Daily Comment (November 18, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

The Daily Comment will go on hiatus beginning Wednesday, November 23, and will return on Monday, November 28. 

Guten Morgen! Today’s Comment begins with our thoughts about the growing financial stress within the international banking system. Next, we discuss how the dollar is faring against countries with opposing monetary policies. We end this report with a discussion about the easing of geopolitical tensions and its impact on financial markets.

 Global Liquidity: As international financial conditions weaken, there are growing concerns that banks are struggling to meet short-term obligations.

  • Financial stress is on the rise in major economies across the world. Rising interest rates in China (one-year note yields jumped nearly 25 bps this week) have triggered investor withdrawals from fixed-income products, as investors fear rising rates will lead to principal losses. Regulators have made unscheduled inquiries of Chinese banks to check their ability to meet these withdrawals. The areas of concern are “wealth management products” which seem to be similar to Western ETFs. They offer higher yields compared to bank deposits, but also offer daily liquidity. However, they are also “mark-to-market” products, meaning that their prices fall as rates rise. We expect the PBOC to prevent runs, but the snap rise in yields is revealing some fragility in China’s financial system.
  • At the same time, a financial stability review conducted by the European Central Bank showed that investment funds are lacking the sufficient liquid assets needed during a financial crisis. Meanwhile, the lack of demand for U.S. Treasuries, especially in the off-the-run coupons, has led to volatility in bond prices. The issues with the international financial system are in part due to global monetary tightening.
  • Although our base case is that the upcoming recession will likely be “garden variety,” a financial crisis could worsen a downturn. It is unclear how the financial system will cope if Fed officials follow through on their plan to raise rates to between 5% and 7%, but the unusually high level will likely add to the ongoing woes. Although central bankers have consistently argued that this time will be different, history shows us that overconfidence leads to blind spots. The shadow banking system is likely a pain point as these institutions sometimes operate with leverage and little transparency. That said, the Federal Reserve reassured markets that it has the tools needed to prevent a liquidity crunch from causing a panic. Unfortunately, the current market structure may be inadequate given the size of government and private sector debt. Without reforms (e.g., clearinghouses for Treasuries, and expansion of market makers) the current system is prone to “freezing,” meaning that bond holders may find it difficult to liquidate holdings.

Different Directions: While most advanced economies aim to tame inflation through tight monetary policy, Japan is determined to keep policy accommodation in place.

  • Japanese inflation accelerated to its fastest pace in over 40 years. Both headline and core CPI rose above the Bank of Japan’s 2% target, increasing to 3.6% and 2.5% from the prior year, respectively. Despite the disappointing report, the central bank has blamed price increases on factors beyond its control. Its position isn’t a surprise. The bank’s insistence on maintaining low-interest rates is likely related to it not wanting to increase the cost of government. Keep in mind that Japan’s government debt to GDP ratio is higher than Greece’s and almost twice the size of Italy’s. Japan has been selling Treasuries to prevent further JPY weakness, exacerbating the problem described above.
  • While Japan is going one way, the Eurozone wants investors to believe it is going in the opposite direction. According to European Central Bank President Christine Lagarde, Eurozone interest rates may need to be lifted to levels that hinder growth in order to tame inflation. Additionally, she emphasized that the central bank must also reduce the size of its balance sheet if it wants to get inflation under control. Her remarks reinforce our view that the central banks are more focused on restoring price stability rather than increasing economic activity. As a result, we suspect that central bank tightening during a recession will prolong a downturn within the bloc.
    • Despite tough talk from Lagarde, we have doubts about how aggressive the ECB is willing to get in order to tame inflation. Earlier this year, the central bank expressed concerns about the possibility of fragmentation, a problem that only worsens as monetary policy tightens. Thus, her comments may be related to propping up the EUR rather than a genuine commitment to fighting inflation.
  • So far, the JPY and EUR have not been adversely impacted by the recent developments despite offering their opposing commitment to price stability. In fact, the DXY index, which compares the USD to peer currencies, is down 0.1% as of this writing. The limited movement in currencies may reflect investors’ hopes that, despite recent Fed comments, the central bank is almost done with its hiking cycle. As mentioned in our previous reports, central banks in advanced economies typically keep rates elevated for longer periods than the Fed. Possible de-escalation of geopolitical tensions is also another potential source of relief. In short, the USD’s rise may be facing some resistance from wary investors.

 Cooler Heads: Western governments have taken a noticeably somber tone toward their rivals as winter quickly approaches.

  • Leaders in the West are paving the way for de-escalation. French President Emmanuel Macron applauded China’s effort to rein in Russia in an attempt to prevent further escalation in the war. Although Beijing is sympathetic to Moscow’s need to defend itself from NATO expansion, it has also come out against the possible use of nuclear weapons during the conflict. Meanwhile, the Biden administration is pushing for Saudi Arabia’s Crown Prince, Mohammed bin Salman, to be granted immunity in a case involving the killing of journalist Jamal Khashoggi. The move will likely lead to better relations between the U.S. and Saudi Arabia. Lastly, President Biden rebuffed Ukraine’s claims that the missile that landed in Poland came from Russia.
  • The change in tactics may be related to concerns over commodity supplies. Although the West has ample inventory to cover its needs so far, there are concerns that this may not be the case next year. Restrictions on Russian energy and the reopening of the Chinese economy threaten to cause a surge in demand and a lack of supply for energy alternatives. The International Energy Agency warned that Europe could enter a deficit of 30 billion cubic meters (bcm) of natural gas in 2023 in a worst-case scenario. As a result, Western governments may be looking to exhaust all options before implementing some of their more extensive penalties against Moscow due to its war in Ukraine.
  • If successful in reducing tensions, Western gestures could support equities and weigh on the dollar and commodity prices. Throughout the year, geopolitical tensions have contributed heavily to investor uncertainty. That said, fears of a possible war spilling over into broader Europe and a direct conflict between the U.S. and China have dissipated over the last week. If this continues, the outlook for international equities will improve drastically as a weaker greenback and cheaper energy sources should help bring down global inflation. Although it is too soon to say whether this will carry over into 2023, signs are generally positive.

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