Daily Comment (May 11, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment begins with an update on the Russia-Ukraine war.  We next review a range of international and U.S. developments with the potential to affect the financial markets today, including confirmation that the European Central Bank will hike its benchmark interest rate in July.  We end with the latest news on the coronavirus pandemic.

Russia-Ukraine:  The Ukrainian military continues to push Russian troops away from the northeastern city of Kharkiv, reportedly to an area less than ten miles from the Russia-Ukraine border.  In response, the Russian military is reportedly redeploying troops to that area from their operations around the northeastern city of Izyum, which will likely further stall their advance southeasterly from that city.  Meanwhile, Russian and Russian separatist forces continue trying to encircle Ukrainian troops in the eastern Donbas region even as they keep trying to mop up the last Ukrainian resistance in the destroyed city of Mariupol.  Separately, the Belarusian military has stepped up its military exercises along its border with the Baltic states and Poland, probably a signal of its ongoing political support for Russia’s invasion of Ukraine.

Sri Lanka:  As an example of the unrest that could be unleashed by rising prices for food and other essentials, violent protests continue against Sri Lankan President Gotabaya Rajapaksa, despite his brother’s resignation as prime minister yesterday.  The army is now enforcing a nationwide curfew and threatening to shoot looters, but the government appears to be on the brink of collapse.

European Union:  Wrapping up an EU self-assessment process that included town hall meetings with citizens, French President Macron has proposed a system of tiered EU membership levels.  Full EU members would be the core of the group, while a second-tier would consist of countries that are official candidates for membership.  A broader “European political community” would also include democratic European countries adhering to EU values, such as the rule of law and freedom of the press.

  • The broader “political community” group would potentially include countries like the U.K., Ukraine, Moldova, and Georgia.  Members of the group could cooperate with the core EU and EU candidates in areas such as security, energy, and infrastructure. They would not necessarily be guaranteed eventual full membership in the EU.
  • Feeding suspicions that the proposal is merely a way to push off current EU aspirants, Macron offered no specifics on what obligations the broader group would have to meet along with its rights.  He also glossed over the immense difficulties that would be involved in changing EU treaties to accommodate the new EU organization.
  • Along with Macron’s push for Europe to build its own “strategic autonomy” in defense, it’s tempting to write off his “European political community” as an unrealistic gambit that couldn’t be implemented for years at best.  Yet, Macron’s visions validly reflect a sense that Europe is now much stronger than when it lay in ruins at the end of World War II.  Macron’s proposals validly reflect the idea that Europe can and should take more initiative in providing for its own defense, and it needs to streamline its decision-making even as it expands to include more members.
    • If something like Macron’s visions were put into practice, Europe could become a stronger and more valuable partner for the U.S. as it works to sustain liberal democracy and free market capitalism in the face of rising authoritarianism.
    • The downside is that such visions could also tempt the EU to form its own geopolitical and economic bloc separate from the evolving U.S.-led bloc, as we described in our latest Bi-Weekly Geopolitical Report.

United Kingdom-European Union-Ireland:  British Prime Minister Johnson yesterday signaled he is ready to tear up the U.K.-EU deal laying out post-Brexit trading arrangements for Northern Ireland, calling the agreement “not sustainable in its current form” despite an appeal from his Irish counterpart not to take unilateral action.

  • As we’ve noted, last week’s regional elections in Northern Ireland have sparked a crisis.  Irish nationalist party Sinn Féin won the most seats in Northern Ireland’s legislature, so it has a right to name the region’s first minister.  The Good Friday Agreement of 1998 would require Sinn Féin to share power with the Democratic Unionist Party (DUP), the biggest party seeking to keep Northern Ireland in the U.K., but the DUP is refusing to form a government unless the post-Brexit trade protocol is scrapped.  Johnson is signaling he will throw his weight behind the DUP.
  • The tug of war raises the prospect of months of political limbo in which Northern Ireland would have no functioning chief executive.  If no new chief executive is in place in 24 weeks, Northern Ireland would have to hold new elections.
  • More importantly, London is already drafting legislation that would allow the U.K. to abandon the protocol, as the DUP is demanding.  That move would likely spark an economically disruptive trade war with the EU.

European Union Monetary Policy:  In a speech today, ECB President Lagarde said her central bank is likely to hike interest rates and stop expanding its balance sheet as early as July.  The remarks are a clear sign Lagarde supports the growing number of ECB officials that have called for a 25-basis-point rise to the ECB’s deposit rate at its July 21 policy meeting.  The deposit rate is now -0.5% and has been in negative territory since 2014 when it was lowered to help fight the region’s debt crisis.

  • Despite Lagarde’s statement, the ECB is not expected to tighten policy nearly as aggressively as the Federal Reserve.  Like most other major central banks, the ECB simply isn’t as behind the curve in fighting inflation as the Fed.
  • With the ECB and other major central banks continuing to tighten policy slower than the Fed, the euro and other major currencies are likely to remain relatively weak against the surging dollar.  The chief investment officer at Europe’s largest asset manager recently said the euro should be trading at parity with the dollar within six months, i.e., its value would fall from $1.05 now to just $1.00.

U.S. Monetary Policy:  The Senate yesterday confirmed President Biden’s nomination of economist Lisa Cook as a governor of the Fed by a party-line vote of 51-50, with Vice President Harris casting the deciding vote.  The Senate is also expected to approve two other Biden picks this week, including economist Philip Jefferson as a governor and Jerome Powell as chair of the board of governors for a second term.

U.S. Digital Currency Regulation:  After stablecoin TerraUSD “broke the buck” this week, as we described in our Comment yesterday, Treasury Secretary Yellen testified in Congress that the incident calls for legislation that would authorize regulating the product.  We continue to believe that digital assets will face growing regulation over time.

COVID-19:  Official data show confirmed cases have risen to  518,814,718 worldwide, with 6,256,004 deaths.  The countries currently reporting the highest rates of new infections include Germany, France, South Korea, and the U.S.  (For an interactive chart that allows you to compare cases and deaths among countries, scaled by population, click here.)  In the U.S., confirmed cases rose to 82,060,805, with 998,069 deaths.  In data on the U.S. vaccination program, the number of people considered fully vaccinated now totals 220,223,617, equal to 66.3% of the total population.

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