Daily Comment (October 7, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment starts with a discussion about central banks around the world becoming more hawkish. Next, we give an overview of rising geopolitical tensions in Central Asia and Europe. We conclude the report with thoughts on how U.S. moves are impacting global financial markets.

Central Bank Worries: Monetary policymakers continue to dig in their heels as price stability remains their top priority even as output falls.

  • European Central Bank officials are worried that an economic slowdown will not be enough to meaningfully bring down inflation. According to the ECB’s September meeting minutes, central bankers expressed concerns that a weaker euro and fiscal stimulus have made inflation resilient. The comments suggest the bank will opt for a jumbo rate hike in its next meeting on October 27. The market has priced in a 66% chance of a 75 bps rate hike and a 34% chance of a 100 bps rate hike.
  • Fed officials keep throwing water on the possibility of a slowdown in rate hikes. Five officials on Thursday reiterated the central bank’s desire to bring down inflation at all costs. In her first remarks since taking over as Fed governor, Lisa Cook argued that the Fed needs to push rates higher until the data shows that inflation is moving toward the bank’s 2% target. In a separate statement, Fed Governor Christopher Waller shot down the possibility that financial instability could force the bank to pivot. If Waller is correct and the Fed maintains rate hikes during a financial crisis, a recession could be more profound than most investors expect.
    • In the event of financial market turmoil, we suspect the Fed will use the emergency tools developed during the pandemic. Accordingly, we may see some cash injections from the Fed to relieve some of the stress in the banking system.
  • Global liquidity is drying up as central banks tighten monetary policy and the world economy slows. The U.S. banking system appears to be ground zero for financial distress. Treasury market liquidity, as tracked by the Bloomberg U.S. Government Securities Liquidity Index, rose to its highest level since the 2020 pandemic. The lack of demand for government bonds is driven by high inflation and large deficits. As a result, if left unchecked, the Treasury build-up could lead to the financial system getting clogged again and the Fed might be forced to end quantitative tightening prematurely.

Rising Global Frictions: As everyone focuses on Russia, there are signs that frozen conflicts are starting to thaw in other parts of the world.

  • Turkish President Recep Tayyip Erdogan threatened to invade the Greek islands on Thursday. Erdogan accused Greece of militarizing the Aegean Islands in violation of the 1923 and 1947 treaties. The U.S. did not welcome the comments as it believes the countries should focus their attention on Russia. Greece has been helpful in the transfer of weapons to Ukraine, while Turkish drones were pivotal in fending off Russian troops at the start of the invasion. A conflict between the Mediterranean rivals threatens to divide NATO and calls into question the military alliance’s unity.
    • Erdogan’s comments are another example of his split allegiance between the West and Russia in the war in Ukraine.
  • A deal to formally end a dispute between Israel and Lebanon is in jeopardy. The sides were close to an agreement that would allow Israel to start drawing gas from the Karish gasfield, but Lebanon has demanded last-minute changes to the deal. The hiccup in talks will prolong negotiations as Israel prepares for elections next month. Assuming the deal is not resolved, the outcome will prevent an additional supply of natural gas from entering the market. Renewed threats from Lebanon against Israel also raise the likelihood of a war between the countries.
  • Lastly, squabbles among Central Asian countries are becoming more common as Russia focuses its attention on Ukraine. Kyrgyzstan’s President Sadyr Japarov skipped the Commonwealth of Independent States (CIS) summit in St. Petersburg on Friday due to anger at home over Moscow’s inability to prevent Tajik forces from invading Kyrgyz territory in September. His lack of attendance is viewed as a slight to Putin, who is celebrating his 70th birthday at the event. We suspect that Russian losses in Ukraine have led countries within Central Asia to question Moscow’s security commitment. Thus, there is the possibility for violent outbreaks in an area that holds 10.6% of the world’s oil reserves.

The U.S. Leads the Dance: American foreign and monetary policy decisions continue to rattle markets as the world waits to see how the U.S. will respond to Russia and rising inflation.

  • President Biden warned that Russia’s threat of a strategic nuke was not a bluff. In a speech at a New York fundraiser, Biden acknowledged that his administration is seeking an off-ramp for Putin following a series of Russian losses in Ukraine. The comment from Biden suggests that his administration is looking for ways to get Putin to the negotiating table. The possibility of nuclear conflict could lead to a broader war in Europe and would be detrimental to risk assets.
    • We do not believe it is probable that Putin will use a nuke at this time, but we think the risk is to the upside.
  • A strengthening dollar has contributed to a substantial decline in foreign exchange reserves in Japan and China. The rise in the greenback has forced countries to enter exchange rate markets to prevent their currencies from devaluing. Japan’s reserve drop resulted from the Bank of Japan’s decision to sell off U.S. Treasuries. In China, the decline in reserves was driven by a reduction in gold holdings. These moves show the level of pressure governments are under to preserve their respective currency’s value.
  • The world waits as the U.S. pressures OPEC to back off its decision to cut its output target by 2 million barrels per day. On Thursday, the Biden administration expressed that all measures are being considered to prevent rising oil prices from putting upward pressure on gas prices and inflation. In addition, the U.S. is considering offloading some of its strategic reserves as well as a potential export ban. Depending on what it decides, it could have slightly beneficial or disastrous effects on global energy prices.

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