The Band - Strength, Death, & Reserve Regimes

Letter to Readers

Almost every dollar in the world started life as someone’s debt.

That is not a metaphor. Under the credit-based monetary system the planet has been running on for the better part of a century, money is loaned into existence. Banks extend credit. Sovereigns issue credit. Central banks accommodate credit. New dollars enter the system as liabilities matched to assets that have not yet earned them.

The one narrow exception is base money, meaning physical currency, coins, and reserves held at the Federal Reserve. Base money is not anyone else’s liability. It exists as a direct claim on the issuing authority, and only the US Treasury and the Federal Reserve can create it. Everything outside that perimeter is created by someone, somewhere, willing to extend dollar credit against their own balance sheet, which means putting their own capital at risk to bring a new dollar into the world.

The broader dollar supply is, by construction, the broader dollar debt outstanding. You cannot have the one without the other, and nothing about the design lets you separate them.

That single fact changes how the dollar system has to be understood.

We have written before about carry trades, a trade where capital borrows in a low-yielding currency, parks the proceeds in a higher-yielding one, and collects the spread until something moves and the trade unwinds.

Based on the monetary systems design, countries outside the United States must run two carry trades at all times, whether they want to or not, and the reason is structural. Because the overall global monetary system is debt-based. And each individual country’s monetary system is also debt-based.

Those are two separate facts, but they stack.

The first creates the global carry trade. Because dollars are the unit needed to operate on the global stage, every economy of meaningful size sources dollar funding in the eurodollar market, earns dollar revenue against that funding from exports, trade-finance receivables, and offshore operations, and runs a constant dollar book on top of its local book.

The second creates the local carry trade. Each country’s own banking system loans its own currency into existence the same way the dollar system loans dollars into existence, which means every domestic balance sheet is also long real assets funded by liabilities denominated in the local credit unit.

Both carry trades exist simultaneously, and both have real world implications.

The reason this combination is dangerous is that currencies trade relative to each other. Both carry trades cannot work at the same time. When the dollar is weak, dollar funding is cheap and the global carry runs easily, but the local currency strengthens, the export economy that feeds the local carry stops competing, and the local carry tightens. When the dollar is strong, the local currency depreciates, the export economy regains its margin, and the local carry eases, but the dollar funding cost climbs, the dollar book gets harder to service, and the global carry tightens.

Whichever way the relative pair moves, one of the two carries is going against them.

That is the structural fact countries outside the United States cannot get out from under. There is no setting of the dollar at which both carries work. The dual carry is not a description of two books on a balance sheet. It is a description of a position the rest of the world is forced to hold in which one side is always under pressure, and the only question in any given cycle is which one.

The United States runs only one carry trade.

The country that issues the reserve currency runs a debt-based domestic banking system, like everyone else, and carries the local carry that comes with that. What the United States does not carry is the second one, because its external obligations are also denominated in the same unit it issues, which means the relative-currency move does not generate a second front of pain on its balance sheet the way it generates one on every other balance sheet on earth.

That asymmetry is the structural advantage the rest of the world has been trying to escape for half a century, and the structural advantage the rest of the world keeps failing to escape.

The deeper point sits underneath both observations. Because the broad global dollar supply is loaned into existence, the entire global monetary system, outside the monetary base, is itself a single, planet-scale carry trade.

Every credit-created dollar in circulation has a corresponding dollar liability somewhere on the other side of the ledger, and the system stays alive only by rolling that liability forward. The act of expanding the broad dollar supply, which is the only thing that puts sustained downward pressure on the dollar index, is the same act that creates more dollar debt. The act of withdrawing the broad dollar supply, which is the only thing that lifts the index, is the same act that liquidates the carry that the prior expansion built.

The system is not designed for either extreme. It is designed to keep rolling, inside a workable band, and the moment the band breaks in either direction, something on the other side of someone’s balance sheet has to break with it.

We are calling this paper The Band, because the phrase does several jobs at once.

It is the price corridor the dollar has to stay inside for the system to function, in the same sense that Tommy Norris on Landman lays out the price corridor crude has to stay inside for the oil patch to function. It is the act the United States is supposed to be managing, the one the Fed and the Treasury are meant to keep on tour and inside the arena, even though the rock star has its own gravitational pull and does not always listen. It is the band the kids cannot stop listening to, even as their parents warn of its dangers and try to ground them. It is the band that no matter how many obituaries get written, keeps showing up to play.

We use the Rolling Stones as the spine of the piece. Their arc and the dollar’s arc track each other almost beat for beat from the early 1960s forward, and the catalog of songs gives us a vocabulary the reader already knows.

The Dollar Milkshake is referenced throughout this paper as the lens through which we view the dollar system, but we do not re-derive the framework here; readers new to the concept can find the original treatment in prior Santiago Capital work and on our website.

Simply put, our view is that the dollar is not dying. And the system is built so that it cannot die of weakness, because every move toward weakness creates more of the dollar debt that keeps the world inside the system. If it ever does die, it will die of strength, because only strength forces defaults severe enough to push the rest of the world to actually build the alternative.

As such, the endgame the consensus keeps writing about has been kicked much further down the road than the consensus believes, and the reasons are structural, not cyclical.

One last structural point belongs in this report, because it sits underneath everything that follows.

Only the US Treasury and the Federal Reserve can create base money. Every other dollar in existence is credit, loaned into existence against someone else’s balance sheet, somewhere outside the perimeter of US base money.

The eurodollar market sits entirely outside that perimeter, by definition. There is no base money in the eurodollar market, with the exception of whatever physical bills and coins are currently circulating there. In other words, every eurodollar deposit is a claim on a bank that itself holds claims on other banks that hold claims on still other banks, with no settlement asset at the bottom of the chain that is not itself someone else’s liability.

To be clear, the eurodollar market is not partially levered. And it is not selectively levered.

It IS leverage, end to end, all the way down.

That fact does not show up in the regular conversation about the dollar system because the regular conversation about the dollar system is mostly about US-domestic monetary aggregates, which are anchored by base money. The conversation that matters for the rest of the world is the eurodollar conversation, and that conversation is a conversation about pure credit.

We come back to this in the Sympathy for the Devil section because the structure of where the leverage sits determines the structure of where any eventual break would propagate.

The pages that follow lay out the case.