At The Mercy of Strangers

The Five Stages of Grief

In 1969’s On Death and Dying, Elizabeth Kubler-Ross developed a framework to track the emotions that follow a profound personal shock that shakes one’s existential core. She identified five stages of grief in the face of impending death. Anger, denial, bargaining, depression and acceptance.

In the geopolitical context of economic and security relations, the subordination of US foreign policy to the needs of one man’s ego has upended our economic lives and undermined our collective security. While we are not facing death, the shock is existential enough to put us on the Kubler Ross emotional path.

The five stages of geopolitical grief, shared most acutely by US neighbours Canada & Mexico but also Western Europe, come in no particular order. But, they are bookended by the anger instilled by levying tariffs against allies and acceptance that the world has permanently changed by the threat of military force against European allies to take Greenland.

Anger. Canada and Mexico were on the front lines of tariff threats and felt betrayed having invested significant resources in production integration with the United States. Canada was first to feel Trump’s menace with the threat of annexation and political integration into the United States.

Second denial: “it won’t happen.” Many felt that American threats of economic destruction were merely well-known maximalist negotiation terms. Third, bargaining (that became appeasement) or throw Trump a bone, take the hit, and adjust to the change of terms. Fourth depression, on the realization that meeting one demand merely encouraged even more outrageous grift. Finally, acceptance that the repeated game of escalation dominance would not end. With just about every taboo broken by the US, it was time to take a stand.

Cometh the Hour

Being closest to the action, Canada walked the Kubler-Ross ,path in a mere six month’s from Trump’s election. After his election, Carney moved immediately to acceptance, drafting and initiating a plan to diversify away from the US both economically and politically, flying first to Paris and then London. He didn’t waste time on being angry or depressed, nor did he bargain as a supplicant. He acted, and now the Europeans have joined him and are prepared to act in the face of rupture.

However, there is a big gap to be filled between here and there. Luckily for Canada, expansion of an oil pipeline to the Pacific coast has brought much needed earnings to paper over some of the economic loss incurred elsewhere, and to provide resources to build for the future. But if Trump follows through as USMCA expires Canada will be in trouble. As usual, the C$ will likely decline to cushion the blow.

Europe is in a much stronger position than Canada, and has a lot of fire power if push comes to shove. The US relies on the EU for almost 20% of its economy’s intermediate inputs, yet the EU relies much less on the US -- half of that amount. More to the point, Europe provides high value precision inputs to the US that it could neither produce nor immediately find anywhere else in the world.

The Europeans have been reluctant to exercise this leverage given its defence integration with the US through NATO. But Trump crossed that line in pursuit of Greenland, so now the Europeans feel that despite the pain it is time to draw a line.

TACO – fact or myth?

True to form, in the face of push back and the recognition of a powerful foe, Trump backed off his threat to invade Greenland (for now) taken aback by the addition of a few hundred Danish and European troops to the Greenland garrison, in what looks like area denial.

Financial markets also responded negatively to Trump’s belligerence, confirming the market’s bias to discount Trump’s menace as noise until it looks a bit hairy.

While many believe in the power of the market to deliver a TACO, and the so-called Fed put on equity markets, these are myths. The Fed makes policy for the economy and inflation not the equity market. While Trump does back away from maximalist action to match his rhetoric, he still creates damage. The market has some impact, but only to limit Trump’s most extreme threats.

What comes with this TACO is not salsa, but Smoot Hawley tariffs: some chickening out. And, once tariffs are in place they are hard to remove. And once you cross the line and threaten a NATO ally, NATO is not the force it was. Ironically, it is likely to remake NATO into a Europe+Canada alliance which in time would be formidable.

Trump blinked because he got a glimpse of Europe’s power. Patronizing beliefs towards Europe shared among Anglo chauvinists ignores the fact that Europe is rich, and while its productivity growth may be small, its productivity level is high. The European military area denial raised the stakes, got Trump’s attention, and got under his skin, But it also made him think twice because in the end all bullies are cowards.

Predictable Surprises

A predictable surprise is a disaster that is known to be coming yet still takes those who could have acted to prevent it by surprise. Many anticipate that the end game of Trump acting on his grievances will be costly, but clear warning signals are ignored because the cost of preparing now is immediate and the consequences are distant. So those that can act often choose to hope for the best rather than prepare for the worst, as we saw prior to -- and subsequent to -- the financial crisis of 2008-09.

This past week’s TACO confirmation should not lead to investor complacency. The risk of a predictable surprise is great in this game of global brinkmanship. Real damage is being done and will be done.

The US is very exposed financially and economically to push back from those it threatens. Threatening economic prosperity is one thing, and capitalist economies can adapt quickly as Finland’s recovery from the collapse of Soviet Russia in the early 1990’s attests. But threatening another country’s sovereignty is quite another and is asking for a fight. Repeated coercion will not be tolerated by countries with agency.

If nothing is off the table in Trump’s exercise of US power, then no one’s US$ denominated assets are safe. The less liquid the asset, the more costly it is to protect . Even catastrophe aware investors move slowly to protect their investments. And, even if some actors want to act, vested interests often prevent a predictable surprise from being extinguished.

Monopoly Returns are Hard to Give Up

When you hedge a future risk you have to quantify the risk and time it right. Too early and you are out of the game and hit with opportunity loss. Too late and you can lose it all. Markets are good at pricing short-term “cross-sectional” risk – or relative-value risk -- but they are not good at pricing long-term structural uncertainty. Someone is going to get hurt.

The US has a monopoly over many global services, especially in tech firms whose financing is underpinned by the value of the US$ as the global payments currency and global reserve asset. An end to this arrangement could be costly if ignored. Ask the market to price the erosion of the US$ as the global payments currency, and the response is “there is no alternative”. Ask it to price-in fiscal dominance and the response is “the Fed is independent”. The risk is thus rationalized and essentially ignored. Investors want the global monopoly rents the US has captured, but it doesn’t want to incur the cost of protection.

Few manage catastrophic structural risk at all, so the potential cost of failure builds. The rot in the US financial system was ignored prior to 2008-2009. It could have been managed with tighter regulation and closer financial system oversight but was not. The stabilization costs to clean up the mess were enormous.

The long-term is made up of the sum of short-terms, so long term risks can be managed one adjustment at a time to stay in the game and minimize the clean-up cost of the predictable surprise when it arrives.

Market action ahead of Liberation Day and Davos did see hedging of US assets creep in, and surprisingly so for many the US did not attract safety capital as the crises grew. Unlike the financial crisis and Covid-19, US treasury yields increased by more than any other peer country (other than Japan which is struggling to adjust to the recontracting price now that inflation is higher).

The dollar fell against most currencies, and gold surged by 4.0% . US thirty-year bonds rose by almost 8 basis points prior to Trump’s Davos retreat, higher than Canada, Germany the UK and France. This is not the normal pattern.

Markets are terrible at pricing structural change in one fell swoop, and investors hope that a sharp shock from the market will constrain Trump. But it is easier to buy into a myth than it is to price and execute on the basis of counsel, logic, and rational argument.

Be prepared for the predictable surprise.

Europe Barks Back

The trust between the US and Europe has been shattered. Leveraging the security relationship in an attempt to dominate Europe over Greenland has generated blowback. Withholding US military support for Europe is the trump card for sure, but Europe’s financial leverage over the US is substantial now that it has been played.

First, Europe holds US$ 300 more in US fixed assets than the US holdings of European fixed assets. Across the world FDI exposure sums against the US by about US$ 1Trn. Secondly, the US owes Europe and Canada about US$ 3.7 Trn in debt. About 42% of that is owed to government with the private sector holding the balance. Japan’s holdings are US$ 1.2 Trn and adding-in other major Asian countries sees this climbs to US$2.4 Tr.

The Greenland fiasco has reawakened the sell America trade. China is commonly believed to be the marginal seller to be feared. Yet China is not the largest holder of US Treasuries, far from it. China is the third largest holder at US$ 683 bn behind Japan and the UK at US$ 1,207 and US$888.5 respectively.

Willingness and Ability

The single biggest issue for any creditor is the willingness and ability to pay its debts. Depending on the kindness of strangers is never a good place to be. Absurdly, the US is making strangers of friends, potentially putting it at the mercy of strangers when it will most need their help – in a crisis.

Carney’s Davos speech incensed Trump and his acolytes by telling it as it is. Given a now overriding sense that the world is ready to face down US coercion, I am frequently asked if I think aggrieved parties will sell their US Treasuries following the old saw “don’t get angry get even.”

An emotional response is not in the interest of the holders, as it will blow back equally on them. Keynes observed that the bigger the loan the bigger the problem for the bank. The US is the borrower and foreign holders the bank. But that doesn’t mean that the lenders are powerless.

Contrary to the belief that the US$ will remain the global reserve currency because there is no alternative, other countries do not have to buy US Treasuries even if the market is deep and liquid. Euro debt markets are increasingly deep, and the Euro is the payments currency within the Euro area. There is absorptive capacity in the Euro debt sovereign market should European countries decide to reduce their US dollar exposure. There are always alternatives.

The US debt market is deep and liquid, and those characteristics are valuable if you trust the borrower’s willingness and ability to pay; but if you have doubts, then you might want to go elsewhere.

As the world disengages from US trade and finance, demand for US$’s will decline. Given that US financial markets no longer behave as the indispensable market in times of stress, the more challenging it will be for the US Treasury to fund its deficit both affordably and effortlessly.

The markers of deteriorating US Treasury demand are found in such metrics as the bid to cover ratio, an indicator of demand strength. To date there is no indication of a break from trend, and sudden surges in the ratio tend to accompany periods of acute stress. And while there is no shortage of stress emanating from Washington, the market is becoming inured to bluster and threats that do not eventuate. Yet non-resident investors routinely take down10% of all US bond auctions, and the danger to efficient and affordable financing for the US because escalation dominance goes too far is not trivial.

A bond auction is unlikely to fail because primary dealers are obliged to take-down an auction, but if their share of future auctions is trending-up then this signals declining investor participation.

Economics and finance theory tell us that it is the marginal (or last) bond sold that matters for price determination. Given Washington’s behaviour, and the sheer size of the annual deficit, US willingness and ability to honour its obligations should be questioned as a matter of course.

Acceptance Is the End of Appeasement

Momentum is a well-known investment strategy, one that investment firm manager AQR asserts has behavioural origins. Investors do not suddenly react to new information as they tend to adjust to news and pattern changes slowly. But they adjust.

When we reach Kubler-Ross acceptance, we can move on. Countries have agency and Canada has laid down the marker for where we are going. The US won’t feel it immediately just as the Brexit shock took about ten years to become apparent. But the 8% loss in UK growth potential has clear and negative consequences for living standards.

Small but incrementally large financial change is underway. Bond giant Pimco has signalled it is diversifying away from US Treasuries despite being a US firm. The Danish pension fund manager AkdemikerPension has liquidated its US$ 100MM Treasury holdings citing political risk. As acceptance of the rupture gains momentum, others are likely to follow. Great power games can be expensive in treasure and lives, and Trump has been shown the limits to military power even if you are the most powerful on earth.

Trump has made his decision to lever US dominance. The world didn’t want to believe it and tried appeasement to minimize the consequences, which only encouraged escalation. But with acceptance comes adaptation. The rest of the world is moving to protect itself from America through disengagement from what it has become. This will have negative consequences for all. America can no longer rely on its friends, and to fund its debt it is now at the mercy of strangers.