by Paul Hoffmeister, Chief Economist
Fed ready to raise rates aggressively.
Recession risk appears contained, for now.
Ukraine peace deal outlined but not imminent.
Betting markets overwhelmingly favor Macron in France’s April 24 election and Republicans in the midterms.
Higher Interest Rates: According to the Bureau of Economic Analysis, the CPI and PCE indices respectively increased 7.9% and 5.4% year-over-year through February, and the unemployment rate stood at 3.6%. Against this backdrop, monetary policymakers are currently more concerned about inflation than growth. And they appear ready to act by raising interest rates aggressively.
On March 16, the FOMC raised the funds rate target range to 0.25%-0.50%; its first increase in more than three years. It also telegraphed another 6 rate increases by year-end, and another three increases in 2023.
Underscoring the Fed’s inflation concerns, St. Louis Federal Reserve President James Bullard said last week that the Fed is “behind the curve” and suggested it must raise the overnight benchmark rate to 3.50%[i]. Soon thereafter, Fed Governor Lael Brainard indicated that the Fed will likely shrink its balance sheet “considerably more rapidly than in the previous recovery”. She added, “It is of paramount importance to get inflation down”. [2]
As a result, the market’s expectations of future monetary policy have caused long-term interest rates to skyrocket, with the 10-year Treasury yield jumping from approximately 1.50% at the beginning of this year to 2.75% as of last week.
The intention of interest rate increases, or what’s called the “monetary transmission mechanism”, is to slow the economy in order to ultimately reduce price pressures. Arguably, the interest rate lever is a blunt tool, and a natural concern is whether the Fed will succeed in threading the needle by engineering a so-called soft economic landing while reducing inflationary pressures at the same time.
Federal Reserve Governor Christopher Waller seemed to echo this sentiment on April 11. He said: “When you have to use a brute-force tool, sometimes there’s some collateral damage that happens. We’re trying to do this in a way that there’s not much of it, but we can’t tailor policy.”[iii]
We’re skeptical that the Fed will succeed in reducing inflationary pressures by raising rates aggressively without harming certain segments of the economy. But, for now, recession doesn’t appear to be imminent. The New York Federal Reserve’s probability of recession indicator for the next 12 months shows a 5.5% chance of recession.
Ukraine War:
The financial panic following the February 24 Russian invasion of Ukraine has significantly abated. As of Friday April 8, the S&P 500 is up more than 7% from its post-invasion low on March 8 and close to its trading levels in mid-February. Meanwhile, the USD-Ruble exchange rate is trading around 81.50 per dollar, compared to 78.65 on February 23 and nearly 135 rubles on March 10. Gold, arguably a useful geopolitical barometer, is trading around $1955, compared to $1910 on February 23 and its peak of $2050 on March 8.
Holding all other macro variables constant, these market prices suggest that the worst of the financial panic related to the Ukraine war is behind us for the near-term. However, the long-term consequences of this conflict are significant; they include higher inflation, slower economic growth, and the continued realignment of the global order.
According to AAA, the national average for a gallon of gasoline in the United States increased to $4.11 on April 8 from $3.54 on February 23. Meanwhile, according to the Chicago Mercantile Exchange, corn and wheat prices have increased approximately 13% and 21%, respectively. This is consistent with the 12.6% jump in the United Nation’s Food Price Index in March, which is the highest level for that index since its inception in 1990. Furthermore, in certain parts of the world, the price of fertilizer has increased more than 30%.
With the jump in food prices and the fact that Ukraine and Russia account for 20% and 30% of global wheat and corn exports, fears of a global food crisis are legitimate. Not to mention, an incipient rise in the cost of living will negatively impact consumers and the global economy.
Even more, we continue to see a bifurcation of the world into two economic spheres: the West with the United States at its center, and the East with China at its center and secondarily Russia.
While this bifurcation has been slowly in the making -- and we’ve highlighted it in recent years -- its reality was underscored again on February 4 when Presidents Xi Jinping and Vladimir Putin met and declared a partnership to counter the United States, stating: "Friendship between the two States has no limits, there are no 'forbidden' areas of cooperation." Among many other agreements, the countries forged a $117B Russian gas deal, Russia voiced its support for China’s stance on Taiwan and opposed NATO expansion and the AUKUS alliance (the alliance between Australia, UK and USA).[iv]
Thus far, the fighting in Ukraine does not appear to have dented the Chinese-Russian alliance. On Monday March 7, for example, China’s Foreign Minister Wang Yi emphasized that the relationship was “rock solid”.[v]
While the global order is important and its implications massive, the more acute concern for financial markets is the war right now. Will the fighting end soon? Or will it spill over into bordering countries?
On March 29, Russian and Ukrainian negotiators reached the outlines of a possible peace deal. Kiev would agree to not join alliances or host bases of foreign troops, but would have security guarantees similar to NATO’s Article 5 collective defense clause. Additionally, there would be a 15-year consultation period on the status of Crimea, which was annexed by Russia in 2014, and the status of the Donbas region would be worked out during direct talks between Putin and Zelensky.[vi] Kiev presented Moscow with a draft proposal last week, and the Russian government quickly proclaimed that it contained “unacceptable” elements, including details that were contrary to what had been previously discussed.[vii] Clearly, any peace deal will require more time. Many military observers expect Russian troops, after regrouping recently, will focus and step up operations in Eastern Ukraine.
Political Outlook:
A major political shift appears on the horizon in the United States. According to Predictit, Republicans currently have an 85% and 75% probability of regaining control of the House and Senate, respectively… Meanwhile, the Predictit market is giving Emmanuel Macron almost an 80% chance of beating Marine Le Pen in France’s second round presidential election, to be held on April 24. We wouldn’t easily assume a Macron victory. A Le Pen upset could be as significant as the Brexit referendum result of June 2016
[i] “Fed’s Bullard says interest rate policy is ‘behind the curve’, but it’s making progress”, by Jeff Cox, April 7, 2022, CNBC.
[ii] Fed’s balance sheet runoff will be rapid, Brainard says”, by Ann Saphir and Lindsay Dunsmuir, April 5, 2022, Reuters.
[iii] “Fed’s Waller Nods to Economic ‘Collateral Damage’ as Rates Rise,” by Craig Torres, April 12, Bloomberg News.
[iv] “China, Russia partner up against West at Olympics summit”, by Tony Munroe, February 5, Reuters.
[v] “China says Russia relations are still ‘rock solid’”, March 6, Deutsche Welle.
[vi] “Russia pledges to reduce attack on Kiev, but US warns threat not over”, by Jonathan Spicer, March 29, Reuters.
[vii]“Russia says Ukraine presented ‘unacceptable’ draft peace deal”, April 7, Reuters.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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