Daily Comment (February 10, 2023)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EST] | PDF

Good morning! Today’s Comment begins with Russia’s latest response to the Western price cap and sanctions. Next, the report discusses what the deepening yield curve says about the financial market. The report concludes with our thoughts on the likely new Governor of the Bank of Japan.

 Russia Retaliates: Moscow will drastically reduce its oil output in response to EU sanctions on Russian oil, and there are rumors of Russian belligerence toward a NATO ally.

  • The Kremlin will cut its oil production by 500,000 barrels a day next month. The move comes as Russia hits back at the West for implementing a price cap on its petroleum. The decision was unusual as it was done in isolation of the Organization of Petroleum Exporting Countries, although it is likely that the group was warned before the announcement. Members within OPEC may make up for the drop in production at their next meeting. However, the size of the cut and the group’s alignment with Russia makes the likelihood of a complete offset relatively low.
  • Moscow’s reaction shows that Western sanctions on its commodities are hurting its economy. The restriction has limited Russia’s ability to fund its government expenditure. The country’s current account surplus shrank by 58.2% in January, largely due to a sharp drop in export volumes. The lack of revenue from oil will make it more difficult for Russia to ramp up its war efforts in Ukraine. The pullback in production also creates the risk that some of its oil wells will permanently be idled. As a result, this drop in oil output could have a lasting effect on crude markets.
    • This may be a game of chicken. U.S. officials wagered that keeping oil prices above Russia’s break-even of $60-$70 a barrel would possibly incentivize Russia to keep production flowing despite the price cuts. Therefore, Russia’s decision to cut output may be a way for it to pressure Washington to abandon this strategy.
  • A Ukrainian newspaper reports that two missiles entered a NATO member’s airspace. The Kyiv Independent claims that two Russian Kalibr cruise missiles entered Romanian airspace after crossing the border between Ukraine and Moldova. If true, the incident could spark a direct confrontation between NATO and Russia. The incident comes a day after a journalist accused the U.S. of blowing up parts of the Nord Stream pipelines. So far, none of the major media outlets are carrying the story, and thus, there is a possibility that this may not be true.

 Bond Warning: The Treasury market has been signaling that a recession is imminent for months, and investors are worried about what that may mean for the next downturn

  • The yield-curve inversion fell to its deepest level in over 40 years. The gap between the two-year and 10-year Treasury yields widened as much as 86 bps, indicating that financial conditions are deteriorating. The spread is related to investor beliefs that the Federal Reserve will continue to raise rates until inflation is under control. Therefore, the inversion was driven by short-term interest rates rising faster than long-term rates. The underlying belief of bondholders is that the Federal Reserve will eventually win the fight against inflation.
  • The fast rise in the short end of the yield curve relative to the long end has worried equity holders. Hence, the deep inversion equities were sold off as investors feared Fed tightening could worsen a recession. The S&P 500 fell 0.9% from the previous day, and tech stocks led the decline as the NASDAQ fell 1.1% in the same period. Meanwhile, optimism that the Fed will eventually be able to curb inflation has led to a rise in the greenback. The U.S. Dollar Index (DXY) rose 0.6% on Thursday, driven mainly by the decline in the EUR.
  • Equity traders and bondholders are working from two different narratives of the war on inflation. Stock traders assume that the Fed will eventually blink and end tightening before inflation falls to its 2% target. Meanwhile, bond investors are operating on the assumption that the Fed will succeed in reducing price pressures. The winner of this debate will have an impact on portfolios. If the equity market is correct, it means that interest rates on the long end are way too low and should begin to rise to a new high. On the other hand, the S&P 500 may experience a new low if the bond market is proven correct.

The Chosen:  Haruhiko Kuroda’s successor has finally been selected; however, markets are still unsure about what this may mean for the JPY.

  • Japanese Prime Minister Fumio Kishida nominated Kazuo Ueda to take over the country’s central bank. Ueda is a professor and former Bank of Japan member. The move came as a shock to the market as it was widely expected that Deputy Governor Masayoshi Amamiya would be selected for the job. Ueda is seen as more hawkish than Amamiya, and as a result, the JPY rallied following his surprise nomination as investors speculated that he would pave the way for the end of yield-curve control.
  • Moments after his nomination, Ueda stated that the current monetary policy is appropriate. This led to a trimming of much of the gains made in the JPY and suggested that the bank may still need to finish implementing its ultra-accommodative monetary policy. That said, his remarks may have also been meant to prevent another speculative attack on the peg of its 10-year bonds. Therefore, the Bank of Japan may intervene in the bond market to ensure that the 10-year yield cap remains within the 50 bps target.
  • Rising inflation and a weaker JPY will continue to lead to expectations that the BOJ will pivot. The bank has earned a reputation as a widow maker for its willingness to clamp down on traders wanting to challenge its policies. Although it is likely safe to assume that the central bank is ready to move away from the nearly seven years of yield-curve control, they will certainly do it on their terms and not the markets. Consequently, the transition’s timing and pace will not be known for some time. However, the switch will likely lead to an increase in demand for Japanese bonds.

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