With a Trump-led Fed getting closer, let's step through this framework we've been discussing all year — how the Fed plays into bringing Europe back into alignment with the U.S., and how the end game is isolating China.
In yesterday's note, we talked about Kevin Warsh's view on the Fed balance sheet — that it's grown to the point where it's become "fiscal policy in disguise," and that it's time for the Fed to get out of the fiscal business.
That's regime change coming at the Fed.
And this should restore the important role of the market in disciplining the government's tendency toward profligate spending. Market discipline means accountability, because market penalties mean higher rates (higher risk premiums).
So, as we discussed yesterday, this Fed regime change should bring fiscal discipline for the current and future governments (by design).
It should be good for the dollar, and dollar assets.
And in the near term, it should clear the way for lower interest rates, because getting the Fed out of the government financing business should remove the structural reason rates are high (the fiscal profligacy premium).
With that, if we wonder where Warsh thinks rates should be, based on the economy, back in February, when he wasn't holding anything back, he said "AI is going to make everything cost less," and that "we are at the front end of a productivity boom."
In fact, he said "we are probably in the early innings of a structural
decline in prices."
Now, this Fed regime change creates a serious problem for Europe.
We talked in our February 5 note (here) about how the Trump-led Fed exit from the QE era (and end to its role as the "global central banker to the world") would put Europe under the gun.
Why?
The ECB has been doing its own version of fiscal policy in disguise for the better part of a decade, buying the debt of fiscally vulnerable euro zone sovereigns to keep the doom loop from collapsing the entire system.
The difference is the Fed backstops the dollar, which is the world's reserve currency. The ECB doesn't have that privilege. And when the Fed steps back from its role as the implicit backstop of the global system, the ECB will be scrambling for the liquidity it needs to prevent its solvency problem from rearing its head.
The screws will be turning on the ECB.
And as we've discussed often in these notes, that reality could be the catalyst for political change in Europe — a populist shakeup, moving Europe back into alignment with the United States (away from China, away from the "third pole" posturing).
And then there's China.
Today the White House and the House Select Committee on China moved in coordination to publicly frame Chinese AI model theft as a national security threat — and deployed the export controls against it.
Meanwhile the Wall Street Journal reports today that the Iran war has drawn down U.S. munitions stockpiles to the point where some officials are worried about a readiness for a different Strait — Taiwan.
As we've discussed, the ramp in the U.S. defense industrial base that's been underway since early this year (to a planned 4 times the amount pre-Iran strikes) suggests that war capabilities are being sized for something bigger than Iran (i.e. China). The Pentagon announced Tuesday a $1.5 trillion budget request for 2027, the largest in U.S. history.
So, we have Fed reform coming at home. Dollar leverage over Europe. Industrial mobilization against China. All following the framework we've been discussing, and all in the same week.
