By Michael Every of Rabobank
Despite oil prices continuing to slump for now due to the combination of the US SPR release and China’s rolling hard lockdowns, both US equities and US long bond yields saw a sell-off yesterday, with the Treasury curve steepening: US 30s were up 8bp to 2.81%; US 10s were up 8bp to 2.78%; US 2s were 1bp lower at 2.50%, due to that oil trend.
We also had a further round of hawkish talk from the Fed ahead of the CPI reading today, which is likely to see headline inflation rise to 8.5% y/y. (8.5%! Who predicted that a year ago when everything was “transitory”? Hands up, let’s see you!) Usual dove Evans suggested he could back a 50bp hike next month: at the very least it is “perhaps highly likely” to happen. Worse, Waller stated the Fed may cause “some collateral damage” from the “brute-force tool” of rate hikes, with the “tricky part” for it not then also hitting production and employment. Logically that means they are aiming at asset prices. But if you hit asset prices in an asset-based economy, you hit production and employment. Ask the RBA – that’s why their base rate and their yield curve are miles apart. On which note, the US 30-year mortgage rates continue to soar – but is this inflation really just about the housing bubble again?
Even White House economic advisor Deese thinks the US economy is “facing rocky waters”, although is still better placed than others, at least in his eyes. Our own US and Fed watcher Philip Marey just published a report titled ‘Hiking into Recession’. He notes:
“America is better able to deal with an oil crisis than in the 1970s, but only on aggregate. Instead of an international income transfer from the US to the Middle East, it is now a domestic income transfer from consumers to producers, and from the poor to the rich. Since this shock to the US economy is of a new variant, its effect is difficult to predict. If the impact is larger than anticipated by the Fed, the aggressive rate hikes might come at exactly the wrong time. What if low-income households get squeezed by both higher prices and higher interest rates? What if higher prices erode their budgets, deplete their savings and then these households can only borrow at rates that they cannot afford? Hiking into this uncertain environment at a high pace only increases the risk that the economy is pushed into recession.”
So, the Fed are wrong to hike if US consumers are squeezed. However, Philip also argues if consumers shrug this all off, the Fed is still in the wrong. That is because the only way consumers can shrug this off is via a wage-price spiral that will then necessitate a much more aggressive Fed policy response:
“Assuming that the US recovery survives the slowdown in the second half of this year, the Fed is likely to push the economy into recession next year. Our expectation is not just based on the Fed’s current state of panic, and the inversion of the yield curve, but also on the wage-price spiral that appears to have started in the US. At this stage, slowing down the economy severely or pushing it into recession is probably the only way to terminate this process. In other words, if it is not by accident, then it will have to be by design that the Fed’s monetary policy tightening causes a recession.”
The dynamic of how entrenched inflation becomes vs. how much damage the Fed has to do to undo it will be the key driver for the steepening/flattening of the US curve ahead; and for stocks; and perhaps oil too. Red lines look more likely on screens than green ones as a result.
Meanwhile, it is other red lines that regrettably have to be raised today.
While unconfirmed by the Pentagon and Kyiv, allegations have been made that Russia has used chemical weapons against the city of Mariupol. Yes, many will shout ‘false flag!’ And, yes, Russia would shout false flag even if it were true. And, yes, if it is a false flag it is still a deeply worrying signal about the path ahead.
For markets, the initial instinct will be to see that if this allegation is true, the consequences will be further Western escalation, either economic or military. It could involve another push towards energy decoupling – though Germany remains the key obstacle; or an even larger transfer of arms to Ukraine – though Germany remains the key obstacle. Of course, Ukraine is also claiming at least 10,000 civilians have died in the siege of Mariupol, and that does not seem to be generating any additional momentum from large parts of the EU.
However, what markets may not grasp is just how much serious this attack would likely be geopolitically, if proven true. Obviously, markets are uncomfortable discussing war, and weapons of mass destruction (WMD). However: (i) the war is going to keep influencing markets - even if it is not the “Putin price hike” the White House is peddling; and (ii) the people who focus on war for a living are paying very close attention to the chemical weapons story. That’s because, if true, it would be a key step towards the Russian military doctrine of ‘escalate to de-escalate’.
As Breaking Defence puts it:
“Let there be no question: with the war in Ukraine, the nuclear weapons issue has returned as a central one in terms of warfighting, deterrence, and escalation management. The problem is, the US has spent the last three decades siloing nuclear capabilities off into their own box, and hence we are behind the ball on thinking of how to deal with an increasingly desperate foe who sees nuclear weapons not as a final instrument, but as part of the broader orchestra… What we have now is a new situation which we have not imagined or thought about… the idea of Putin using a nuclear weapon - especially a lower-yield, “tactical” nuclear weapon - as part of an otherwise conventional war cannot be ruled out, especially if Ukrainian forces continue to take back territory and fight off the Russian military. How the US and its allies would respond is incredibly unclear.”
The last point is key: nobody knows what the US would do in a WMD situation. Would it escalate to its own nuclear threat? At the other extreme, would it do nothing and so normalize the battlefield use of tactical nuclear weapons? Or would President Biden demand a dialogue with Putin – who would demand his preferred lines on the map to de-escalate? What is the correct response when you face such enormous risks either way?
This backdrop *vastly* magnifies the damned-if-you-damned-if-you-don’t dynamic the Fed now faces. Just like the signs of inflation last year that were brushed aside as “transitory” because nobody wanted to be where we are today, a chemical weapons attack on Mariupol would be a key step towards the above geopolitical WMD stand-off unfolding. I pray the Ukrainian allegation is false, so I can go back to worrying more about the Fed.
Meanwhile, China delivered plane-loads of weapons to Serbia; Newsweek carries allegations that China aims at “controlling foreign governments and societies through economic warfare”; and the FT talks about Chinese investors scouring the globe looking for strategic strips of land… which the Chinese state then moves into.
By contrast, the US-India call yesterday appeared to go reasonably well, with President Biden saying, “The root of our partnership is a deep connection between our people, ties of family and friendship”, and PM Modi stating, “I am confident that our friendship with America will be an integral part of India’s development journey over the next 25 years.” Of course, friends can differ – and there are still very clear differences between the two over Russia. Friendships can also have red lines.
What a chemical weapons attack might mean on those fronts remains to be seen.