Warsh Must Choose The Dollar Or The Bond Market | Luke Gromen

Kevin Warsh is widely expected to be hawkish at his first Fed meeting as chair, but Gromen argues this reading misses important context. Warsh co-authored a Wall Street Journal op-ed in December 2018 urging the Fed to stop hiking, and wrote another last fall arguing the US can grow out of its fiscal problem in a disinflationary manner driven by AI and technology, analogous to the 1990s. Gromen calls that narrative a fairy tale. He frames Warsh's real situation as a binary choice between sacrificing the dollar or sacrificing the bond market, and predicts Warsh will eventually implement a bond market put and begin buying bonds despite prior statements against it. Warsh's public role, in Gromen's view, will be to appear on television arguing that policy is disinflationary when it is actually inflationary, with trimmed mean inflation serving as his preferred measure precisely because it is the lowest available.

The structural driver of repeated Treasury market dysfunction since 2020 is that US debt is too high and there is not enough balance sheet to finance it without Fed assistance. Debt to GDP stands at roughly 122 percent with deficits running at approximately 6 percent of GDP, driven by interest costs, entitlements covering 65 million boomers, and defense spending that has risen from one trillion to one and a half trillion dollars, all three of which Gromen considers politically untouchable. The Iran war has pushed headline CPI above 4 percent and will increase the deficit further, effectively discarding Bessent's three-arrow fiscal plan. Gromen notes that Bessent publicly criticized Yellen's buyback policy in 2024 but doubled the rate of Treasury buybacks after taking office, which he interprets as evidence that Bessent changed course once he saw the actual fiscal situation from inside the chair.

Warsh's plan as Gromen describes it involves cutting the front end of the yield curve while shrinking the Fed balance sheet to steepen the curve, combined with bank deregulation removing leverage requirements so banks can absorb the treasuries the Fed is selling. This effectively functions as quantitative easing channeled through the banking system rather than directly through the Fed, using the temporary SLR suspension in Q2 2020 as the precedent. The administration shifted Treasury issuance to the front end over roughly two and a half years because the back end was blowing out, but Gromen argues starting an inflationary war while issuance is concentrated at the front end is self-defeating because rising inflation sends front-end rates higher. He predicts the Strait of Hormuz stays closed through fall, with inflation rippling through oil, fertilizer, and crop planting expectations simultaneously, pushing the deficit from roughly 6 percent toward 8 to 10 percent of GDP.

Foreigners hold 13 to 14 trillion dollars in dollar-denominated borrowings and 27 trillion dollars net in dollar assets including 9.5 trillion in treasuries. Gromen predicts foreign holders will sell treasuries to raise dollars to buy oil and cover dollar borrowings as rates spike, risking a debt spiral. He was shocked that the dollar did not rise during a recent risk-off episode given typical safe-haven behavior, and argues that energy and food rank higher on Maslow's hierarchy of needs than treasuries or dollar assets, which is why capital can flow toward commodities instead of dollars under stress.

China's oil imports have dropped by four to five million barrels a day without China economically collapsing, partly because EV charging infrastructure usage in China rose 55 percent year over year and China holds approximately 1.8 billion barrels or more in its strategic petroleum reserve. Gromen argues China's strategic posture is to let the Strait stay closed because China anticipates US, UK, and EU bond markets are about to blow up. He also reports that an F-15 was shot down by a Chinese shoulder-fired missile, that China provided high-end long-range radars to Iran capable of detecting US stealth technology, and that Russia is shipping military supplies into Iran via the Caspian Sea while China does so via rail.

The UAE leaving OPEC enables it to ramp production beyond OPEC quotas, and Gromen says the UAE told the US it would start pricing oil in yuan if dollar swap lines were not provided, after which Bessent quickly promised those swap lines. China has established offshore yuan clearing banks at every major gold trading hub globally, allowing surplus yuan holders to exchange yuan for gold, amounting to a petro-gold system. China also has swap lines with approximately 185 countries excluding the United States, which has drastically reduced the value of dollar swap lines as a geopolitical tool because countries now have a credible alternative.

Global bond yields are breaking out everywhere except China, which Gromen calls a negative signal for all risk assets simultaneously including bonds, stocks, gold, and bitcoin. He created an adjusted Buffett metric defined as total equity market cap minus US federal debt divided by GDP, and says the current reading is higher than in Q1 2000 and Q4 2021, the highest in 65 years, both of which were terrible times to own stocks. He predicts authorities will not inject mass liquidity yet and that real market pain must occur before a policy response, while acknowledging he was too slow to react to rising yields in early 2022 and does not want to repeat that mistake.