Written Mar 31, 2022
March saw “Covid all the time” turn “Ukraine all the time” overnight in mainstream media. Those talking-heads sure can switch scripts without missing a beat on sensationalism.
Of course, the human toll in Ukraine cannot be overstated. But the global impact of this war goes far beyond the Ukrainian borders. The whole world will feel, for a long time to come, significant blowbacks from freezing Russia’s foreign exchange reserves, its banks from the SWIFT payment platform, and its offshore assets. Seizure of global credit flow (reminiscent of the inter-banking crisis of 2008) immediately sounded alarms of systemic risks in the credit market:
- Credit Default Swaps (CDS) got more expensive for sovereign bonds of not only Russia but Poland and Scandinavian countries.
- Value At Risk (VAR) escalated at commercial banks around the world, prompting tighter lending due to higher reserve requirements.
- U.S. junk bond rates spiked, threatening the 75% Zombies corporate borrowers.
Credit seizure also means disruption of capital flow, which creates liquidity bottlenecks around the world. That is to say, the “liquid” (i.e. the world’s Reserve Currency, —the U.S. dollar) that lubricates the global economy becomes more scarce and “expensive”. This chokes off foreign investments in emerging economies at a time of higher input costs, which spells global stagflation.
Meanwhile, sanctioning of trade flow between Russia and the rest of the world worsens pre-existing global shortage (from Covid induced supply chain disruptions), — especially food, energy, and base metals. For rich countries, this will eventually translate to $10/gal gas and $10 a loaf of bread, — back-breaking for lower income households. For 3rd world countries, it will be worse; it may mean Arab Spring. As of March, the Ruble had depreciated by more than 1/3, Russia’s inflation was running 20%, and its GDP was already -12%. The rest of the world will increasingly feel the spill-over effects.
Persistent and worsening inflation will cause demand destruction and hasten recession (“The best cure for high prices is high prices” translates to “Recession is the best cure for inflation”). The 2–10 yield curve flattened even before the Fed rate hike on Mar 17, signaling impending recession. The equity market gradually realized this means both earnings and price-multiple contraction (due to future cash flows discounted back at a higher interest rate). This screams revaluation of currently lofty risk-asset prices (multiple expansion had accounted for 70% of the S&P’s doubling since 2018, — that is a bubble by definition!). Accordingly, volatility (both the VIX and the MOVE indices) spiked. This is the “bad moon rising” presaging decline of both equity and bond prices. Sure enough, by mid-March, the Nasdaq and Smallcaps bumped and ground their way down to “bear market” territory (>20% decline from peak) and the S&P and Dow were hovering around “correction” territory (10% decline from peak).
The latter half of March started with news of a new wave of Omicron breakout all along the Chinese eastern seaboard. Closure of key factories (and the 4th largest port in the world) in tech-center Shenzhen spells further supply shocks around the world. GDP slowdown that already started in China with the collapse of its housing sector will no doubt steepen. The official narrative would have you believe rising PPI is a testament to economic growth everywhere. Reality is, rising PPI means rising input costs and portends higher CPI downstream. And as bad as inflation shock is felt in the U.S., it is MUCH worse in Europe. Things will get more chaotic as this 4th Turning progresses.
Then everything reversed with the most anticipated but least meaningful rate hike by the Fed on March 17. By bringing a pea gun to a war of supersonic missiles (1/4 percent rate hike from zero-base in the face of now 7.9% inflation), the Fed made clear its intention: It is not to fight inflation despite verbiage, but to continue monetizing the Federal government’s deficit spending at near-zero rate, and supporting the “wealth effect” (i.e. Wall Street). The equity market rejoiced and launched a mother-of-all-short-covering rally (exacerbated by dealers taking off hedges in the face of options expiry on March 19) for four straight days.
The bond market was much more somber. Treasuries have been on the down-slide since Dec 2021 without even a bounce. And bonds and stocks are typically positively correlated in times of high inflation (2009 was the opposite case — they were clearly inversely correlated because of deflationary recession). So why was the equity market going up? Simple: It figured that the Fed will preempt recession by pivoting from raising rates to cutting rates sooner than later. In other words, the equity market does not believe the Fed’s hawkish verbiage of 8 rate hikes. The irony is, as long as the equity market keeps going up, the Fed has no reason to pivot. Instead, it has to continue pretending to fight inflation with pea-size rate hikes. The adage is: “The Fed always tightens until ‘something breaks’”. The pivot will come only after the equity market breaks. That may not be far off since the 5–10 yield curve temporarily inverted during the 3rd week of March, further foretelling recession.
Alas, financial and economic calculus didn’t matter in March. March ended the way it started: “Ukraine all the time”. The talking-head sensationalists attributed the equity market rally (in great part a result of quarter-end window dressing) to optimism in Ukraine negotiations. They have no clue that the real driver of risk-asset (i.e. equity and crypto) valuation is sovereign bond yields. They (particularly U.S. Treasury yields) are kept from exploding even higher than they already are by way of BOJ’s Yield Curve Control policy. That is, Japan has been quietly doing the heavy lifting for the U.S. Whether post-Covid, post-Ukraine global inflationary and recessionary pressures will allow BOJ to continue its YCC policy ad-infinitum remains to be seen. If not, entropy will further rise in 2022, as I laid out in January.
