Capital Flight, Trade Policy, and the Fate of the Dollar | Joseph Wang

20:58Demetri Kofinas:I mean, that's the thing. And I feel like a lot of us have been waiting for that continuity, but we may not get to a point in the Trump presidency where companies and countries get enough clarity about the president's tariff policy to feel confident about where they stand vis-a-vis the United States. Well, there are whispers of a third term. I don't know if that'll happen. I have heard those. In some cases, not whispers. I think Bannon has been consistently saying something to that effect. I think he has some kind of phrase that he uses, like when the president is reelected, I think he says. So let's say we did get more clarity.

21:29Demetri Kofinas:Much of the damage has already been done. What are the changes to the global trading system that you think are already baked in, but whose effects we won't see for years, and in some cases, maybe even decades to come? So like we were discussing, because there's not a lot of clarity, it's probably hard to make those structural investments to make the U.S. self-sufficient that the president would like. And I think we could all agree on would be an interest of national security. So in the short term, it seems like we're just going to have to live with higher tariffs. And so who pays those higher tariffs?

22:01That's a really complicated question. So it can be paid by the exporter. It can be paid by through lower margins and importer. And of course, at the end of the day, it could also be paid from the consumer. Who actually pays it is really going to be sector specific. And it's really hard to know ex ante. So if you look back to what happened in 2018, when Trump made his first trade war with China, looking back, I've read studies where people went through and looked at prices of over 100 ,000 goods that are traded on the internet. And their conclusion was those 2018-2019 tariffs were largely paid by US companies who just had lower margins.

22:38So that is one possibility that it could happen. Fast forward to today, we are in a time where consumers are just getting off a bout of high inflation. So maybe companies feel like they can raise prices and have the consumer bear that. And there's a study, well, a survey by the New York Fed that shows that a very large fraction of companies feel that they can pass on those carotops to the consumers completely. But you also have other sectors, for example, Japanese automakers that have been very clearly bearing basically the entirety of the auto tariffs. So if you look at auto export prices from Japan to the U.S.

23:14on a year-over-year basis, they've declined by 20%, which is coincidentally basically the auto 20-some percent auto tariffs that the U.S. is putting on auto's imports globally. So in that instance, the Japanese exporters are eating all of the tariffs. So this is a complicated question. You may have inflation, you may have lower profit margins, or foreigners could just eat it. So how that plays out is something we're going to figure out in the coming months. But in terms of global trade, I think it makes the U.S. a little bit less a reliable trade partner, especially if things are trading so much.

23:48So you do see a lot of countries trying to get together and work through alternative trading arrangements. Canada, for example, there's a push to try to have closer ties with the EU. and the EU. There are even people there who think, you know, we should not be such close friends with the US. Maybe we should be closer friends with China. So you have this strategic movement going on. It's hard, I think, to make that, how durable that is, it's going to depend on US policy. But I think it's really hard to break away from the US simply because we are the largest consumer market in the world. We are basically the client.

24:20And all these other countries there, they all want to sell to other countries rather than buy. So it will be hard for the world to change significantly. But I think the way policy is going here in the US, we are doing everything we can to try to encourage that change.

24:37Demetri Kofinas:Indeed, that's actually what we are doing, whether we intend to do it or not. So what do you think are some of the longer term downstream consequences of these changes for the purchasing power of Americans through perhaps precisely higher tariffs, higher input costs to manufactured goods, and I think chiefly a lower dollar. I think the upshot is that the Americans overall will have lower living standards, but that, okay, to be clear, there are good things and bad things to it. The way that I think this is pretty clear is that the US overall imports about$3 trillion of goods a year. That's just on a growth space is not just the net trade deficit, which also has to take into account US exports.

25:20But if you're importing$3 trillion of goods in a year, and now you're having tariffs, basically, we're going to consume less of imported goods. So again, it's basically like a tax. And so if you consume less, your materials living standard will decline. And of course, the way that we pay for a lot of these goods is just basically by giving them dollars, which we can just print. So I think that is going to be a direct impact. However, you also have to look beyond that and saying, if imports are more expensive, then you're going to have people in the U.S. who are going to be able to expand their market and take market share from foreign imports.

25:59And there are stories about that where small manufacturing businesses are expanding because now they get a lot of people who don't want to pay for those more expensive imports now and are choosing instead to buy domestic. So there's going to be a reshuffling, a rebalancing, and I think it could be good for some sectors of the economy. But overall, this will be, I think, an impact on living standards on aggregate.

26:23Demetri Kofinas:So the opposite side of a current account deficit is a capital account surplus. And US capital markets in the US have benefited enormously from being at the center of the global financial system, especially during the last 30 years of trade liberalization and hyper-globalization. What do you think are the consequences on US asset markets and US capital markets to a reversal in the flows that we're describing here in terms of trade and a reorganization away from the United States? So I think this trade stuff is very obviously going to have an impact on dollar assets. So it's going to have an impact in a couple of ways.

27:00So the way that the world is set up right now is that the US buys a lot of goods and services from abroad and pays for them by exporting dollars. Foreigners take those dollars and they go and they buy US assets. They buy all sorts of things, treasuries, obviously, but also corporate debt, equities. And so if you kind of reduce this flow of dollars, you could have less demand by foreigners for dollar assets, and that could put downward pressure on dollar assets. Now, the second thing is that, and we see this from a geopolitical stance already over the past few years is that by having all these changes in trade policy, there's a perception that the US is not as a friendly country as it was before.

27:43So this is something that started a few years ago, even during the Biden administration, when during the Russia-Ukraine conflict, the Biden administration basically froze the Russian reserves. You can think of it as a bank basically denying you access to your bank account. And that policy shift made countries, Russia and maybe friends of Russia like China, be a little bit wary of having too much exposure to US capital markets. And so you see right now that the People's Bank of China buying a lot of gold. So to the extent that stayed there, that was not good. But now that we're kind of expanding what we're doing with foreign policy to even closer allies like Canada, like Mexico, like the EU, that I think overall is creating more of a perception that the U.S.

28:31may not be the great capital destination that it once was. Now, there was even whispers in the BBB bill that there was something called Section 899, that it was eventually, that ultimately a tax on foreign capital. That was negotiated away. So, there was market reaction and Secretary Besson took that out. But that kind of shows you that there's kind of a zeitgeist shift in Washington in how foreign capital, foreign investors are perceived. And so I think that all adds up to a climate where the world is maybe a little bit less confident in having so much dollar exposure. Now, we've seen that dollar weaken 10 % this year, and there are articles going around showing that it's the worst start to the year since 1973.

29:13That's in part, I think, driven to by all this trade tension. But there are other two very big pillars that are driving it as well. And that is, of course, fiscal policy and the potential weakening of monetary policy independence. Now, going back to my framework that I discussed earlier in the session, I think policy is what drives markets. And I think the biggest, biggest macro trend in the coming years is the structural dollar weakness. And I think that's going to have a huge impact on all dollar assets.

29:42Demetri Kofinas:So you literally precipitated my next question, which is whether the decline in the dollar is cyclical or structural. What are the structural forces that you think are driving the value of dollar lower, and that will continue to force it lower in the coming years. So if you take a look at about, let's say, the dollar index, it's down about 10 % this year, but zooming out, it's still, let's say, above recent historical averages. So this decline, well, sudden in a short period of time, the dollar is still relatively strong. So I don't think it's something that we should worry about just yet, but taking a step back and zooming, you can see that it has the potential to decline a lot further.

30:21And I think it will. Now, the reason is threefold. First off is our fiscal situation. So like I mentioned before, the way that I look at a fiscal deficit is that we're basically printing dollars, right? If I were to give you a billion dollars in treasury securities, Dimitri, it would be like giving you a billion dollar bill. You'd be able to take that. Again, you won't be able to buy lunch with it at your local restaurant, but treasuries are liquid, credit risk-free. You can easily sell that for bank deposits and go and spend it. So when the Treasury is printing, say,$2 trillion a year in its fiscal deficit, it's printing a lot of dollars.

30:59And if you look at Congress, it doesn't look like that's going to change right now. Heading into this year, I had high hopes that we would actually shrink the fiscal deficit. You had Secretary Besant give his 333 plan that suggested a 3 % fiscal deficit. You had Elon being a prominent member of the Trump administration in the beginning with his doge efforts trying to string government. And, you know, that didn't seem to be effective. And now the big, beautiful bill shows that Congress is just going to keep spending and spending. I think from my sense, from conversations with people who are close to this, it's just basically there's no forcing mechanism to stop spending, right?

31:36So if you are a member of Congress, the way that you get elected, the way that you retain your support is by being able to deliver to your constituents, so giving them stuff both at home and, of course, your corporate sponsors as well. So there's this widespread bipartisan effort to just kind of just keep spending because there's no reason not to. And if you look at the breakdown of the U.S. fiscal situation, you can see it's actually quite difficult to stop. There are three big parts of it. One is interest rates. Again, the U.S. is not going to default on interest rates payments, so that part can't be touched.

32:10And with interest rates right now, where they are, it's becoming a larger part of the fiscal deficit. You have mandatory spending, which is Social Security, Medicare, stuff like that. It's very, very difficult to cut, just politically impossible. And lastly, you have these discretionary spending, which is stuff like military expenditures, salaries, and so forth. And it looks like the world is heating up geopolitically, so that's not going to stop either. So if you can imagine a world where we can just continue to have a 6%, 7 % fiscal deficit for the foreseeable future, Yeah, that's very obviously dollar negative.

32:44And just for frame of reference, there's no country in the world that can do this. If any other country had this persistent fiscal deficit, their currency would sell off a lot, their bond yields would be a lot higher. A country that's somewhat close is France, and you already see that French oats yields are going higher. But of course, they're part of the broader European Union, so you don't see a strong currency impact. So what the US is doing is truly exceptional in this fiscal deficit. it. And it's kind of surprising that we've basically just socialized it. But it is what it is. And that's, I think, very dollar negative, simply because it's forecasted to continue indefinitely.

33:22I think the other thing that's super, super negative for the dollar is there is potential for a weakening of monetary policy independence. Now, this can be done through the Fed, or it also can be done through the Treasury. Right now, we have all sorts of talks that the president is unhappy with Chair Powell and would like him to be replaced. Now, I'm not sure why the president is unhappy with interest rates where they are right now. Stocks are at all-time highs. It seems like that would make many people happy. But his public commentary suggests he would like a 300 basis point cut in the Fed funds rate, which is a lot.

33:58But the president typically shoots for the moon and settles for something less. So in any case, he wants the Fed to cut rates. Now, there was a lot of commotion earlier in the year where there was threats of maybe him firing Chair Powell and the market reacted poorly, but that misses the bigger picture in that Trump will eventually get his own Fed chair. Chair Powell's term ends next year, and so Trump will get his own Fed guy. So there's a lot of news right now that maybe the people in the administration are finding a reason to try to get rid of Powell. The only way you can get rid of a Fed chair is for cause.

34:34And there's some people drumming up, finding reasons, saying perhaps Chair Powell did not manage the 2.5 billion renovations in the Fed building properly. And so that's cause to be fired. I don't know if that will actually go through. But I just tell you that this is different than how the U.S. used to behave. The U.S. for the past few decades, not always. Before the 1950s, there was no monetary policy independence. But for the past few decades, there largely was. So the U.S. is changing in how it conducts monetary policy. And if you are going to systemically have rates lower than the other ways it would be, that's obviously dollar negative.

35:10You're printing a lot of dollars through treasuries. Usually, you could have the interest rates to encourage people to hold them. But if you also structurally shift interest rates lower, that's going to be less reason for people to hold that. Now, one thing I also note is that monetary policy is an art. It's not a science. So even though, let's say, that Trump just has his guy, his Fed chair on the Fed board, there's a lot of discretion in how the Fed conducts monetary policy that you can easily shift rates lower than there otherwise would be. You can think of it in a couple of ways. So the Fed conducts policy with a view of the future.

35:45And sometimes that view is incorrect, but you can always make it defensible. A good example was just recently, right? So the Fed was telling everyone when inflation was quite high that inflation is transitory. We don't really need to do anything. That was based on their judgment, based on their perception of the future. That was wrong, but it allowed them to keep rates lower than they otherwise should have been. Going forward, you could easily have a new Fed that says, inflation today is transitory, right? So we're just going to cut rates or leave rates lower because the stuff is just going to pass.

36:18Tariff inflation is just a one-time increase in the price level. And another way that the Fed has a lot of discretion is because the US Fed is a dual mandate. Central bank, you have priceability and full employment. And how you balance these two mandates gives you a lot of space to adjust rates. You could, for example, place higher weight on full employment and be more willing to tolerate higher inflation. And that, again, can structurally lead to lower interest rates. So I think that having a more political Fed is something that can really shift the interest rate complex, but that doesn't seem to be in the market at the moment.

36:56Now, one last thing that I think is that the administration could impact interest rates is just through the Treasury. And this doesn't require any controversy. Well, it will get controversy, but it doesn't require any congressional support or anything unconventional. So if you think about, say, longer-dated rates like the 10-year yield, that is in part driven by supply and demand. So the U.S. Treasury controls the composition of U.S. debt. It doesn't control the overall size. That's by Congress. But how much of that debt is issued in bills? How much of it is issued in notes? How much of it is issued in, like, 30-year bonds?

37:31That's up to the U.S. Treasury. And so what we saw under Yellen, for example, was that when the 10-year was pushing over 5%, Yellen basically shortened the maturity structure of the debt, issued a lot more bills rather than longer-dated, say, 10-year notes, 30-year bonds, and that put downward pressure on longer-dated interest rates. You saw the same thing happen in Japan just a month ago. Again, Japanese bond markets also seeming a bit fragile. So you have someone from the Ministry of Finance there saying, hey, maybe we'll just issue more JGB bills. OK. And that calmed the market down a lot, got 10-year interest rates, longer-year interest rates in Japan down a lot.

38:08And Trump has already said something commentary to that extent that we could do that. And so going forward, you could easily have a treasury that kind of freezes coupon auction sizes and just increases the bill share. And that would also structurally put downward pressure on interest rates. All this is adding together to a dollar that can go, I think, much, much lower, 20%, 30 % lower. and bearing in mind, of course, that historically it's not that low. And the icing on the cake, of course, is all the stuff we talked about, Dimitri, with trade and making the US, I think, perceived to be a little bit not as good a place for foreign investors.

38:44Demetri Kofinas:Excellent. So there's a lot to unpack there. And I have a number of more questions on the dollar to ask you, including capital flight as well. Just a point of clarification, are you inclined to believe the arguments that higher interest rates in the last few years, given the structure and nature of the economy and the fiscal expansion were on net stimulative? Well, that's a really hard question. Like we mentioned before, interest rates have an uneven impact on the economy. It is slowing some segments and helping others. So right now, when I look at the economy, I think there's a very noticeable slowdown in housing, for example.

39:20And so that's going to eventually bleed into things like construction jobs. There's credit quality and auto seem to be declining a bit. So I think that when you're looking at the real economy, I think it is having us on net a contractionary impact.

39:34Demetri Kofinas:So it actually worsens the wealth and income divide as well by that logic, correct? Well, that's kind of the policy trajectory for the past few decades, right? So that's not a surprise. But it also runs counter to the president's stated and implicit objectives. So one thing, so when thinking about the people who benefit from this interest income, who are the people who own bonds? I think they tend to be well off. And so if they have more interest income, I mean, they could just consume it in goods and services. But you know what, maybe they just take that and they reinvest it and buy other risk assets as well.

40:11So that stimulative impact from interest expense, I suspect maybe it gets reinvested in financial markets more than actually being spent in goods and services, which would have a real economy impact. So yeah, I think on net, interest rates would be contractionary. That being said, in the future, we could easily have a world where that interest impact dominates. And with a debt to GDP climbing and climbing, that's something that's almost certainly to happen.

40:41Demetri Kofinas:So by that logic, does that mean that there's an argument to be made that lower interest rates would actually cause a decrease in the value of assets and an increase in inflation because they'll be net positive for lower income brackets that have a higher propensity to spend? How do we think about the effect that lower, just a lower Fed funds rate? We're not even talking about balance sheet expansion with a new dovish Fed chair, but just on the interest rate side, what do you think are some of the more probable effects of a more dovish interest rate policy? So conventionally, people would think that the Fed cuts rates.

41:19Immediately, what you could see happen is treasuries rise. So again, bond market appreciates in value. That generates some sort of wealth effect that can prompt some rebalancing with these funds that have to maintain their allocations, go and buy equities. And so that causes all financial assets to rise. I think that's how the market is conditioned, and that's how things have worked in the past. But I suspect that things can actually be a bit different going forward, and that's why that I'm very bearish for financial assets, dollar assets, for the coming years. Now, when the Fed actually begins to cut rates, and again, we got all these other things that we're talking about, that will accelerate the decline in the dollar.

41:59Now, like I mentioned before, I look at the world through policy, but also how it relates to the structure of the financial system. And one thing that I've noticed is that over the past few years, the foreigners have become highly, highly exposed to dollar assets. And that's no surprise. We have really cool stuff in the US, right? We got AI, we got big tech, we got NVIDIA. And those things have done super well over the past few years. Not only that, until recently, the dollar has been appreciating. So if you're, say, a Japanese investor and you bought Nvidia a few years ago, well, of course, Nvidia, price appreciation.

42:35And on top of that, the dollar appreciated. So you're getting a double play. So what's not to like? And people have been pouring money into the US for decades. It's like the global piggy bank. It's where everyone keeps their wealth. And that's kind of our expertise, producing capital markets services. But let's say that you are a Japanese investor. you look at things both in price appreciation, so price of stocks, but also through currency. When the Fed begins to cut rates, and maybe it cuts rates a lot because we have a new Fed chair that is under orders to do that, you could be losing a lot on the currency aspect.

43:13And that could spur you on top of concerns about, say, U.S. policy to just rebalance your exposure a little bit to the US. And so maybe you have, let's say, I think there's BIS data suggesting that about 30 % of foreigner portfolios are in US assets. Now, that's a lot. And I'm telling you that US investors don't really think about investing abroad all that much. But let's say that you just rebalance it to 25 % or 20 % of your overall portfolio, simply because you don't want to take losses on your currency and you're already overexposed. That could be a very negative capital flight-like situation.

43:50And we've kind of already seen glimpses of that. For example, in April, during the height of the Liberation Day commotion, we saw dollar sell off, equity sell off, and we also saw treasury sell off as well. And now that we have official data, for that month, there was a net outflow of 50 billion of foreigners selling a net 50 billion in assets. And that's the largest it's been for a couple of years. So we kind of saw a glimpse of that, But I think that as the dollar continues to depreciate, which could be precipitated by, say, a dovish Fed, like you mentioned in your scenario. Yeah, I think that would be actually bad this time.

44:28And that might be surprising to many.

44:30Demetri Kofinas:Well, capital flight is the nightmare scenario for dollar holders and dollar asset holders. I don't want to be too dramatic. We can just have a rebalancing, right? Everyone is super overrate dollar assets. And then, yeah, just going from super overweight to maybe just fairly overweight. Okay. Yeah. So fair enough, fair enough. Let me just restate it and say again, to reiterate a point that the United States has chronically dependent on running a capital account surplus. And so the economy has been structured to depend on those inflows. And a reversal of those inflows would be very negative for the value of US assets and the dollar.

45:04Demetri Kofinas:And we're going to, again, capital flight and the potential for a doom loop where capital fight leads to austerity and a recession. And then we can throw in AI and the possibility of a white collar recession, where we see the service sector and the white collar workforce, and especially younger people, begin to experience a chronic uphill when it comes to employment that the blue collar workers experienced in the 90s is something that I think also is worth discussing, as well as the radicalization of the Democratic Party along the lines that we've seen with the Republicans. The Republicans had their moment in 2016.

45:35Demetri Kofinas:I think the Democrats are really set up for a similar type moment in 2028. But again, I don't know to what degree you want to speculate on that, but I'm going to certainly ask you about it. One more question before we go to the second hour, and that has to do with a comment that you just made, which was that the dollar sold off after Liberation Day. But recently with the announcement of some of these other tariffs, we've actually seen a strengthening of the dollar. I'm not saying that the reaction is causal, but what would you say to the argument that the dollar has sold off pretty dramatically, and it's due for a cyclical rebound at this time.

46:07Do you have a view on that at all? So I think you make a very good observation. So just this past week, we're recording this mid July, President sent out these - July 15th, to be clear for listeners. President sent out these tariff letters and the dollar seemed to strengthen a bit. Now, I would just take a step back and say that according to standard economic theory, the dollar should have appreciated, right? A lot of an administration's case that tariffs wouldn't be inflationary was that the dollar would appreciate. So that is the normal baseline. Now, what was really weird was when we saw in April when tariffs actually led to a weaker dollar.

46:41Now, that is kind of the red flag there. So what we're seeing is that markets coming down a bit and maybe reverting a little bit to their normal behavior. I think that's positive on the margins, so what we're doing. But if we're having this big shift in market regimes, we're shifting market regimes that have persisted for a very long time, I wouldn't expect it to be just, you know, overnight you turn a switch and everything goes to a new regime. So I would expect, you know, two steps forward, one step back and so forth. So I would still wait to see how these things are happening. And to be clear, you still have a lot of things going on that are weighing on the dollar.

47:19For example, like I mentioned before, the weakening of monetary policy independence. So I think it takes time for a whole zeitgeist to shift. I wouldn't really just look at this one week and say that, no, things are back to normal.

47:33Demetri Kofinas:So I'm going to move into the second hour, Joseph. I think I've already hinted to listeners where I want to take this conversation. I want to have a larger conversation by capital flight, the consequences of that, a lower dollar. As I mentioned, the white collar recession, which is something that we've explored on this podcast in the past, the political ramifications of what we're describing, I think are very important. And especially for someone like you who puts policy first, I think thinking about how the politics in the country will change is going to be really important for understanding what sort of economy we're going to get.

48:02Demetri Kofinas:Also, to the extent that you have an opinion, I'd love to talk to you about gold, silver also, which I think you've called the OG meme stock. Is that right? Yeah, that's what I think of it. I love that. I want to talk about that too. And also crypto. For anyone new to the program, Hidden Forces is listener supported. We don't accept advertisers or commercial sponsors. The entire show is funded from top to bottom by listeners like you. If you want access to the second hour of today's conversation with Joseph, head over to hiddenforces.io slash subscribe and sign up to one of our three content tiers.

48:35Demetri Kofinas:All subscribers gain access to our premium feed, which you can use to listen to the rest of today's conversation on your mobile device, using your favorite podcast app, just like you're listening to this episode right now. Joseph, stick around. We're going to move the rest of our conversation onto the premium feed. If you want to listen in on the rest of today's conversation, head over to hiddenforces.io slash subscribe and join our premium feed. If you want to join in on the conversation and become a member of the Hidden Forces Genius community, you can also do that through our subscriber page.

49:09Demetri Kofinas:Today's episode was produced by me and edited by Stylianos Nicolaou. For more episodes, you can check out our website at hiddenforces.io. You can follow me on Twitter at Kofinas, and you can email me at info at hiddenforces.io. As always, thanks for listening. We'll see you next time.