borrow and that doesn't seem to matter if it's it's the private sector or the public sector that's borrowing it's just something that is deep enough an asset because you're when you're borrowing you're creating an asset for someone to buy

or someone to lend to, borrowing and lending have to add up, right? So that willingness to borrow is a fundamental part of being the world's reserve currency and being at the center of the global financial system. And then not only those first two preconditions, but also there has to be a willingness to run a strong dollar policy as well. And that's intimately related between the...

fiscal policy and the role of the Fed. So what are the policies that are required to maintain those three conditions? What has been the policy that has created high risk adjusted returns in the past several decades, hyperglobalization and automation? These are the things that have created increase in profits as a percentage of GDP and shown the US being exceptionalism.

I think it's not quite as simple as that because there is something, some kind of magic around the US economy that has created this, that does over very long time periods create high returns. And so in the context of the past few decades, the policies that have actually created an upswing in those returns are hyperglobalization and automation.

But there's been winners and losers in that. So hyperglobalization essentially means this positive supply shock. But who's the loser in the positive supply shock? It's the people that would have been employed in the US if it weren't for the big increase in cheap labor abroad.

Then when we think about sort of willingness to borrow, I'm not going to get into the cultural side of this. Like, I don't know if there's sort of some cultural aspect of that makes the US citizen more willing to borrow there. But certainly, there has been that willingness to borrow. And this comes back to the point that you were talking about with regards to the trade deficit.

Like that trade deficit to me is not really because the US consumer is desperate for borrowing and has kind of sucked in capital from the rest of the world. It's more that there has been a desire to get in on high returns from the rest of the world to the US. And that has kept interest rates low enough in the US that it's been sustainable, at least before the financial crisis.

for the household sector to sort of be that borrower of first resort and then post financial crisis for the US government to be that borrower of first resort. So those elements all sort of come together and it's actually, I would say it's the capital account that creates the trade deficit.

And that channel is something that a lot of people will push back against and they'll say it's just, you know, they're just an identity. You can't really tell anything from that. And if you're one of those people, the other way of thinking about it is that there's a big positive supply shock, a lot of labor coming online and particularly sort of compression of domestic demand in Europe.

Eurasia, policies that create, that channel income towards the corporate sector, which means greater sort of retained earnings, and that's essentially a form of savings, but also policies that tamp down on private consumption in China and in Germany. These policies, the flip side of that is essentially that there's a big excess of savings. What is an excess of savings minus the investment that you have domestically? That's the current account surplus.

but those policies also engender low inflation and disinflation, which then means there's low interest rates. And if you have the willingness to borrow on the other side, then you are going to get a big current account deficit in the US economy. That creates the assets.

And then if you have all of these financial institutions globally that need to make returns and they have the longer term objectives, then how do they get in on that? If the US is the center of the global financial system, what that also means is that they're borrowing short and they're lending long in long term US dollar assets.

And that whole gross flows basis is how the real kind of creator of the global dollar is. In my mind, it's not so much about the trade deficit. It's those gross flows that create the global dollar.

And then there's the willingness of the Fed to run strong dollar policy, which again, what's the policy that is needed to maintain the US dollar at the center of the global financial crisis? It's kind of cutting off the wage cycle at the end of the cycle. And we know that labor markets lag the cycle.

And so if you're continuously preventing the wage growth from rising at the end of the cycle, then you're actually cutting off the part of the cycle where the middle income part of the distribution gets replenished. And so sort of cycle after cycle, there's been this decline in the labor share of income in the US, which again is like intimately related with the policies that are there and required to maintain the dollar at the center of the financial system.

So those are the things that are sort of policies that are required to create the dollar's standing. But then because the dollar is at the center of the financial system, then you get all these sort of accelerator effects, which is the gross flows that I mentioned.

which on one side create a lot of wealth inequality because they're sort of pushing up the asset prices over and above where the real economy is. If you look at sort of just assets as a function of, as a percentage of the real economy that has risen massively over this period of time.

But then it also accelerates the actual borrowing and the crash on the other side of the borrowing. So when you then have the crash, then there's a long period of deleveraging, for instance, which causes slower growth. But also when you have the crash, because there's so much short-term dollar borrowing, then that's going to create a lot of dollar strength at that moment in time.

So if we look at lots of the periods where you have seen this sort of level shift in the dollar, it's July 2008. And even though the story was in the US dollar assets, because there was short term borrowing in US dollar assets, then that's when we see the spike in the dollar.

in 2014. Again, because the US is at the center of the global financial crisis, the dollar spikes when we have the euro crisis, the dollar spikes when we have the renminbi depreciating. And so that again, sort of hollows out the ability of Ohio and Detroit, these places to actually

be competitive on a global standard because the US dollar rallies when there's financial crashes that don't either whether they're to do with the US or whether they're to do with the rest of the world. So I think it's a huge melee of different things, which you can't really disentangle. But I do think there's a sort of a, there's a case to be made for those policies to

sort of working together to create essentially Trump's electorate. And so because the US dollar is the reserve currency, there's tons of inflows into US assets. And on the other side of that, that's why we have a huge trade deficit. That's just how balance of payment math works. And then also because the dollar is

The capital flows cause a strong dollar, which makes U.S. exports less competitive. Freya, just how much is the dollar overvalued? You hear anecdotal reports of if you go to China, you can buy a nice men's suit for several hundred dollars that in Europe or the United States would cost $1.

multiples of that, you know, you can look at how US currencies are valued on interest rate differentials. But if you actually look at the real economy, how much stuff does this actually buy? Just how undervalued is the, you know, the Chinese Yuan relative to the US dollar and how just how overvalued are is the US dollar with with other currencies. So this is

Because there's like different answers to this, depending on whose perspective you're looking at. This is part of the reason why I think there's actually not very much hope for the current system to be sustained because from the perspective of a Chinese policymaker that is trying to run a supply led growth model, the renminbi is actually overvalued. From the perspective of the rest of the world,

of course, it's very, very cheap and they're able to sort of displace workers in the rest of the world still. And with this massive rise of electric vehicles, it might sound strange to think, exports of electric vehicles, it might sound strange to think that from the Chinese perspective, it's actually sort of not that competitive. And that's because to actually create

to hit the Chinese growth target through supply-led growth, then what's happening is they're trying to create a whole bunch of production that cannot be consumed at home. By definition, it's a supply-led growth policy.

And that means a lot of exports, but it also means sort of compression of domestic returns. We always have to sort of come back to what does this mean for returns? And if you're compressing domestic returns as compared with the rest of the world, then that means capital outflows that carry the renminbi down. So from that perspective, from a capital account perspective and the kind of continuous compression of Chinese returns through deflationary policies, then the renminbi should be

by market standards continuing to depreciate. That's why it's very, very important that we saw in September the Chinese authorities responding to their own sort of civil pressures and responding to the sort of the pushback from the rest of the world saying we actually don't want this flood of supply. It's kind of causing quite a lot of dislocations for us in terms of our production.

And that sort of pivot from supply-led policy to more domestic demand-led policy. And Xi Jinping himself wants to internationalize the renminbi and therefore wants a strong renminbi policy. But that's completely at odds with the supply-led growth policy that they were running until September of last year and still at the margin and still in terms of the big picture are running.

From the perspective of the US, though, if we look at my favorite way of looking at it is just to take a very long term average since 1973 of the real effective exchange rate on a unit labor cost basis. And on that basis, we're still pretty, we're very kind of overvalued for the US dollar. And that's the problem, right? For the Chinese authorities to continue running things

type of policy that they have been running almost exclusively until September of last year and still basically are running, that's just fundamentally at odds with the US managing to sort of reshore production because there's just

different perspectives on what is overvalued and what is undervalued. And so when the Trump administration and its officials say China is quote unquote cheating on trade, and it's not just tariffs that you know, I don't believe Chinese tariffs are particularly high on the rest of the world if you if you average it out, but one of those is currency depreciation. So explain just how from

You said from the Chinese perspective, the yuan could actually be undervalued. It's not competitive enough for them to hit 5% growth targets because for them to hit a 5% growth target, they need to continue getting net exports contributing 50% of GDP. So from their perspective, and this is not necessarily a very fair perspective from the perspective of the rest of the world, but from their perspective, it's not competitive enough.

enough. But again, there's a huge amount of cake ism there because Xi Jinping wants the currency to appreciate and that's at odds with running a supply led supply led growth policy. So I guess you kind of have a conflict there with Xi in the same way President Trump President Trump says he wants a strong dollar. He loves the dollar but a weaker dollar would propel his ambitions of narrowing the trade deficit and helping us manufacturing.

Xi, the leader of China, has the exact same thing. So where do you think this goes if the Chinese yuan is very, very undervalued and that is promoting Chinese exports? And by the way, I mean, China has a trillion dollar trade surplus with the rest of the world. So they may say that's not enough because in order to hit our GDP goals, but at some point, that's quite a large surplus. Where do you think this goes?

So I guess just to be clear, it's not enough for them to hit their 5% growth target. So it's like, given that they are trying to hit that growth target through a supply-led policy, then the market pressure on the renminbi is for depreciation because they're trying to hit it through a supply-led demand-deficient growth policy. That means depreciation.

deflation and they're stuck in deflation. And that means compression of returns. And so the interest rate differential between China and the US and the rest of the world continues to sort of compress down. And that's what causes the capital outflows and causes the renminbi to depreciate. So that's the sense in which from a market perspective, given their supply led growth policy, the renminbi is, is, is, is the market pressure is for depreciation because they're just in a, in an environment where they're just compressing returns.

And then typically what you see in a long-term scope and taking sort of Japan as an example here, what you see is when you enter deleveraging, that's an environment where the real effect of exchange rate will depreciate. How do you get out of a debt crisis? You can either default.

It doesn't look like they're going to default in a great enough scale to get out of this. Or you can depreciate the currency, or you can go through demand deflation. And demand deflation is essentially just compressing wages and creating this kind of excess supply environment where you get this deflation that comes through and compresses returns. And that's exactly what we're sort of seeing for China. So that's the sense in which overvalued, undervalued, it depreciates.

depends which perspective you sort of look at it from. If you're thinking about it from the perspective of the market impact of their chosen policy being supply-led, then it looks like the renminbi has to depreciate on a long-term basis. The reason why I sort of

worry about, are they able to pivot away from that? They seem to be trying to pivot away from that since September. And I think, again, that's a result of the politics domestically, and it's a result of the politics in the rest of the world, that politics is finally wakening up and punishing the surplus nations for the policies that have created the deflation in the global system that has sort of gone too far on a super cycle basis.

They've pivoted now at the margin towards domestic demand and we see the fiscal numbers coming through and we continue to expect those fiscal numbers to come through on the stronger side. That helps at the margin, but then, you know, Japan has run fast.

pretty large, a great degree of largesse in fiscal policy for a very long period of time. And on a long term basis, the trend in the real effective exchange rate of the yen is one of depreciation in real effective terms.

And that's just a sort of a simple fact of when you have excess of surpluses, that's a deflation environment and it's compressing returns. So you're just going to get at the margin continuously people coming out of the currency and seeking returns in the rest of the world. And that's what carries the currency down. What would get China out of that environment is there's a couple of different things. I think there's there's.

sort of a few different levels of policy that would translate to different levels of success in transition towards private consumption led growth, which I think is essentially what leads to an appreciation of the currency over a longer term time period. One is, you know,

you'd think most simply to redirect income from the corporate sector to the household sector. And that comes both through removing the extent of financial repression, allowing households to get returns on wealth,

And also through building the social safety net, building the social safety net, you know, in China, you'd think it's a communist country. So you'd think it would have a lot more of a social safety net than the US. Actually, it's completely the other way around. There's a lot of saving that people have to do at the individual level, because they know that the state isn't there to have their back if things get rough.

If you were to redirect income into the pockets of households through kind of removing financial oppression, allowing returns to sort of to increase and in terms of reducing the need for individual savings, then that would sort of, I think, be a beneficial thing for the currency over a longer time period.

But is that going to happen? The financial repression side of it, I just think it's very unlikely that the Chinese Communist Party is going to allow capital to sort of find its natural place. Yes, they've sort of extended the hand of friendship to the tech entrepreneurs again, but have they allowed...

Ant IPO, are they going to do that? I think that that would be a very clear indication if they did that, that they're willing to allow consumers to get more reasonably high deposit interest rates, which has been a big thing previously. If they do that, that means they're accepting that they can't use the state-owned banking system as a form of fiscal policy anymore because they don't have control over the deposits.

So are those things going to happen? In my opinion, probably not. Similarly with the kind of reorientation of people

of a fiscal policy to build the social safety net, yeah, I think at the margin we'll see some progress there. What we need to see in order for that to happen is redressing the imbalances between revenue and expenditure between the local and the central government. And that's been a major reform that they've kind of failed to make for a long period of time, but this is a crisis and maybe we see some benefits there coming through.

The other sort of major thing, so we've talked about two parts of the transition to private consumption led growth. The other major thing is to recapitalize the banking system. At the moment, even the state owned banks are, it's quite expensive for them to raise capital.

And to recapitalize the banking system, what would you have to do? Probably you'd have to get the PBOC involved through an expansion of the balance sheet. And that, in turn, would mean depreciation of the currency in the first instance, which in the current global environment is just not possible.

So I think it's unlikely that we see them making the reforms necessary to genuinely sort of turn the currency around onto an appreciation path. But that doesn't mean to say that I think that Chinese goods, you know, let me not use a double negative. I think that Chinese goods are, you know, uncompetitive. They are unfairly competitive, right?

because of a whole range of Chinese policies. But that doesn't immediately translate into what I think the renminbi is going to do over the longer time period. Thank you for that, Freya. So the US wants China to pursue a domestic consumption boom. That way they can have growth without exporting to the rest of the world, their lack of demand. China also has stated they want to have boost domestic consumption. So it seems like the two biggest countries in the world want the Chinese consumer to consume more.

Do you think that they will be successful? And is it wise to bet that if these two extremely powerful governments want this to happen, it will happen? Or do you think you'll take the other side and say the Chinese consumer has always been weak and it will continue to be weak? I think...

From a longer term perspective, I'd take the second part of the way that you framed it. I think for the reasons that I said, I think it's very difficult for China within a five, 10 year timeframe genuinely to transition towards private consumption led growth. But I think at the margin, they've shown very much that they do want to transition towards stimulating domestic demand. They haven't really come through on

numbers rhetorically, I actually think that the NPC numbers were reasonably strong on the fiscal front. And then actually looking at the amount that they've issued in local governments, they have front loaded that much more so this year than they have in recent years as well. So I think that there definitely is improvement at the margin towards that sort of

reorientation towards domestic demand. And I think that very much reflects the global environment as well. When we look at what the PBOC has been doing until sort of post-liberation day, they've been preventing the currency from depreciating. They've been sort of sucking liquidity out of the system and pushing up short-term rates in order that, again, these capital flows are sort of maintained

within the currency, or at least that the pressure, the depreciation pressure is less. So I think in that sense, that plays into our wider belief that the US and China both want a deal, because Xi Jinping doesn't want to see the currency depreciating rapidly. Like we've just said, he wants to internationalize the currency. And it's not a great look if there's this sort of spiral down in the currency. And at the same time, I think that

Trump's reaction function has been triggered. That was clear sort of midway through last week. And then over the weekend, we've had these sort of positive stories coming through with regards to exemptions, which he said he wasn't going to do and now he has. So I think on both sides,

They just need to find a moment for them both to be calm. And we'll see some improvement there in terms of the level of tariffs, not all the way down to the 10%, but sort of 20, 30% rather than a gazillion percent right now.

Yeah. So I'm glad that we spent so much time talking about the international monetary system, because that will still be relevant. When you talk about tariffs, the news flow changes so rapidly. So as we recorded the week, the beginning of April 14th, on Friday, the Trump administration, I believe through the Customs Department, put out things that are exempt from

the tariffs that are already in place. Then on Sunday, President Trump and some of his more hawkish, hawkish on trade advisors said they're not exemptions and they will be in place. So they are forthcoming. So there will be sectoral tariffs on semiconductors and iPhones and smartphones are going to be included in that. But again, it's not 125%. I mean, it could be. So as we record today, the

Tariff rate on China is 125%. Is it 145%?

I think it's 145. But actually, this doesn't matter at all, because by the time you get above 55, 60%, Chinese exports to the US would be zero. So a gazillion gazillion percent of zero is still zero. So the over 100% tariff rate the US has on China, and then as we record today, the US has a 10% minimum tariff on the rest of the world.

And then in, I believe, 90 days, those reciprocal tariff rates are scheduled to go in place. So again, a 99% tariff rate on Lizotho, or actually, so sorry, no, close to 50% tariff rate on Lizotho. The countries that have a deficit with the US, the US has a trade surplus with them, they will be at the 10%, UK, where you were recording this from, is one of those. So how is that going to change global trade? You said US-

If those over 100% tariff rates from US on China stay into effect, you said that's going to cause Chinese trade to the US to go to zero. How is China going to offset that? Is China to Europe trade and China to Australia trade, is that going to go up? And then also share your base case of where you think tariff rates on the US are going to be on the rest of the world. You said maybe in that 20% to 30% range.

Just how dramatic is that? How is that going to shape the economy? I think in the end, the 10% is the one that will prevail for everyone apart from China. And that 10% has been our long-term call because there's a number of different things that tariffs are being used for here. There's tariffs for negotiation, which is the so-called reciprocal tariffs.

And then there's tariffs for fiscal policy. And I think the tariffs for fiscal policy is the 10%. I think that's perceived as necessary to square the circle between the more fiscally hawkish side of the Republican Party and the side of the Republican Party that is up for re-election in the primaries and has high levels of low-income people in their constituencies. So I think that's where we'll sort of shake out at,

And we came to that figure because we do believe in the guardrails. The guardrails have had to go higher than one might originally have expected. But I think we have seen that Trump will blink if certain things happen in financial markets, which we've discussed.

And so I think he will pull back to a level that is absorbable by the US economy without necessarily driving it into recession. Now, whether the uncertainty effect is just too great in addition to the sort of subtraction from growth that is implied by the 10% tariff, that's a sort of another question. But that's how we worked out the 10%, that it's sort of

It's big enough to be meaningful as a fiscal revenue flow, but it's not big enough to tip the US economy per se into recession. So that's where I think we end up with China. China is just different because there's a strong perception, which as I've said, I think is not completely unfounded, that China has been not playing a fair game. And there's just a visceral hatred of China between the US administration and China.

So I think China will end up on a higher tariff rate. That's the sort of the 20 to 30%. And so a lot of what has been almost, you know, the bulk of what has been announced on China, I think will be negotiated away in return for various different things. But yeah, I think we'll keep some level of tariffs in place. Then the other sort of aspect of what you mentioned, I think is, you know, China's response to

Yeah, it is going to be very disruptive for the rest of the world if, certainly if these tariffs stay in place. And in that case, that is a sort of a recessionary environment.

But even if the tariffs are negotiated down to sort of 20 or 30 percent, there is going to be a flood of tariffs, of I'm sorry, exports that is redirected to the rest of the world. And, you know, that is disinflationary. How does the rest of the world respond to that? They probably won't accept that level of reorientation of tariffs.

of global trade flows because there are lobbies within each of these different economies for the auto sector and for the various different sectors that are very, very exposed and already have been under attack from the flow of Chinese goods.

in the post-pandemic era, in addition to the whole kind of two decades of opening up or since 2001. So a long, long period for these lobbies to sort of get their act together and be ready to sort of push back against a further flow of

goods from China. So I think that's a potential for further escalation further down the line as well. Then in terms of China's kind of fiscal response, there's a sort of a temptation to

I think of the greater is tariffs, then the greater than fiscal policy will be. And those two things will sort of offset each other. I don't think that works because trade as a contributor to growth is probably more meaningful than fiscal policy as it currently stands today.

in China because there's been so much fiscal policy and there's been so much overinvestment domestically that the returns there are very low and the multipliers are probably very low as well. And so that in itself means a further structural slowdown.

And then on a cyclical basis, it's very unlikely that we'll get a smooth handoff from trade to fiscal policy. So actually, what we have at the moment is probably a considerable front loading of both trade and fiscal policy in the sense that, you know, that people are trying to get ahead of the tariffs. And there's been this big issuance of lending from the sorry of borrowing from the

the local government borrowing. And so that all probably gets front loaded, but there's going to come a stage over the course of this year where that runs out and the sort of the broader shift in fiscal policy is not yet online. And that's going to be problematic as well.

So 10% tariffs from the US on the rest of the world, ex-China, and 20% to 30% tariffs from the US on China. That is your base case. Who do you think has greater negotiating power, the United States or China? The Trump administration and, for example, Treasurer Secretary Scott Besson has made the case that

The US is a trade deficit country. China is a trade surplus country. And as a result, the US has negotiating power because if imports go down, it's going to hurt China way more than the United States.

Do you agree with that? And how does your answer to that question inform your response on to what degree China might be willing to, quote, do a deal? And you can offer your explanation for what that means. I actually think that the U.S. did have all the cards or not all of them, but I think on balance, the U.S. was in a better negotiating position, partly for the reasons that I expressed with regards to the Chinese holdings of treasuries, which I said is, I think, counterintuitive.

But then also because, yeah, the Chinese exports were, you know, 50% of growth last year. That's a big shock if you're going to take the US out of that 100%. And so that is, I think that's problematic for the Chinese authorities. I think there's much less wiggle room than people think in terms of Chinese stimulus. As I said, I think the multiple

are now very low. And I think that there's this nasty dichotomy between trying to maintain the renminbi so that they don't escalate the trade tensions and the effect that that has on domestic growth, which I want to be really clear is not that I think that they need a whole bunch more exports in order to get strong growth. It's more that I think that they've, in

in order to maintain the renminbi at its rate against the dollar, they've had to destroy liquidity and pull up interest rates, which then that also has a knock-on effect onto domestic growth, which is a deleterious effect. So I think there's just much less wiggle room for China in the big picture sense to really...

be strong on a negotiating stance. But I think the US just massively overplayed its hand, like it had the cards and then they went out there and they just took it too far. And so now we know what their reaction function is. And that somewhat puts China in a better position. And so I think they both want the deal, actually. I think there's just a question

like face and sort of how they come to that. But as I said, I think it's unlikely that all of that tariff gets negotiated down. Thank you. And my understanding of an aspect of President Trump's philosophy of art of the deal is basically shoot for the stars and land on the moon. Start with the negotiating position of

a very, very extreme ask. And then you narrow it down and you still get a lot, but in relative, you know, it says, oh my God, they negotiated. So for example, you start with a 50% tariff on China and then you go to 100%. And then in comparison, a 20% tariff, it seems so low. Of course, China is going to agree to that. I think that the U.S. administration has encountered a slight challenge or

bigger than a slight challenge in that financial conditions tightened way more and way more quickly than those tariffs hurt China or other countries. So the US had to do a pullback before really receiving significant concessions from the rest of the world. They said 70 countries are calling, but that's different than subsidence concessions. However, I do think that with regard to the market,

the art of the deal is going to work. Because if it's only 10% tariffs and then 20% in China, a month ago, that would have seemed extreme and a bear market outcome. But relative to now, I think every market participant would welcome it, right? That has essentially been the way that we've been thinking about it in the sense that

we do believe that they want some degree of tariffs for fiscal policy. So they needed to sort of negotiate, start higher and kind of negotiate lower to make that kind of the 10% seem sort of reasonable by the end. But I just think they just took it too far. They just crossed the line in terms of like, both in terms of how quickly they were escalating it in terms of how they delivered it, which just seemed to create the tension

you know, the appearance of incompetency. Like they had this board and they were sort of pointing at things and it just...

They were negotiating, they were thinking about these tariffs apparently right up until the day when they talked about, when they actually revealed them and just multiple things about the way in which it was delivered made investors really question the competency behind the delivery there. So that played, I think, into markets' response.

And then just the size of the shock. So actually, the size of the shock, it almost seems like simplistic to say this, but the size of the shock is really important because you can have a there's a threshold, essentially, you can have a rising stable regime of inflation, and then you can have a rising volatile regime of inflation. And those things mean very different things for how they're absorbed into into asset prices.

Rising stable regime, if you're creating this through a negative supply shock, it's not great, but it's a sort of a cyclical stagflation. It's like a few quarters in which growth and inflation go in the wrong direction. But if you have a rising volatile regime, and we've actually sort of statistically tried to quantify where the threshold for this is,

Then, from the perspective of the 10-year, especially coming on the back of the pandemic, where we had a negative supply shock of the pandemic, we had a negative supply shock from Russian invasion of Ukraine, perceptions of the likelihood, that's the important point, the likelihood of negative supply shock.

are gradually being pulled higher. And every time you get a negative supply shock, then there's a sort of an adaptive expectations part of the way in which investors think about things. And it pulls up the term premium. And that seems to be what is so sort of

destructive for capital markets and what seems to have triggered Trump's Trump's response. So basically, from where we're starting, any level of tariffs that pushes us above a 4%, consistently above a 4% inflation handle, puts us into that rising volatile regime, where it's a big enough shock for it to be digested by the 10 year as something that the 10 year needs to think about and price into into term premium. So anything that's like,

Above 10% tariffs across the board in conjunction with deportations, that could get you above 4%. Or tariffs above 20%, that gets you into that rising volatile regime. So I think essentially that is where it looks like we're headed. I don't think that's necessarily going to be validated over the next year.

next kind of nine months or so. But I think over when you start to get the interaction of deportations and where tariffs, if tariffs do end up at sort of 20, 30% on China and 10% on the rest of the world,

you put that together with deportations and you're really starting to change the dynamics of inflation. So I understand that deportations and maybe you didn't mention Badoge, those can take many months, years to take effect. But with tariffs, if US tariff rates are over 100% on China, aren't they taking effect already? And won't you see a one-time price adjustment or a price adjustment that

may or may not result in persistent inflation quite quickly. And how do you think that the 10-year would react to that? Yeah, I think, no, you're right. I should correct myself. I think it's like multiple layers of incorporation of these various different shocks. And that actually, if you understand these dynamics and these thresholds, that's going to create narratives that we should be able to play if we're sort of shorter term investors.

In the sense that, yeah, there is going to be a short, sharp increase in inflation, and it could be really significantly sharp. If we look at sort of how prices behaved in 2018, there's a lot of opportunism around tariffs. Tariff prices for the affected goods shoot way, way up. If you look at sort of laundry equipment, that was 100% annualized rates at the peak.

the level of prices then actually came almost all the way back down again subsequently. So there was a huge amount of, as I said, opportunism beyond the actual tariff effects. And then a lot of that sort of comes out of the system. And so there's like an initial spike, which, yeah, you'd imagine that the 10-year, the term premium just has to respond to because of the numbers that are likely to sort of come through.

But then there's a period when the people that are telling the narrative on the other side, that this is just a one-off inflation shock and it's just going to come out of the system, that's going to reverse. And so then yields might start kind of coming back down again. The story is going to get priced out. And then there's a sort of a longer term truth, which none of us know which side of this is going to get validated. But my opinion is that

Actually, probably tariffs do change fundamentally the inflation dynamics of the US economy because there's less of an impact of labor markets in the rest of the world and more of an impact of domestic labor markets.

And so you start to see a recoupling of domestic inflation price, output price inflation with domestic unit labor cost inflation. I think the likelihood is that unit labor cost inflation is at least as strong as it was in the 2010s, if not stronger. But then on top of that, there's less of a...

profit margin essentially because it's the US marginal unit of labor rather than the Chinese marginal unit of labor. And so the relationship between unit labor cost inflation and CPI inflation goes back to a sort of a 90s relationship, which does imply higher inflation and lower margins.

So that's my longer term truth, but we won't know if that's true or not for a long period of time. Whereas in the short term, yes, we're going to have this spike of inflation at that moment in time, all the narratives will be about, yes, totally, this is changing the inflation dynamics, and then there'll be the disinflation, and then there'll be no, it's not changing the inflation dynamics.

One of the sort of point that I'll make there is also just how quickly can this be implemented in practice? Because some of the doge stuff goes against the actual implementation because, you know, is there actually going to be, are there actually going to be changes to the tariff schedules in time and will it actually come through and, you know, how much, how

how much front loading has there been in terms of inventory being already in the US. And these things could potentially slow down the inflationary response. But I think my money would be on quite a sharp initial inflationary response because I think there'll be a lot of opportunism there.

Thank you for that. So how does this, everything we talked about, your views, inform your asset allocation view? I think you said you're not particularly bullish on the US Treasury. You're definitely quite bearish on the US dollar relative to other currencies.

But where do you think investors can find a safe haven? And then also, what is your risk appetite with regards to credit or equities? I think with regards to sort of risk appetite, I think there are going to be opportunities there for sort of shorter term investors, just because, as I said, I think that the

the tendency is going to be towards sort of good news with regards to deals. I would then say that those are sort of selling opportunities. So how did my strategy counterpart put that? Sell the rip, don't buy the dip or something like that. And then sort of thinking about, yeah, so...

assets on a longer term basis. I do think that there's a significant risk there that the average of valuations that has persisted since 1989, being sort of above 20, sort of 23 or so, is at risk, and that we could see that average being sort of revised considerably down over the next

10 years or so. And I think actually that increase in likelihood of negative supply shocks is one of the triggers for that. Then thinking about sort of shorter term and where can we hide

Beyond those short-term possibilities of tariffs being negotiated away, what's the alternative to the dollar? Obviously, there isn't an immediate alternative to the dollar, but what comes closest is that there appears to have been an improvement in the risk-adjusted returns in the euro area. So we kind of look at the response of policymakers in Europe today

to the threat of Trump and, as I said, to the political shifts that have happened within Europe and the response has been to change that silly old fiscal rule that they had. And that seems to be something that could benefit the bloc and benefit Germany in terms of creating

creating these sort of synergies between the public investment and private investment. I think initially the fiscal multipliers there won't be that high, but they will rise quite sharply over time. And that plays into a sort of two to three year story that will validate sort of reflation stories around the euro area. But in the meantime, I think there's going to be more burn supply coming online. And I think there'll be a lot of buyers for that. And I think that that area is important.

something certainly to look into, particularly as the short end of the curve, we have the ECB likely to cut rates and able to cut rates because it's, if anything, a sort of a short-term disinflation story that we have for Europe.

And your longer term view that we started this conversation with about the change in the international monetary order. So do you expect the dollar holdings as a percentage of reserve assets to decline sharply? It has been falling significantly.

very, very gradually over the past 15 or so years. But do you expect it to deteriorate and fall sharply? And then also, where is that reserve going to go? You said bunds, but is it going to be other, you know, the Nordic countries that have been increasing other sovereign bonds, just like

I don't know. Or gold. I think gold has to be one of the recipients, but I don't think it's big enough to be the only recipient, I think. And that goes for pretty much everything else in the world. There's some marginal benefit for the euro. There's a question there, which my colleague on the euro...

Your area raises is typically historically when you have a reserve currency, it tends to be correlated with a strong defense sector. And unfortunately, Europe has sort of allowed its defense sector to to go to to go to waste. Then there's there's China. As I said, I think that the long term trajectory there has to be still one of depreciation in real effective ways.

terms, but I think there's, there's, there's, there's geopolitical reasons why we might expect some greater uptake of, of the renminbi after, which is a trend that has been there already as you sort of highlighted. But I think that speeds up now. And particularly if you get sort of boring in short term renminbi, and if there can be some sort of geopolitical shift towards lending in, in renminbi, then you start to get some, some increase in, in the level of, of global circulation there.

I think what becomes particularly interesting is when you start to get monetary cooperation outside of the US. So we already have seen a lot of that. China essentially has a

parallel system which is much more sort of digitalized the outside of of the dollar and that is very shallow at the moment like it's there and it's in parallel but it's not it's not been kind of used to any great sort of depth but I think there is now a sort of a geopolitical shift to to to speed up that process towards the renminbi but I don't think it as I said I don't think it's a a sort of

successor to the dollar in any way in the same way that I don't think the euro is. So I think there's, there's lots of different places where it can sort of go. And I think that the trend that we've seen previously is, you know, it is what it is, but I think now we're seeing a genuine sort of shift in that, which, which speaks to investors reassessment of, of,

the prospects for risk-adjusted returns in the US over the next sort of decade or so. And I think that plays out into a multipolar currency system with the prospect for some forms of monetary cooperation, especially if some of those more dire responses from the US start to take place. So sort of tampering with capital flows

the undermining of the Fed, these things would create the sort of chaotic environment which would incentivize the rest of the world to sort of get its act together in terms of maybe creating some sort of system that might revolve around sort of central bank digital currencies and sort of parallel the dollar system and maybe even have some advantages from a technological standpoint to the dollar system.

A lot to think about. Freya, thanks so much for coming on Monetary Matters. Where can people find your work? How can they, you know, whether they're a client or not, how can they read your reports? You shared with me several of your reports, and your analysis is excellent. Your writing is excellent. So how can people get access to that?

So they can, they can, you can please do reach out. We're happy to offer sort of trials. We, we also have our own podcasts called Perkins versus Beamish where Dario Perkins and I try to sort of knock lumps out of each other all in, in good spirit. Yeah. And we, we, we have every now and then we have a, we have a blog on, on kind of big, big picture matters as well, but yeah, certainly sort of reach out if you, if you want a trial.

Thank you. Thank you, everyone, for listening. Don't forget to subscribe to our YouTube channel and leave a rating or review on Apple Podcasts, Spotify, or wherever else you listen to your podcasts. Thanks again. Until next time. Thank you. Just close this door.