“It’s The End Of The World As We Know It And The Fed Feels Fine”

By Michael Every of Rabobank

Politico managed to achieve the most click-worthy title this weekend – ‘It’s the end of the world as we know it – and Munich feels nervous.’ I will return to the Munich Security Conference in a moment, but first let’s look at a snapshot of recent economic trends:

• US core PCE inflation on Friday is expected 0.4% m-o-m and 4.3% y-o-y, more than double the rate of the Fed’s 2% CPI mandate.
• Between Q4 2019 and Q1 2021, as services spending collapsed and pandemic assistance programs flowed, total US credit card debt fell from $930bn to $770bn. In Q3 2021, it started to rise, and in Q4 2022 leaped $61bn, the largest increase since 1999, to hit a record $986bn. Whether people are borrowing and spending because of the economy, or because they have no choice because of the economy, it is happening.
• @GuyDealership says: “Used car prices are *skyrocketing* at a concerning pace. Prices have increased 4.1% so far this month: The LARGEST February increase since 2009. Buckle up.” However, delinquencies on car loans are also soaring.
• Labor hoarding continues in construction due to the backlog of work that wasn’t done during Covid and as state spending picks up.
• The Washington Post says ‘Biden’s ‘Buy America’ bid runs into manufacturing woes it aims to fix: Infrastructure officials complain they can’t find US suppliers for items they need to buy American by law.’ That sounds inflationary.
• As we focus on US wage growth, Social Security and Supplemental Security Income benefits for approximately 70m Americans will increase 8.7% in 2023. That flows through to those with the highest marginal propensity to consume: pensioners who have done their life-time saving, and those at the bottom of the socio-economic pyramid.
• Recent liquidity expansion by the BOJ and PBOC, as well as the use of the US Treasury General Account balance, is arguably countering the effects of Fed QT. (And on QE, the late Shinzo Abe’s memoir notes: “Issuing JGBs for COVID stimulus checks does not mean that debt is being passed onto our grandchildren. The Bank of Japan purchases all government bonds. The Bank of Japan is like a subsidiary of the government so there is no problem.”)
• Outside the US, rate hikes are hurting. Australia’s Westpac has warned that almost half of its A$471bn in home loans were written using interest rate buffers that are set to be exceeded.

The key question is this: do the Fed keep going until they break things; or do they stop and admit 3-4% CPI is good enough?

Both of those outcomes imply the end of the world as we have long known it in markets. The first is an argument for bear flattening in bonds, a collapse in everything except bonds, and of everything against the dollar. The second implies bear steepening in bonds, a rally in everything else as an inflation hedge, and a collapse of the dollar against everything else.

So, back to Munich. This key security conference was covered by Bloomberg, but desperation to believe the world they represent is not ending saw its headline writers spin that the US and China were “talking”. Yes – except the US accused Beijing of unacceptable behaviour over spy-balloons, and claimed China is considering providing “lethal support” to aid the Russian invasion of Ukraine. China effectively called the US a warmonger while trying to woo Europe, and on Sunday warned the US it would “bear all the consequences” if it escalated the balloon further.

Moreover, US talk about Russia was equally confrontational. Vice-President Harris accused Moscow of crimes against humanity, climbing a ladder that will be very hard to come down from. UK Prime Minister Sunak is lobbying to send Ukraine the most advanced NATO weapons. China will release its peace plan on the first anniversary of the war on Friday: the West is sceptical.   

This matters as the geopolitical is now the geoeconomic. NATO chief Stoltenberg directly stated Europe’s dependency on Russian gas was dismissed as being economic, not security-related before February 2022 and that the EU should not make the same mistake with China, or others, by depending on their raw materials or exporting key technologies to them. Of course, such talk is cheap. Indeed, geopolitical thinker Michta noted in a sombre analysis:  

“Was this what 1938 felt like before the German Nazi rape of Czechoslovakia? Satiated countries in the West issuing solemn assurances to Prague and others, but knowing deep in their bones that those checks would not be cashed?  Because it was somebody else’s business, not ours?…

Rhetoric is not policy. I’ve sat through too many discussions where everything has been said but not by everyone, so we droned on… It’s not rocket science. It’s about spending the money to produce weapons and munitions so we can send them to Ukraine. It’s about agreeing what the end state should look like not for Ukraine, but for all of us. It’s about imagination, leadership and courage.”

It is also about supply chains, on/friend-shoring, massive defence spending, capital controls – and then inflation and interest rates. One can no longer look at the latter in isolation.

Relatedly, Senator Hawley just gave a speech ‘China and Ukraine: A Time for Truth’ hammering home that the US cannot do what is it doing in Ukraine and step up in the Pacific, and arguing Europe must defend itself –and Ukraine– now. Neither Europe nor markets grasp the tail risk of what this shift in US stance would entail, just as they ignored Trump in early 2016, and didn’t read Marx ahead of China’s Common Prosperity. Even for the US, Hawley claims:

“Suppose China invades and seizes Taiwan. We try to stop it, but our forces are defeated and the island is lost. What would that mean?… Americans will confront a new, terrifying reality. Every American will feel it. The price hikes and disruptions we’ve seen in recent years will pale in comparison. Product shortages will be commonplace – shortages of everything from basic medicine to consumer electronics. According to some estimates, a war over Taiwan would send us into a deep recession with no clear way out, since huge swaths of our economy run on Taiwanese semiconductors. But the economic consequences are just the start. 

If China takes Taiwan, it will be able to station its own military forces there. It can then use its position as a springboard for further conquest and intimidation – against Japan, the Philippines, and other Pacific islands, like Guam and the Northern Marianas… As Asia’s new reigning power, China could restrict US trade in the region – perhaps block it altogether. Maybe we’ll be allowed in, but only on terms favourable to China. China exploited the trade system once before. They can do it again…

Imagine a world where Chinese warships patrol Hawaiian waters, and Chinese submarines stalk the California coastline. A world where the PLA has military bases in Central and South America. A world where Chinese forces operate freely in the Gulf of Mexico and the Atlantic Ocean.” Hawley’s proposed solution to prevent this “dark future” is “a nationalist foreign policy. A foreign policy in the spirit of Alexander Hamilton and Theodore Roosevelt. A nationalist foreign policy places America’s interests first. And deterring China from seizing Taiwan should be America’s top priority.”

Meanwhile, today’s headlines are also that inspectors say Iran’s uranium processing has almost reached nuclear weapons-grade purity (as they stand next to Russia and China); and North Korea just tested both short-range missiles and an ICBM that might soon be capable of holding a nuke. Both developments make urgent US, and European, action more likely. I don’t mean rate cuts.

One does not have to worry about the end of the world per se, but the world we knew is ending: in geopolitics; in geoeconomics; in monetary policy; and, with a lag, in markets