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

Luke Gromen argues that Wall Street consensus expects Kevin Warsh to be hawkish at his first Fed meeting as chair, but this misreads the situation. 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 debt problem in a disinflationary manner driven by AI and technology. Gromen calls this a fairy tale, arguing US debt at roughly 122 percent of GDP and deficits running at approximately 6 percent of GDP are too large to finance without Fed support.

The original Warsh plan had internal logic before the current inflationary environment: cut the front end, sell the long end, use bank deregulation to let banks absorb Treasury supply via near-infinite leverage on government debt, and overlay an AI-driven disinflationary narrative. Gromen describes this bank deregulation mechanism as functionally equivalent to QE conducted through banks rather than directly by the Fed, with the temporary SLR suspension in Q2 2020 as a precedent. The tariff war and the Iran conflict have severely complicated or broken this plan. The Iran war has driven headline CPI above 4 percent, the US defense budget has risen from approximately one trillion to one trillion five hundred billion dollars, and Scott Bessent's three-arrow fiscal plan has effectively been abandoned. Gromen says Bessent was not consulted on the war decision.

Gromen identifies the fundamental binary choice Warsh must make as sacrificing the dollar or sacrificing the bond market. He predicts Warsh will not stand aside and allow Treasury market dysfunction, making him not meaningfully different from Powell in practice. Gromen expects Warsh's public role to be presenting a disinflationary narrative while actual policy remains inflationary. The market configuration of stocks down, bonds down, and dollar flat or down simultaneously is what Gromen calls the Fed's worst nightmare. He interprets dollar down, bonds down, and stocks down simultaneously as capital flight out of the dollar, noting CIPS volumes have exploded as entities route around US dollar sanctions. The same price action appeared after Liberation Day for one to two weeks before Trump paused tariffs. Gromen notes gold and Bitcoin rising together signals something wicked is coming.

Gromen predicts that sometime between now and Labor Day, US oil storage tanks hit bottoms and oil prices spike sharply, rippling into fertilizer, crop planting expectations, and broad inflation, pushing the US fiscal 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 facing rising oil prices will sell Treasuries to raise dollars, triggering a debt spiral. He acknowledges AI will eventually be disinflationary but places that outcome five to ten years away.

On China, Gromen says the overwhelming consensus three months ago was that China was more economically damaged than anyone by the Hormuz blockade, but that consensus has proven wrong. China's oil imports have fallen by approximately four to five million barrels per day without the economy collapsing, explained by massive EV infrastructure buildout and approximately 1.8 billion barrels in its strategic petroleum reserve, with EV charging usage up 55 percent year over year. China's strategic posture is to let the strait stay closed and wait for US, UK, and EU bond markets to blow up. An F-15 was reportedly shot down by a Chinese shoulder-fired missile according to NBC citing Pentagon officials, China provided high-end long-range radars to Iran capable of detecting US stealth technology, and Russia is shipping supplies into Iran via the Caspian Sea while China does so via rail.

Gromen identifies Japan as ground zero for a potential financial implosion. Japan and Korea have been trading like emerging markets since late last year, where higher relative yields drive weaker currencies rather than stronger ones, signaling markets believe elevated yields indicate proximity to a debt crisis requiring currency debasement. China has weaponized gold purchases over the past three years to defend the yuan and is buying more gold as gold prices fall, the opposite of what analysts predicted. China has established offshore yuan clearing banks at every major gold trading hub and swap lines with approximately 185 countries excluding the United States, which Gromen says has drastically reduced the value of dollar swap lines as a geopolitical tool.

Global bond yields are breaking out everywhere except China, and Gromen says this is bad for bonds, stocks, risk assets, gold, and bitcoin in the near term. US equity valuations are in what he calls silly season, pointing to an adjusted Warren Buffett metric that subtracts US federal debt from total equity market cap before dividing by GDP. That adjusted metric is now higher than at any point in the past 65 years, exceeding levels seen in the first quarter of 2000 and the fourth quarter of 2021, both of which he identifies as terrible times to own stocks. Gromen expects real pain in markets will be needed before authorities inject significant liquidity, and believes the Fed will ultimately buy every bond it has to in order to maintain Treasury market functioning and will monetize all of it if necessary.