Balance of Power

“US Trade Policy remains unpredictable… a loss of independence of the Fed would affect us all.”

Bank of Canada Governor Tiff Macklem, 28 September

To understand what just happened with Warsh being selected as chief of the Fed requires imagining the power dynamic at play, even if we can’t obtain all the corroborating evidence. On the face of it, Warsh makes no sense. His claim to fame is opposing Ben Bernanke and advocating for tight money during the global financial crisis—a decision that would have been a bad policy error. Not the type of guy Trump would want running things, it would seem.

So I look elsewhere for an explanation. To run the Fed, a nominee must get approved by the Senate Banking Committee, chaired by Republican Tim Scott. Scott’s policy preferences are traditionally conservative. He has been explicit that the Fed should remain independent. Is it possible that the Senate let the White House know that if they preferred a “hard money” candidate? Perhaps. Then Warsh’s tight-money credentials go from a seeming weakness to a strength. That’s the most plausible explanation I have for Warsh, and it sets up the possibility that if the economy weakens in the second half of the year—which I expect—and Warsh is at the helm, the Fed will be late and wrong. This would tend to hurt stocks, help the dollar, and be bullish for the long end.

If the Senate did push back on the White House, quietly, the break comes at a critical time—investors are applying a higher risk premium to US assets. Once this risk premium kicks in, it can trigger self-reinforcing actions that exacerbate the initial move, boosting the US cost of capital.

In more detail:

1. Copper prices moved 10% on the day Thursday morning. This is the physics of liquidity—the prices of things that are rising a lot are not as liquid as the prices of things that are losing relative value, so the shift in one relative to the other is disproportionate.

2. The table below is a rough, back-of-the-envelope calculation of what is going on. The table is a list of assets that macro managers are involved in that might be off your radar, depending on where you live: Korean and Hungarian stocks, the South African Rand… you probably know Nvidia.

   

As I have noted previously, the Brazilian stock market has a fraction of the liquidity of Nvidia. Silver and gold have more liquidity, but that is because prices have skyrocketed recently (prices are as of Thursday). While both Nvidia and the Hungarian forint are up this year, the forint is up more because 9 million people live in Hungary and 330 million people live in the US, and if a small amount of capital leaks out of Nvidia, it is a lot of capital for Hungary to absorb. Prices adjust. Similarly, while gold was up a cool 24% this month before plunging around 10%, there isn’t much of it to trade. Most of it is held in vaults.

3. The risk premium hinges on Fed independence and rule of law. The conversation shifted from “will the Fed cut/hike” to “will the Fed remain independent.” Optimists note that the Supreme Court didn’t seem receptive to administration arguments to strip the Fed of independence and that whoever is Fed chairman will need to corral votes and does not have autocratic control. But that misses the point. The odds of the Fed losing independence have gone from zero 24 months ago to perhaps 10% or 20%. As Macklem said in further remarks, it is such a big change it’s difficult to comprehend what it would look like. Some people aren’t waiting to find out.

4. Recognize that when the dollar falls and a foreign currency rises, it is a deflationary shock for the foreign country. The cost of all their imports begins to decline. The more open to trade an economy is, the bigger the impact. This means that foreign central banks will be easing policy, which would then boost their asset prices, attracting more inflows because a foreign investor gets rising assets and a rising currency. For US investors invested unhedged in Japanese stocks, they are up 7.8% this year versus about 1.5% in the US. How will Warsh act once he gets power? We will find out soon enough.

This document is strictly confidential and is intended for authorized recipients of “A Letter from Paul” (the “Letter”) only. It includes personal opinions that are current as of the date of this Letter and does not represent the official positions of Kate Capital LLC (“Kate Capital”). This letter is presented for discussion purposes only and is not intended as investment advice, an offer, or solicitation with respect to the purchase or sale of any security. Any unauthorized copying, disclosure, or distribution of the material in this presentation is strictly forbidden without the express written consent of Paul Podolsky or Kate Capital LLC.

If an investment idea is discussed in the Letter, there is no guarantee that the investment objective will be achieved. Past performance is not indicative of future results, which may vary. Actual results may differ materially from those expressed or implied. Unless otherwise noted, the valuation of the specific investment opportunity contained within this presentation is based upon information and data available as of the date these materials were prepared.

An investment with Kate Capital is speculative and involves significant risks, including the potential loss of all or a substantial portion of invested capital, the potential use of leverage, and the lack of liquidity of an investment. Recipients should not assume that securities or any companies identified in this presentation, or otherwise related to the information in this presentation, are, have been or will be, investments held by accounts managed by Kate Capital or that investments in any such securities have been or will be profitable. Please refer to the Private Placement Memorandum, and Kate Capital’s Form ADV, available at www.advisorinfo.sec.gov, for important information about an investment with Kate Capital.

Any companies identified herein in which Kate Capital is invested do not represent all of the investments made or recommended for any account managed by Kate Capital. Certain information presented herein has been supplied by third parties, including management or agents of the underlying portfolio company. While Kate Capital believes such information to be accurate, it has relied upon such third parties to provide accurate information and has not independently verified such information.

The graphs, charts, and other visual aids are provided for informational purposes only. None of these graphs, charts, or visual aids can of themselves be used to make investment decisions. No representation is made that these will assist any person in making investment decisions and no graph, chart or other visual aid can capture all factors and variables required in making such decisions.