War and the Macro Backdrop

Russia's invasion of Ukraine was well tipped by US intelligence. It warned that an attack could take place at any time on February 11th turning the simmering issue into a generalized market force. The dramatic response seemed to be an over-reaction compared with what happened when Russia invaded Georgia in 2008 and when it annexed Crimea in 2014. Russia has forces in Transnistria (part of Moldova) and has poisoned enemies of Putin on foreign soil.  

Yet, energy and food trade ties are as strong as ever.  The US has increased its purchases of Russian oil. Reports suggested that even while the invasion was underway, several of Europe's utilities were trying to buy more Russian gas in long-term contracts after the spot price at European hubs jumped by over 60% at one juncture before settling nearly 31% higher on February 24.  Despite the pullback ahead of the weekend, the European gas benchmark finished the week up nearly 27% and almost 40% year-to-date.  EU energy ministers will hold an emergency meeting on Monday.  

Many countries, including the US announced new export restrictions that will limit non-essential goods being sold to Russia that can be used by the military, aerospace, and maritime sectors, including semiconductor chips. Ahead of the weekend, reports indicated the US would join the UK and EU in sanctioning Putin and Foreign Minister Lavrov.  It is seen as a largely symbolic move. 

Putin's intentions are still not completely clear.  Will Russia annex the eastern and southern part of Ukraine?  Will Russia reincorporate all of Ukraine? Will Putin force Ukraine into a federation with Russia after imposing a regime change?  We suspect the latter is Putin's first choice. It could bleed Moscow financially and leaving a new government in place is what the US did in the war with Iraq. After finding that NATO forces would not fight alongside Ukrainian soldiers, reports suggested that Kyiv offered neutrality (Finlandization).  

The timing of Russia action is not coincidental.  It comes after Merkel has been replaced.  It is after the US messily pulled out of Afghanistan, and polls show the US public has little appetite for a new foreign conflict. Putin's move also comes as the US and Europe combat the worst inflation in a generation.  The economic risks of Russia's invasion could be higher food and energy prices and slower growth.  

It has been nearly 120 years since the British geographer Mackinder presented his "heartland" theory of geopolitics.  Just like chess players recognize the strategic importance of the middle four squares of the board, Mackinder emphasized the geostrategic importance of eastern Europe.  Indeed, he would later summarize his view as:  "Who rules East Europe commands the Heartland; who rules the Heartland commands the World-Island; who rules the World-Island commands the world."  

The "world-island “is the Eurasian landmass, and, of course, it is a euro-centric view of the world.  The center of the world economy has shifted, and for more than 40 years, more goods have crossed the Pacific than the Atlantic. The rise and integration of China into the world economy is arguably the most significant "fact" of early 21st century.  Nevertheless, European security remains crucial.  

The world has known that Putin's Russia was not content with the post-Cold War arrangement since at least 2008. Russia's actions to change this makes most of its neighbors less secure.  A year from now there will likely be more NATO on its frontiers rather than less. This will remain a source of instability and disruption. Given the narrative Putin offers, it is unlikely to be his last move in the region. 

There was some talk about removing Russia from SWIFT but at this juncture, it does not appear presently.  This is the price of a coalition.  The US and UK seemed the most in favor.  Europe less so but might be persuaded later. President Biden claimed that sanctioning the large Russian banks was tantamount to banning them from SWIFT. Some argue that removing Russia from SWIFT could encourage it to more aggressively push its alternative Mir payment system launched about five years ago.  

Still, it appears that within 48 hours of the invasion, the market began looking past it. The S&P 500 bounced about 6.1% from the panic lows.  The NASDAQ rallied even more, surging 8.5% from its exaggerated low. It managed to close higher on the week to snap a two-week drop. The US 10-year yield was straddling the 2.0% mark after falling below 1.85%.  Ahead of the weekend, the April WTI contract made a new low for the week near $90 after briefly poking above $100 the day before.

II

Two G10 central banks meet in the week ahead: the Reserve Bank of Australia (March 1) and the Bank of Canada (March 2).   

After a Covid-inspiring soft patch in December-January, the Australian economy appears to be recovering smartly.  The February composite PMI (55.9 vs. 46.7) is the highest since last June.  Even during the slower period, the labor market proved resilient.  Australia grew 50k full-time positions on average in the November-January period, the most since the middle of last year.  

Governor Lowe of the RBA softened his rejection of the need to raise rates this year. He has allowed for a hike if the economy continues to recovery.  The market leans toward the first hike in July and has it fully discounted in August.  The swaps market has about 50 bp of tightening priced in over the next six months.  

How will the gap close between market expectation and the central bank's forward guidance?  We suspect that the economic data will likely force the RBA to bring forward its hike but at the same time, the idea of as many as five hikes this year seems a bit aggressive.  By recently adopting a variable rate for its open market operations, the RBA took the necessary technical step to allow for a rate hike.  Of course, it says nothing about the timing.  

The main question around the Bank of Canada's meeting is how aggressive it will be.  A hike of at least 25 bp is as sure of a thing as these things get.  The overnight index swaps imply about a 75% chance of 50 bp move.  That is a greater chance than by the Federal Reserve or the Bank of England (~28% and 17%, respectively). 

There is more.  The Bank of Canada could announce that it would allow the balance sheet to begin running off (not recycle maturing issues in full). The Bank of England has already signaled similar intent and its balance sheet will be shrinking next month.  By expanding the balance sheet quickly and unwinding it quickly, this is was a way of normalizing what had been un unorthodox measure that former Fed Chair Bernanke once quipped that works in practice but not in theory. Bank of Canada Governor Macklem indicated that the central bank would consider adjusting its balance sheet "in fairly short order" following the start of the interest rate hikes.  

The Bank of Canada puts the neutral policy rate between 1.75% and 2.75%.  In the last cycle, the peak was at 1.75% (2017-2018).  The market looks for the peak in late 2023 or early 2024 around 2.25%.  The hikes are seen to be front loaded with nearly 125 bp to be delivered over the next six months. 

III

It does not appear that Russia's invasion of Ukraine and the spike of crude oil above $100 a barrel will prompt a change in the OPEC+ strategy.  At its monthly meeting, it is expected to affirm its plan to produce another 400k barrels in April.  As is well appreciated now, its declaratory policy is one thing, and the operational policy is another.  Many cannot meet their quotas.  US President Biden delivers the State of the Union address on March 1.  It will attract much attention but is unlikely to be much of a market mover.  

Three sets of high-frequency data points that command attention in the coming days are: US jobs, the preliminary February eurozone CPI, and China's PMI.  

Another strong US jobs report is expected.  Recall that nonfarm payrolls rose by an average of 555k a month last year and increased more than expected in January (467k vs median forecast in Bloomberg's survey for a 125k increase).  Moreover, the softness seen in November and December were revised away.  The December jobs gain was 510k not 199k. November's gain that was initially reported at 210k but was revised to 647k on its second revision.  

The median forecast in the Bloomberg survey is for a 400k increase nonfarm payroll in February. The employment component of the manufacturing and service PMI strengthened. The rise in weekly jobs claims in recent weeks blunts some of the optimism, but the fact is that the labor market recovery remains intact.   

The unemployment rate may slip back through 4.0% to 3.9% where it was at the end of last year.  Recall that before Covid struck, the US unemployment rate was around 3.5% and the participation rate was 63.4%.  In January, the participation rate was 62.2%.   

Some (employed) observers expect the higher wages to draw people back into the workforce, but it seems more complicated.  Average earnings are not keeping pace with inflation.  In real terms real average weekly earnings have been falling since April 2021 on a year-over-year basis.  Rather than higher wages inducing re-entry in the workforce, we suspect that the loss of purchasing power may force some back to work. This may include newly retired people.  Many often seek employment after a bit, but not so much during the pandemic.  Unit labor costs, which take into account wages, benefits, and productivity rose by 0.3% in Q4 22 and averaged near 3.2% last year, almost half of the average 2020 pace (6.25%), but still more than 2018 and 2019 put together.  

A strong report could renew speculation that the Fed will hike rates 50 bp when the next FOMC meeting concludes on March 16.  Although Fed Governors Bowman and Waller suggested a 50 bp hike could be delivered in March depending on incoming data.  We note that the market is not delivering a fait accompli to the Fed as it was on February 10 when the market had priced in slightly more than an 80% chance of a 50 bp March high.   

The eurozone reports it preliminary estimate of February inflation on March 2.  Recall that the January reading surprised on the upside.  Seasonal patterns suggested a modest decline and instead the headline CPI rose by 0.3% to lift the year-over-year rate to 5.1%.  The core rate was also firmer than expected at 2.3% (2.6% in December).  Input prices from the composite PMI rose in February, driven by services, suggesting that headline CPI will likely remain elevated.   

The ECB's economists emphasize wages in the inflation outlook. Yet, negotiated wage growth was 1.4% in Q3 22 and 1.5% in Q4 22. Wage growth will likely accelerate this year.  The ECB's staff forecasted 3.8% wage growth this year and 2.9% in 2023.  

The median forecast in Bloomberg's survey anticipates inflation accelerated this month to 5.3% from 5.1%.  The core rate is expected to have risen to 2.5% from 2.3%.  However, the upside surprise from France (4.1% vs a median forecast of 3.7% after 3.3% in January) warns of the same for the aggregate.  

However, almost regardless of the actual print, the market is unlikely to be swayed to bring the first rate hike into Q2 22.  The swaps market looks for the first hike around September and expects about 55 bp in hikes over the next 12 months.  The deposit rate is expected to rise above zero next year for the first time since 2012.  The key then is ending the Asset Purchase Program in June, which could be announced in at the March 10 meeting.  ECB Chief Economist Lane opined that the war could shave growth this year by 0.3%-0.4%.  

China's February PMI is expected to confirm, on the one hand, the world second-largest economy continued to slow, and that more stimulus will likely be delivered, on the other.  The manufacturing sector is unlikely to have gotten much traction, and instead, the slowdown may have deepened.  The "official" manufacturing PMI was at 50.1 in January and the Caixin version had already slipped below the 50 boom/bust level in January for the second time in three months.  Weak domestic demand, partly as a function of the response to the pandemic, likely slowed service activity. The latest Bloomberg survey show a median forecast of 1.2% quarter-over-quarter growth, but nearly 2/3 through the quarter and the Chinese economy appears to be nearly stagnating.  

The direct monetary and fiscal stimulus provided thus far has been relatively meager. This is not to say officials have done nothing.  Instead, it is to draw your attention to the other indirect levers available to Chinese policymakers, such as encouraging lending by state-owned banks and encouraging regional government spending.  Typically, a central bank wants the exchange rate to move in the direction as monetary policy.  Otherwise, it is offsetting or blunting the official effort.   

However, after initially warning against yuan appreciation as monetary policy diverges, Chinese officials have accepted a stronger yuan.  It is trading at new four-year highs against the dollar and seven-year highs against its trade-weighted basket.  Still, it is important to keep the move in perspective, the yuan has appreciated by about 0.7% against the US dollar here at the start of 2022.  Over the last couple of weeks, the PBOC has often set the dollar's reference rate (around which it can ostensibly move by 2% but rarely moves by 0.5%) lower than the market expects.  This is a reversal of its typical reaction function in such an environment.  

The strong yuan is a sign of China's indigestion problem.  It has a large trade surplus, and it is attracting portfolio capital. It cannot purge itself quick enough. Raising reserve requirements on foreign currency deposits as was done twice last year may deter some activity but it does not address the underlying demand for yuan.  Chinese officials could further ease the restrictions on portfolio capital outflows from the mainland.  While the yuan has appreciated, the move has been too small for it to be much of a shock absorber.   

Given the importance of the 20th National Congress later this year, having a favorable economic backdrop and firm yuan are integral to the image being portrayed. While the Covid wave is ebbing in the North America and Europe, it is more threatening in China. It remains a "known unknown" in the vernacular and could still be a significant disruptive force in terms of supply chains, and therefore prices.  

   

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