Base case: global recession

The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).

10-Year & minus 3-Month Treasury Yield

The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.

S&P 500

 

21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.

S&P 500

Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.

DJ Industrial Metals Index

Supported by a similar primary down-trend on Copper, the most prescient of base metals.

Copper

Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.

Brent Crude

Natural gas prices are climbing.

Natural Gas

Especially in Europe, where Russia is attempting to choke the European economy.

Russia: EU Gas

Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).

EU: PPI

Conclusion

Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.

Fiona Hill | Putin is pushing our buttons

British-born Fiona Hill is an expert on Russia and Vladimir Putin and served as security adviser to US Presidents George W. Bush, Barack Obama and Donald Trump. Her take on Russia’s invasion of Ukraine is that Vladimir Putin still thinks he is winning. The Kremlin has a far higher tolerance for troop losses than Western governments and Putin believes that he can grind out a victory of sorts. He thinks he has the upper hand in terms of leverage, through his influence on energy markets and food shortages, and is prepared to wait out the West — waiting for them to lose patience and attempt to force a negotiated settlement.

“Putin is a contingency planner. If one thing doesn’t work, he’ll try another. If things get dire, expect more nuclear sabre-rattling. They already rhetorically deployed nuclear weapons, and used them, on national television.

Bear in mind they take a very careful read of us and how we react. Think about when they moved through the Chernobyl exclusion zone into Ukraine….People said they wouldn’t possibly do that but they did. This scares the heck out of everyone….Same thing with Zaporizhzhia nuclear power plant. They deliberately shelled it. Think about the timing. It was just when Germany and Japan were considering recommissioning their nuclear power plants. All this happens because Putin knows he can push our buttons. He knows our fears and can play to those fears.”

The West has to get ahead of this. But we always tend to do things too late. Earlier action in Ukraine — in terms of supplying weapons — may have deterred Putin.

“Putin and the Kremlin have a major advantage: continuity. They have been in power for a long time and have no effective opposition.

The West, by contrast, has no continuity. This is the main obstacle to getting ahead of the game. Democracies tend to lose focus over time…..The more domestic problems you have, the more likely you are to lose focus.

….Putin’s business is to find points of leverage.

Political donations. Corruption. Germany’s pact with the devil — it’s economy is built on reliance on cheap Russian gas. We have to wind this all back.

Funding both sides of the war | Thomas L Friedman

Our continued addiction to fossil fuels is bolstering Vladimir Putin’s petrodictatorship and creating a situation where we in the West are — yes, say it with me now — funding both sides of the war. We fund our military aid to Ukraine with our tax dollars and some of America’s allies fund Putin’s military with purchases of his oil and gas exports.

~ Thomas L Friedman, NY Times, May 17, 2022

S&P 500 rallies as Fed tightens

Stocks rallied, with the S&P 500 recovering above thew former primary support level at 4300. Follow-through above 4400 would be a short-term bull signal.

S&P 500

Markets were lifted by reports of progress on a Russia-Ukraine peace agreement — although that is unlikely to affect sanctions on Russia this year — while the Fed went ahead with “the most publicized quarter point rate hike in world history” according to Julian Brigden at MI2 Partners.

FOMC

The Federal Reserve on Wednesday approved its first interest rate increase in more than three years, an incremental salvo to address spiraling inflation without torpedoing economic growth. After keeping its benchmark interest rate anchored near zero since the beginning of the Covid pandemic, the policymaking Federal Open Market Committee (FOMC) said it will raise rates by a quarter percentage point, or 25 basis points….. Fed officials indicated the rate increases will come with slower economic growth this year. Along with the rate hikes, the committee also penciled in increases at each of the six remaining meetings this year, pointing to a consensus funds rate of 1.9% by year’s end. (CNBC)

Rate hikes are likely to continue at every meeting until the economy slows or the Fed breaks something — which is quite likely. To say the plumbing of the global financial system is complicated would be an understatement and we are already seeing reports of yield curves misbehaving (a negative yield curve warns of recession).

Federal Reserve policymakers have made “excellent progress” on their plan for reducing the central bank’s nearly $9 trillion balance sheet, and could finalize details at their next policy meeting in May, Fed Chair Jerome Powell said on Wednesday. Overall, he said, the plan will look “familiar” to when the Fed last reduced bond holdings between 2017 and 2019, “but it will be faster than the last time, and of course it’s much sooner in the cycle than last time.” (Reuters)

The last time the Fed tried to shrink its balance sheet, between 2017 and 2019, it caused repo rates (SOFR) to explode in September 2019. The Fed was panicked into lending in the repo market and restarting QE, ending their QT experiment.

SOFR

QT

Equities are unlikely to be fazed by initial rate hikes but markets are highly sensitive to liquidity. A decline in the Fed’s balance sheet would be mirrored by a fall in M2 money supply.

M2 Money Supply/GDP & Fed Total Assets/GDP

And a similar decline in stocks.

S&P 500 & Fed Total Assets

Ukraine & Russia

Unfortunately, Ukrainian and French officials poured cold water on prospects of an early ceasefire.

Annmarie Horden

Neil Ellis

Samuel Ramani

Conclusion

Financial markets were correct not be alarmed by the prospect of Fed rate hikes. The real interest rate remains deeply negative. But commencement of quantitative tightening (QT) in May is likely to drain liquidity, causing stocks to decline.

Relief over prospects of a Russia-Ukraine ceasefire and/or any reductions in sanctions is premature.

The bear market is likely to continue.

Never waste a good crisis

The Russian Federation has amassed a large army on the border of Ukraine and threatens to invade unless the US and NATO make concessions including the withdrawal of forces from Eastern Europe, securing Moscow a broad sphere of influence. There has been much hand-wringing in Western media: will Putin invade or is this just a ruse designed to extract concessions?

If we look past the uncertainty, it is clear that an increasingly over-confident Putin has entered a trap of his own making.

The West is faced with an ultimatum: either concede or Russian forces will invade Ukraine.

But every problem presents an opportunity.

The more aggressive Russia becomes, the stronger NATO gets.

Russian actions have united Western alliances, with even long-term neutrals Finland and Sweden, moving closer to NATO.  Both Finnish and Swedish presidents reiterated their right to join NATO in response to the Russian ultimatum.

Germany has long obstructed a stiffening of NATO defenses, increasing its vulnerability to Russian energy blackmail by shuttering nuclear power plants and supporting the Nordstream 2 gas pipeline across the Baltic Sea. But opposition is growing. A recent poll shows that the percentage of Germans who trust Russia has fallen by 11% over the past two years:

German Poll: Which Countries Do You Trust?

Concessions are unlikely, simply because there is nothing to gain from them. Concessions by the US would weaken NATO and encourage the Kremlin to make even more outlandish demands in the future. Concessions by NATO without the US would produce a similar outcome.

Russian invasion of Ukraine would be a strategic mistake.

First, invasion would be a flagrant act of war, removing the cloak of deniability that has covered Russian operations in the Donbas region. A formal state of war would increase the flow of Western technology and weapons into Ukraine as Western leaders are required to openly acknowledge Russian aggression.

Land invasions are costly in terms of both blood and treasure. The Russian army may eventually overrun the Ukrainians through the weight of forces and technological advantages. But Ukrainian armed forces have been in a protracted war in the East and are well-trained and equipped with modern anti-tank weapons, artillery and unmanned drones. The costs would be high.

Turkey’s Bayraktar unmanned combat drone

Turkey’s Bayraktar Unmanned Armed Combat Drone – Source: Ukrinform

Where the Ukrainians are at a disadvantage is in air defenses and vulnerability to long-range missile attacks. But that window is closing.

To stiffen Ukraine’s ability to resist, the United States and NATO have dispatched teams in recent weeks to survey air defenses, logistics, communications and other essentials. The United States likely has also bolstered Ukraine’s defenses against Russian cyberattacks and electronic warfare. (David Ignatius, Washington Post)

An air campaign would also achieve little without a follow-up land invasion.

Even if the Ukrainian forces are defeated, that is where the real problem starts. Occupation is a costly and morale-sapping exercise as the Soviets discovered in Afghanistan in the 1980s and the US discovered in Vietnam, Iraq and Afghanistan (they’re slow learners). An insurgency negates the occupiers’ advantages in air power and technology, leading to a drawn-out campaign with no outcome.

“You have the watches. We have the time.” ~ Taliban fighters in Afghanistan.

A Russian occupation force would require 20 combatants for every 1,000 Ukrainians, according to a formula devised by Rand Corp. analyst James Quinlivan in 1995. That would translate into an a required Russian force of almost 900,000, illustrating the impracticality.

We could expect a Russian occupation to be exceedingly brutal, along the lines of Syria, creating a humanitarian crisis and flooding the West with refugees. But that is only likely to harden resolve, marginalizing appeasers in the West, and increase support for the insurgents.

The cost of an extended Russian campaign would deplete the Russian Treasury, even without increased sanctions. It would also escalate opposition within Russia, spurred by the high cost in lives and deteriorating living conditions. The result would threaten collapse of the Russian state in much the same way as the campaign in Afghanistan led to the eventual disintegration of the Soviet Union.

Conclusion

The threat of armed invasion of Ukraine is a mistake. It is likely to strengthen resolve in the West and, if the threat is carried out, result in a long, protracted war in Ukraine. The cost in both blood and treasure would threaten to topple the Russian state.

Russian overconfidence has led them into a trap. Thinly spread across a number of conflict zones, they are vulnerable to an escalation in insurgencies wherever they have “peace-keeping” occupation forces: Syria, Belarus, Ukraine, Moldova, Georgia, and now Kazakhstan. The cost to the West would be low but would exact a huge toll on the Kremlin, depleting their military and already-vulnerable financial resources.

“Moderation in the pursuit of liberty is no virtue.”
George Crile, Charlie Wilson’s War: The Extraordinary Story of How the Wildest Man in Congress and a Rogue CIA Agent Changed History

What would Putin do?

The Communist Party of China has an unwritten contract with the 1.4 billion people living under its rule: they will tolerate living under an autocratic regime provided that the CCP delivers economic prosperity. So far the CCP has delivered in spades. A never-ending economic boom, fueled by exponential debt growth as investment in productive infrastructure grows ever more challenging.

But they are now familiar with the law of diminishing marginal returns: governments can’t just keep spending on infrastructure without falling into a debt trap. All the low-hanging fruit have been picked and new infrastructure projects offer lower and lower returns as spending programs continue.

That was probably the primary motivation for the CCP’s Belt-and-Road Initiative (BRI): to source more productive infrastructure investments in international markets. But the COVID-19 pandemic brought the BRI to a shuddering halt and the CCP is unlikely to maintain its exemplary growth record — no matter how much they fudge the numbers.

Xi Jinping is faced with an impossible task: how to placate 1.4 billion people when inflation sends food prices soaring and ballooning debt precipitates a sharp rise in unemployment and falling wages. The CCP has been preparing for this very eventuality for some time. Investing billions in surveillance and social credit systems, brutal crackdowns on religious organizations and minorities, suppression of democratic forces in Hong Kong, the latest take-down of tech giants — Jack Ma’s Ant Group and Tencent Holdings — which could form a focal point for democratic opposition, and beefing up internal policing. These are not the whims of an autocratic regime but a desperate attempt at self-preservation. China’s internal security budget is even bigger than its military budget (WION).

Xi Jinping

Behind that inscrutable facade, Xi Jinping is a worried man. Even with all the technology and forces of suppression at his disposal, confronting an angry population of 1.4 billion people is a daunting task. In his darkest hours he must have asked himself the question: WHAT WOULD PUTIN DO?

Even if you don’t believe the RT hype of the bare-chested deer hunter, judo expert and chess grandmaster — a combination of Chuck Norris and Garry Kasparov — you have to give Vladimir Putin credit for surviving 20 years as the head of a murderous regime where only the strong and completely ruthless stay alive.

Vladimir Putin

What would Putin do? The answer must have hit Xi Jinping like a 500 watt light bulb: INVADE CRIMEA. Vladimir Putin enjoyed record popularity at home (if you can believe Russian opinion polls) after invading Crimea. Despite the economic hardships that the Russian people had to endure from Western sanctions. The only force more powerful than hunger is a wave of patriotic nationalism.

Now being the canny fellow that he is, Xi figured that Crimea was too far away to be much use. Luckily for him, there is a handy substitute. An island of 23.5 million inhabitants, living under a democratically-elected government, only 180 kilometers away, across the Taiwan Strait.

Conclusion

We expect the CCP to fuel a wave of nationalist fervor to distract the 1.4 billion people living under their harsh rule from the economic hardships they are about to endure. Conflict over Taiwan is an obvious choice.

At present the PLA is conducting daily incursions into Taiwanese airspace, to map ROC air defense systems and wear down defenders with “response fatigue”.

ROC Reports Incursion by 28 PLA Aircraft

The CCP would not want to interfere with the Beijing Winter Olympics but may use it as a distraction — straight out of Putin’s playbook.

Melik Kaylan at Forbes:

I can say one thing about Vladimir Putin without fear of contradiction: he cares about timing. When he’s up to no good, he loves a sleight-of-hand distraction in global headlines. In 2008 [invasion of Georgia], the Beijing summer Olympics served as cover. More recently, the Sochi Winter Olympics ended just three days before Russia marched into Crimea.

Notes

  1. The 2022 Winter Olympics — also known as Beijing 2022 — is scheduled to take place from 4 to 20 February 2022.

Goldman Cuts 2017 Oil Price Forecast Due To Slower Market Rebalancing | Zero Hedge

Goldman Sachs has cut its long-term crude oil forecasts:

The inflection phase of the oil market continues to deliver its share of surprises, with low prices driving disruptions in Nigeria, higher output in Iran and better demand. With each of these shifts significant in magnitude, the oil market has gone from nearing storage saturation to being in deficit much earlier than we expected and we are pulling forward our price forecast, with 2Q/2H16 WTI now $45/bbl and $50/bbl. However, we expect that the return of some of these outages as well as higher Iran and Iraq production will more than offset lingering issues in Nigeria and our higher demand forecast. As a result, we now forecast a more gradual decline in inventories in 2H than previously and a return into surplus in 1Q17, with low-cost production continuing to grow in the New Oil Order. This leads us to lower our 2017 forecast with prices in 1Q17 at $45/bbl and only reaching $60/bbl by 4Q2017.

But these forecasts are premised on a Chinese recovery:

Stronger vehicle sales, activity and a bigger harvest are leading us to raise our Indian and Russia demand forecasts for the year. And while we are reducing our US and EU forecasts on the combination of weaker activity and higher prices than previously assumed, we are raising our China demand forecasts to reflect the expected support from the recent transient stimulus. Net, our 2016 oil demand growth forecast is now 1.4 mb/d, up from 1.2 mb/d previously. Our bias for strong demand growth since October 2014 leaves us seeing risks to this forecast as skewed to the upside although lesser fuel and crude burn for power generation in Brazil, Japan and likely Saudi are large headwinds this year.

While production growth continues to surprise:

…..This expectation for a return into surplus in 1Q17 is not dependent on a sharp price recovery beyond the $45-$55/bbl trading range that we now expect in 2016. First, it reflects our view that low-cost producers will continue to drive production growth in the New Oil Order – with growth driven by Saudi Arabia, Kuwait, Iran, the UAE and Russia. Second, non-OPEC producers had mostly budgeted such price levels and there remains a pipeline of already sanctioned non-OPEC projects. In fact, we see risks to our production forecasts as skewed to the upside as we remain conservative on Saudi’s ineluctable ramp up and Iran’s recovery.

We expect continued growth in low-cost producer output
Saudi Arabia, Kuwait, UAE, Iraq, Iran (crude) and Russia (oil) production (kb/d)

Tyler Durden has a more bearish view:

While there is much more in the full note, the bottom line is simple: near-term disruptions have led to a premature bounce in the price of oil, however as millions more in oil barrels come online (and as Chinese demand fades contrary to what Goldman believes), the next leg in oil will not be higher, but flat or lower, in what increasingly is shaping up to be a rerun of the summer of 2015.

Source: Goldman Cuts 2017 Oil Price Forecast Due To Slower Market Rebalancing | Zero Hedge

The Man Who Got Russia Right | Foreign Policy

Susan Glasser on George Kennan, author of the famous Long Telegram that formed American policy during the Cold War:

….Based in Moscow a few years later, Kennan saw the historical contradictions that undermined the foundation of the Soviet regime — while at the same time giving it a veneer of power. Russians were “used to extreme cold and extreme heat, prolonged sloth and sudden feats of energy, exaggerated cruelty and exaggerated kindness, ostentatious wealth and dismal squalor, violent xenophobia and uncontrollable yearning for contact with the foreign world, vast power and the most abject slavery, simultaneous love and hate for the same objects.” Looking for an insight into the forces competing for political supremacy in Russia today, you could do far worse than Kennan’s observations.

Today we would call that bi-polar.

……”The strength of the Kremlin lies largely in the fact that it knows how to wait,” Kennan wrote. “But the strength of the Russian people lies in the fact that they know how to wait longer.”

Source: The Man Who Got Russia Right | Foreign Policy

A New Cold War? Russia’s Confrontation with the West

Michael A. McFaul, Stanford University professor of political science; director and senior fellow, Freeman Spogli Institute for International Studies; Peter and Helen Bing Senior Fellow, Hoover Institution; Stanford University, former ambassador to Russia (2012 – 2014).

Colin’s Comment:
Here is what I see as the big picture:

  • The current confrontation is more about the actors than about long-term strategy or geopolitical conflict
  • Russia is part of Europe, culturally and economically, and its destiny lies in the West
  • A strong Russia is in the West’s interest — a weak Russia invites encroachment from China in the East
  • The West has to build a strong deterrent to aggression from the current regime
  • While leaving the door open to long-term participation in European democratic structures, scientific cooperation and trade.