From that horrendous market open in early March, broader indexes have now rallied between 5% and almost 15% from the lows. And they did it in just a week's time. That big move reminds us: The market is not only about fundamentals, but it is also about sentiment and positioning. So, after liquidation across the board, the market went into a state of extreme fear and shorting.
We can try to blame what's been happening in the market on the invasion of Ukraine, but it's more complicated than that. Let's tackle how the global conflict, oil, bonds and rates -- and the Fed -- all fit in.
Indeed, this year has been far from stable, as the trend has been challenged, even before Russia began sending out troops and tanks. The bigger issues prior to Russia barging into Ukraine were that markets were inflated with too much debt and the Fed had been ignoring secular signs of rising prices -- even as asset markets began slowing after the initial burst of Covid-induced stimulus on steroids that took everything higher since the March lows in 2020. Achieving a soft landing, while containing inflation, is a delicate balance. The market is unsure of how that balance will be set, or if can be. Only time will tell, but for now the Fed is like a child that has had its wrist slapped too many times and is hell bent on raising rates as fast as it can and by as much as it can, before it becomes a problem.
The war in Ukraine only exacerbated the underlying trend of slowing growth and heightened inflation, taking us to the tipping point, months before we would have gotten there. Supply chains were tight and demand robust, leading to higher prices everywhere. We all know that these higher prices are present until the supply side has had enough time to play catch up to the current demand. It is either that, or demand that needs to fall to cope with the lower supply. The Fed knows this, and hence its aim is now to contain this demand to keep prices and, in effect, inflation in control.
Oil Gunks Up, Greases the Wheels
Brent oil's price, after reaching highs of $135 a barrel, fell all the way down to $98 a barrel, and is now back up around $112 a barrel. Russia is one of the largest producers of oil, so any "perceived" shortages can cause massive spikes. But it is important to make a distinction between fear and reality. Initially, oil prices went parabolic, as the market feared the loss of Russian oil after all the Western sanctions were put in place. Following recent reports, oil and gas flows are still moving and are protected from the sanctions. Buyers in India and China have used this opportunity to buy up cheap Russian Urals at a $30-a-barrel discount, despite the sanctions. They simply do not care, as what matters to them most is the price. In effect, Russian exports are actually going up, not down, even if it is hard to secure a cargo or insurance easily, it is possible. This demand that is getting soaked up in Urals is bound to take some away from Brent. Outside of a full European Union ban on Russian oil, it is important to keep an eye on global oil demand.
Bonds of the Market
The bond markets have been in a state of distress since the start of the year. The shape of the yield curve has now inverted all the way from the 3 Year to the 10 Year, the 2 Year/10 Year is almost there, shy of 17 basis points. The bond market is signaling to the Fed that it's about to make a big policy mistake. The equity market is busy chasing shorts and "fear of missing out" trades, as it's too conditioned to buy any dip purely because of "The Fed always supports the market" logic. But it is influenced and inflated by a host of derivative positioning and algorithm flows. At the end of the day, it may get pushed and pulled, but make no mistake, the bond/rates and boarder asset classes do not lie. Given previous hiking cycles, we know that each time the Fed starts its hiking campaign, something snaps. The only question is how many times can Fed Chief Jerome Powell hike rates before he has to reverse policy yet again? It's a shame that before rates were in single digits, he had some room to cut them. Today, the Federal Funds rate is close to 0%, so he better raise rates fast so that he has some amount to ease ... when the time comes.