Are the markets ignoring the collateral damage of the sanctions?

Nicholas Glinsman | March 1st, 2022

Are the markets ignoring the collateral damage of the sanctions?

The announcement by the West that they would prevent Russia from using most of its FX reserves is a breathtaking acceleration into an economic war of which we are all now part. The West has decided that a G20 nation should no longer be part of its financial system. Previous freezes on FX reserves have happened to the likes of Iran and Venezuela. Russia has spent the last two decades insinuating itself into the western world; the plug has now been pulled overnight. The outbreak of Covid was a similar shock but one that would follow a clear path: a virus predictably evolves and people’s fear predictably waxes and wanes. We now have a non-linear actor playing a central role in events while the West has decided to escalate its response.

This will have far reaching ramifications politically but also delivers a short term shock to the markets:

·         Firstly, nobody will know what the price of the rouble is, aside from it being far lower than it was on Friday. No western institution can therefore afford any exposure to Russia. The uncertainty is too great, both over the value of the asset and the creditworthiness of the counterparty;

·         As a result, there are now two financial systems: those for the Western world and those for the pariah states. It is up to the geopolitics to determine which becomes more powerful in the long term, but in the short term the financial system is too interconnected to bifurcate overnight. And remember, monetary authorities will only support the system in which their insitutions operate (the Bagehotian lender of last resort);

·         The disruption is deliberate and ultimately can be contained, for example by bailing out any systemically important institution if that should be required. But the disruption itself can and must continue.

Now, if you take the above three points together, you can but conclude that western financial institutions will have to divest from anything that even hints of Russia. But this chain reaction cannot be contained to Russia. Uncertainty levels have gone through the roof. The system has to deleverage.

·         More collateral will be demanded as volatility will increase, which will force unwinds of positions, with some funds having to sell liquid assets in order to fund positions that have been rendered illiquid at the stroke of a pen. If you own an index whereby a portion sits in Russia, you will be forced to get out of it;

·         What looked safe might now be far less safe. Gold is not particularly useful in a world where ease of payments becomes king. It is expensive to store and cannot always be liquidated. Not to mention that Russia itself is likely to need to liquidate the Gold part of their FX reserves that they still have access to;

·         Leverage had risen to high levels following almost two years of money printing, but the gamma/vanna position does not yet denote a crash risk. As such, ceteris paribus, you are likely to see an orderly sell off in risky assets.

These three points tell you that cash and cash equivalents are king. Everyone’s risk manager will tell them to take some risk off the table – I know, as I have been there in 2008 and 2013. But what kind of cash?

·         The demand for USDs will go up just as their supply goes down. Western institutions will simply have to own more US Dollars in exchange for ditching any less liquid currency. But where some emerging nations might have been selling dollars to stimulate their economies, that will no longer be possible. Throw in Fed Quantitative Tightening and supply of Dollars falls as demand goes up.

Now, let’s consider Putin’s response! Nobody can with any authority predict what is in his mind. We knew in March 2022 that a virus would evolve to survive. Vladimir will attempt the same, although human logic is more non-linear than that of a pathogen. But we can all see the possible outcome of risks has now changed substantially. You probably didn’t start the year thinking you had to factor the capture of Chernobyl and the threat of nuclear war into your portfolio, but this is now a world where the impossible becomes possible uncomfortably quickly. (No, we do not believe the nuclear war threat is real)

·         The most immediate concern should be a cyberattack that disrupts western financial markets. Remember the loner based in Hounslow, near Heathrow airport, who apparently managed to spoof the most liquid stock market in the world from the bedroom in his parents’ house in 2010. We have seen countless more flash crashes since then as the system has become more automated. Even if hackers manage to cause a brief wobble in one market, the outbreak of hostilities will lead us to imagine that far more could be round the corner.

·         Beyond that the hacks could hit health systems, national electricity, flights and so on. Facebook managed to take itself offline for six hours in October 2021 because their system was so interdependent. BA had to cancel all short haul flights this Saturday due to a technical issue.

Given these two points, you should be ready for what feels impossible.

What about the long term consequences?

·         Opportunity and threat for China (see today’s special Xi’s Russian Roulette)

They can step in to help Russia where the West has frozen them out, but at a price that Russia may not be prepared to pay. Equally, China is already reeling from the pandemic, both geopolitically and economically. They might like to think the renminbi can now challenge the USD for reserve currency status, but they have just found out their 3 trillion dollars of FX reserves is worth less than it was yesterday. If they provoke the west now, they face the same bankruptcy threat as Russia.

They might decide to distract from this by invading Taiwan, although we doubt it..

·         Global recession (and stagflation)

We already anticipated long-run growth would struggle in the wake of the pandemic until we adjusted to the impaired velocity of people. Now we can throw in a monumental cost shock as the price of energy and food will rise further. This will weigh on Aggregate Demand. As if the world wasn’t already burnt out from two years of fear, this will panic consumers once again. Banks are unlikely to lend as much credit as confidence ebbs.

·         Monetary and Fiscal Response

This will be tougher to execute than in the pandemic.

–          More spending will go towards Defence, which famously has a low multiplier in terms of its impact on growth.

–          Debt and deficits are already creaking, although war provides a decent excuse to avoid bringing them back down.

–          If central banks were already worried about a possible wage-price spiral with oil at $100, how will they feel if it gets to $200? They need to ensure they remain vigilant on the inflationary threat.

–          Whatever It Takes was already dead. Now it’s a world of least worst options where either Russia withdraws its gas or Europe stops buying it, leaving everyone economically worse off.

The world has changed. This is no longer just about Ukraine. The land war is just one front. We are now all in an economic war

The litany of costly Fed errors

The initial phase of the Fed’s ongoing inflation mistake, an error that will likely be remembered as one of its biggest ever, started with last year’s protracted mischaracterization and dismissal of price increases as “transitory.” Although evidence of persistently high inflation dynamics was increasingly visible, the Fed repeatedly dismissed these signs, failing, most notably, to heed the warnings expressed by firms on one earnings call after another.

It is not entirely clear what was behind the Fed’s initial misstep on inflation. What remains baffling is that, for most of 2021, policymakers seemed eager to double down on their “transitory” claim, rather than show humility as their inflation forecasts were revealed to be repeatedly and spectacularly wrong. Even today, officials are hindering the restoration of the Fed’s badly damaged credibility by not explaining why they made this protracted mistake. This lack of mea culpa likely involves some combination of cognitive capture, loss of focus, unwillingness to admit error, and reluctance to abandon a “new monetary framework” that quickly became outdated and counterproductive.

It was not until the end of November 2021 that Fed Chair Jerome Powell – finally and belatedly – declared it was time to “retire” the word “transitory.” But then came the second stage of the Fed’s multifaceted blunder. The policy adjustments that followed Powell’s statement were extremely modest, with the Fed announcing only that its large-scale asset-purchase program, known as quantitative easing (QE), would be wound down entirely by March 2022. That was the time for the Fed to do two things to restore its inflation credentials and retain adequate control of its policy narrative. First, it should have explained why it messed up its inflation call so badly and how it had adjusted its forecasting models to be less wrong in future. Second, the Fed should have taken significant initial policy steps and provided guidance about what would follow.

Having failed to do either, the Fed then entered the third stage of its historic mistake by losing control of the policy narrative just as inflation readings were getting worse. Nothing highlighted better the big hole that the Fed had dug itself than the fact that, as late as February 2022, it was continuing its QE liquidity injections, even though inflation was running at 7.5%, a 40-year high. Astoundingly, and despite calls to act, the Fed had rejected an immediate halt to QE at both its December and January policy meetings.

All of which brings us to today. Inflation readings continue to surprise on the upside, and Russia’s invasion of Ukraine will increase the risk of a stagflationary shock. Meanwhile, Fed officials have offered different views publicly regarding how the central bank should approach both interest-rate hikes and reducing its bloated $9 trillion balance sheet. Lacking any proper guidance from the Fed, the market rushed to price 7-8 rate hikes in 2022 alone. Some Wall Street analysts went as far as ten, including a 50-basis-point hike as soon as the Fed’s mid-March meeting. Others urged the Fed to implement an emergency intra-meeting rate increase.

The Fed’s suboptimal decisions over the past 12 months mean that its next policy decision also is likely to be suboptimal. Even if it had a good feel for the current “first best” policy response, the Fed is unlikely to be able to implement it, given how far policymakers have fallen behind economic realities. Rather than being able to deliver a smooth landing for the US economy, the Fed must now judge what constitutes the least harmful alternative. Such a choice is like being forced to select an already dirty shirt because no clean ones are available anymore. And that is not a good look.

Clearly, the question is could inflation force the Fed into steeper rate hikes? Well, we are not seeing so in the markets right now.

Ahead of the Ukraine conflict, the theory was that a flight to Treasuries as a haven would drive yields lower and ease conditions. In trading last Thursday, real yields came down dramatically, and then investors thought better of it as the initial sanctions package came over as a damp squib. Yesterday and today, real yields came back down again, and this time there were no second thoughts. Indeed, it has continued today:

At this point, the risk-off Ukraine trade has canceled out roughly half of the increase in real yields that had happened this year as markets adjusted to drastic new expectations of the Federal Reserve. This in turn helps to explain why the damage to equities has been relatively limited so far; steeply negative real yields make it that much easier to buy stocks. This is one way, then, in which the geopolitical situation has made the Fed’s job of curtailing inflation harder.

Another is through commodity prices. Energy prices are central to the conflict, but if we look at the Bloomberg indexes for industrial metals and agriculture, we find that both have made new highs for this cycle in the wake of the invasion, surging further ahead today (just as we at IQ had been forecasting):

Hopes that commodity prices had put in a high near the end of last year now appear to have been dashed decisively. At the same time, the point at which raw material prices begin to take headline inflation rates lower is moved further into the future. Economists’ forecasts still call for a peak in inflation some time in the next few months — the Ukrainian conflict looks as though it will delay that peak.

The conflict is definitely making Jerome Powell’s job much harder. The rest of this week, with Tuesday’s customary first-of-the-month data drop followed bythe Fed chair’scongressional testimony on the next two days, and then US unemployment data Friday, promises to be difficult. Attention will still be focused on the eastern borders of Europe, but markets remain concerned about a generational increase in inflation. We are about to get the first inklings of how the Fed intends to maintain its battle againstrising prices while an all-too-literal battle carries on seven time zones away.

As such, then, it is interesting that, the Wall Street Journal’s Fed trial balloon outlet, Nick Timiraos, opens his article today with the following comment:

“The war in Ukraine isn’t likely to prevent the Federal Reserve from raising interest rates next month, but any worsening of inflation pressures could force the central bank to tighten policy even more aggressively than already hinted by senior officials…

During geopolitical shocks, the Fed generally avoids taking steps that increase uncertainty. But with inflation running far above its 2% target and the Ukrainian crisis threatening to push prices even higher, the Fed could face considerable urgency to continue with planned rate rises…

One question for Fed Chairman Jerome Powell is whether he needs to prepare markets for the possibility of larger-than-anticipated increases this summer—by half-percentage-point increments—if inflation doesn’t diminish soon enough. He is set to begin two days of testimony on Capitol Hill this week, where he could face questions on the inflation outlook…

But this could be tricky for the Fed right now because U.S. inflation is already high. Officials are turning anxious about an overheated labor market with wage gains well above their pre-pandemic highs and the risk that consumers and businesses will expect bigger price increases in the future, fostering persistently higher inflation. More Fed officials have indicated they would prefer to begin raising their benchmark rate in March by a quarter percentage point—the size of all Fed rate increases since their last half-point move in 2000…

At their March meeting, Fed officials also could try to finalize plans for shrinking the central bank’s $9 trillion asset portfolio, which could allow that process to begin by May or June.”

Take note of this article, as Nick is in a privileged position with regard to the Fed.

Now, moving on to the last point mentioned  above in the excerpts from Timiraos’s article – the balance sheet. What are the inputs to estimating a roadmap for balance sheet reduction?

The Fed’s balance sheet runoff and balancing that with the underlying demand for reserves from the banking system

The first, and easiest, part is to determine the level of reserves as of the start of the runoffs.  Every Thursday, the Fed issues a weekly report, its H.4.1 release (Factors Affecting Reserve Balances), providing those data.  As of the week of February 24, reserves stood at just under $3.8tn, and the total of Reserve Bank Credit (ie the size of the balance sheet) was just under $8.9tn.

Second comes the hard part, and indeed one of the critical issues – estimating the underlying demand for reserves as of the start of the runoffs. Underlying or ‘organic’ demand is assumed to be scaled to economic growth.  As the economy grows and transactions grow, the need for reserves increases.  Organic demand is the demand associated with the routine healthy functioning of the bank system (liquidity and resolution requirements) and the interbank market, as opposed to demand triggered by a shock to the economy, to financial markets, changes in regulation and other structural developments.

However, demand for reserves is not accurately observable, and so has to be estimated.  Right now, it is reasonable to assume that the system is awash in reserves and excess reserves can be counted in the trillions of Dollars.  But Fed policymakers need more precision. There are two basic approaches to estimation:

·         The first is to directly ask the banking system about the level of reserves it needs.  In planning for the balance sheet runoffs in 2017, the New York Fed included special questions about reserves demand in its regular survey of Senior Financial Officers and repeated those questions several times thereafter.  The results showed a surprisingly persistent strong demand for reserves above the level necessary for what the banks identified as normal smooth functioning.  That in turn informed policymaker assumptions about the equilibrium size of the balance sheet and the scope for shrinking it.

·         An alternative is to start at some presumed level of organic demand in the past (pre-Covid level perhaps) and then project that forward.  The next step is to then understand what if any structural changes to reserves demand might have occurred in the interim.  Since we cannot survey the banks to ask about reserves demand, we use this second approach.

Next, the Fed chooses a path to reduce supply to meet demand at some point in the future.  Once the FOMC has an estimate of how demand for reserves will evolve, it can consider many scenarios for reducing supply to meet demand at different points in the future. Of course, this begs the question when and at what level will such decreasing supply meet increasing demand.

This is a chicken-and-egg question.  Does the FOMC start with a preferred pace of shrinkage and then see how long it will take to equal demand or choose a date when it wants to complete runoffs which will then imply the pace of reduction?  It’s going to be a little of each, some decreasing supply and some increasing demand, but which side prevails.  For example, some policymakers may have a strong view on the scale of runoffs that financial markets can comfortably digest.  Others may have a preference for normalizing the balance sheet over a particular time period.

Once the FOMC has an estimate of how demand for reserves will evolve, it can consider scenarios for reducing supply to meet demand at different points in the future. The Fed will reduce supply gradually even if, as the Fed has forecast, the pace of runoffs is faster than in 2017-19.  During the time it is shrinking the balance sheet, underlying demand will be growing as the economy expands.  For an estimate, using $9.0tn versus $3.7tnfrom the latest data from the above-mentioned H.4.1. release, if underlying reserves demand is consistent with a $5.3tn equilibrium balance sheet as of March 2022 (versus the current almost $9.0tn), it may be about $5.75tn in March 2023, $6tn in March 2024, $6.25tn in 2025 and $6.5tn in 2026, barring new structural changes to reserves demand.

As such, it is fair to expect the FOMC to be willing to run off maturing securities and not reinvest paydowns on MBS pools at a pace about twice as fast as that of the 2017-19 runoffs.  Multiple policymakers, including Chair Powell have commented that the balance sheet runoff will be faster than in 2017-2019, which indicates both a higher level of runoffs and a steeper acceleration compared to 2017-19. In 2017, the initial pace of runoffs was $6bn a month for Treasuries (the remaining maturing securities continued to be reinvested) and $4bn for MBS.  The FOMC also announced a scheduled acceleration of the runoffs of $6bn a month for Treasuries and $4bn a month for MBS, until they reached $30bn monthly for Treasuries and $20bn a month for MBS.  During much of the ensuing two-year period of reducing the balance sheet, the actual paydowns of MBS ran well below the scheduled paydowns that would not be reinvested, leading to a slower pace of shrinkage than the FOMC hypothetically would have implemented.

From the above, it is fair to assume that the FOMC will consider runoffs of at least $10bn and as much as $20bn of Treasuries a month as an initial pace, starting sometime later this year, and subsequently, to step up the pace.  If the runoffs start around $10bn a month, the acceleration could well reach a pace of $50bn a month before plateauing.  On the other hand, if they start at the faster $20bn a month pace, then the pace of acceleration will be slower, perhaps rising $10bn a month for six months, ending around $70bn monthly.  If those hypothetical paces were sustained, the annual reduction in Treasuries would be in a range of $600bn to $840bn annually.

For MBS, the natural runoff, meaning with no reinvestment of paydowns, will be very slow owing to the long duration of the Fed’s holdings.  As a result, the MBS paydowns will likely contribute very little to the early stages of the shrinkage.  The FOMC may well announce a faster pace than initially implemented in 2017, but actual paydowns likely will be far slower. Furthermore, look for the FOMC to set a cap on paydowns not reinvested.  That could be in the neighborhood of $5 – 6bn per month, with a similar escalation to that of Treasuries, up to $20bn or $24bn a month.  Indeed, the actual paydowns will most likely fall short of that in almost every month for several years. In other words, if the FOMC initially announces a total of $15bn ($10 + 5) or $25bn ($20 +5) in maturing Treasuries and MBS paydowns, the actual number will be much closer to the total for Treasuries alone.   In addition, as the runoff schedule accelerates, that will continue to be the case.

It should also be noted that the FOMC are willing to consider selling MBS and rebalancing the portfolio with Treasury purchases, although not in the early stages of reduction, at least for the first year.  Why so? Well, actually the January FOMC minutes confirmed that sales of MBS may be in play:

“…many participants commented that sales of agency MBS or reinvesting some portion of principal payments received from agency MBS into Treasury securities may be appropriate at some point in the future to enable suitable progress toward a longer-run SOMA portfolio composition consisting primarily of Treasury securities.”

Consequently, when presenting the roadmap for the balance sheet, the FOMC will not explicitly announce any sales of MBS, but simply not exclude that option, which the Committee did rule out in the earlier plan announced in 2017.  It will maintain the plan that balance sheet reductions would be achieved principally through runoffs. To put some figures on this, it looks like the annual pace of shrinkage, once the runoffs have accelerated to their sustained pace, will be in the range of $600bn to $840bn for Treasuries and with some modest MBS paydowns in the vicinity of $30bn to $50bn, thus making the range of total theoretical shrinkage $630bn to $890bn annually.