Chain Reactions

By Benjamin Picton, Senior Macro Strategist at Rabobank

Markets remained largely in risk-off mode. That’s understandable; two days with no liquidity or price discovery feels like an age in the current environment. The S&P500 was down 1.26%, gold climbed $7/ounce, the Swiss Franc performed well, USDJPY hovers threateningly below the 150 level and most soft commodities sold off. Bonds, crude oil and coffee managed to buck the trend. US 10y yields were down 7bps as markets walked back from the ledge of the 5% psychological level and who can blame anyone for putting a bid under coffee? They must be going through plenty of it in the White House Situation Room (more on that below).

The flow of data on Friday contrasted European weakness with a Japanese economy gathering steam. UK retail sales ex auto fuel was down 1% in September. The Office of National Statistics blamed unseasonably warm weather for households delaying purchase of their winter woollies. This analysis may be taking British preoccupations with the weather to new heights; the volume of retail turnover has been trending down since May 2021 and the household goods category was also very weak in September.

German September PPI figures also printed very soft on Friday. The m-o-m figure was -0.2%, which translates to -14.7% y-o-y. That’s the biggest year-on-year fall since records began in 1949, driven largely by falling energy prices. The implication is that there is quite a bit of deflation coming down the production pipeline in Europe, which ought to add to conviction among ECB officials that there is no need to hike rates any further when they meet later this week.

While the data in Europe pointed towards deflation, in Japan it was a different story. The Nikkei reported over the weekend that BOJ officials are considering another fiddle with their yield-curve control policy to allow JGB yields to push above the current 1% ‘flexible’ limit. The report is unsourced, but adds to market perceptions that the BOJ’s easy-money policies are unsustainable.

The timing is interesting. Last week saw core measures of national CPI for September print higher than expected, and the BOJ conducted unscheduled bond-buying operations after the yield on 10-year JGBs hit a decade high of 0.815% on Wednesday. That didn’t stop yields from going higher still the next day. They ultimately closed at 0.845% on Thursday afternoon. Keep an eye on Tokyo CPI later this week.

Evaporating monetary easing from the Bank of Japan comes at a delicate moment. The USA is running colossal deficits to finance their guns and butter spending, China is selling Treasuries to defend the CNY, and Argentina *could* be poised to elect a Libertarian President who has promised to dollarize the economy.

The threat of a global liquidity squeeze raises questions for markets where fragilities have already been exposed by the UK pension blowup and the mini banking crisis in the USA and Switzerland. A scramble for cash is underway, which probably means that somebody is going to miss out. What does that mean for emerging markets that the USA needs to keep in the geopolitical tent? If the BOJ retracts the control rod of yield curve control from the monetary reactor core, will this set off a chain reaction in bond markets that will break something else?

Geopolitics is once again rightly in the financial headlines. The Middle-East is very close to triggering the first link in a chain that could lead to the regional war we flagged after the 7 October Hamas attack: Israel's Gaza ground offensive.

This weekend saw incoming exchange of fire from Hezbollah, the Iranian proxy in Lebanon, and Houthis in Yemen sent cruise missiles and drones towards Israel which were shot down by a US warship. There have also been attacks on US forces in Iraq. Recognising these escalation risks, the US is shifting more missile defence systems to the region. Reportedly, in perhaps an important signal, the crew of the USS Ford, the super carrier in the East Med, were served lobster and steak on Saturday, something only done on holidays or before announcements negative for moral, such as extended stays at sea, or military action.

Meanwhile, Israel has vowed to cut off 'the head of the snake' and launch a military attack against Iran if Hezbollah joins the war with Hamas - the second and third links in the chain that may follow rapidly after the first.

This is as the West sees massive street demonstrations against Israel and fewer, smaller ones for it. There has also been a surge in anti-Semitic attacks, leading to worries about social stability and 'lone-wolf' terrorism (e.g., a progressive Rabbi was found stabbed to death outside her home in Detroit this weekend). Both Al-Qaeda and ISIS have called on their remaining followers to attack Jewish and Western targets where they can, and the Dutch justice minister, a prospective future PM, has warned Europe is at risk from the war, which "will get translated to our societies". One such translation into Swiss-German may be the sharp swing to the right seen in weekend parliamentary elections. 

However, the situation is even more concerning. We had already flagged that the risks of a Mid-East conflagration would suggest to some actors that the US would lose focus on the Indo-Pacific, and against that backdrop China and the Philippines are now in another tense stand-off in the South China Sea. The former is physically preventing the latter from resupplying one of its outposts in maritime territory both claim. Note that the US recently publicly underlined its bilateral defence treaty with the Philippines, and stated it would defend it against any attack. Is a geopolitical test being made of the US ability to afford a three-front global escalation, not just two?

As Axios notes: 'Behind the Curtain: Rattled U.S. government fears wars could spread'.

"Never before have we talked to so many top government officials who, in private, are so worried about so many overseas conflicts at once.

Why it matters: We don't like to sound dire. But to sound a siren of clinical, clear-eyed realism: U.S. officials say this confluence of crises poses epic concern and historic danger."

We underlined exactly this kind of deliberate test of US hegemony back in 2018's 'The Rise and Fall and Rise of the Great Powers (and Great Currencies)'. Here we are, five years later, perhaps for real.

Even the Federal Reserve now warns of growing geopolitical risks to the global financial system. And if they are finally prepared to talk about it, markets should be concerned.

This is going to be a very tense week. And, sadly, it's hard to see a realistic off-ramp. The confluence of risks in the Middle East threatens a geopolitical chain reaction that has the potential to make monetary reactions look like small beer by comparison.