A whole lot of things are going wrong, all at the same time — leaving major central bank policy makers in a more precarious spot against a dicier, stagflation-like backdrop.
It’s not just Russia’s attack on Ukraine, which sent the prices of commodities like oil
corn, and soybeans soaring on Thursday. China is expressing support for Russia’s interests, leading some observers to say it may be eying Taiwan. And pandemic-driven disruptions continue to create shortages of everything from rental cars to semiconductor chips.
There are a few other, more seemingly random events: Climate change is making the world’s supply of food less stable and a lack of wind in Europe last year even led to a slowdown in wind-driven electricity production, pushing up the price of natural gas. The Suez Canal, the major waterway where a huge container ship became stuck last March, is still more than two years away from completing an expansion. And China’s zero-tolerance policy on COVID-19 is stretching supply chains months after the country’s drive toward sustainability led to electricity shortages.
“Everything that could go wrong, did go wrong,” Rabobank rates strategist Richard McGuire said via phone Thursday. “And central banks can’t do anything about this.”
Referring to recent hawkish pivots made by developed-market central banks, such as the European Central Bank and Federal Reserve, he said: ”They’re all facing varying degrees of trouble and raising rates may prevent the supply issue from being resolved because it reduces demand and the incentives to invest. That leaves central banks between a rock and a soft place” and trying to crack a supply-side “nut with a demand-side hammer.”
In a note titled “Utterly Depressing,” McGuire and strategist Lyn Graham-Taylor laid out a case for why the world is navigating through a series of “numerous unrelated negative supply shocks,” and an unexpectedly prolonged buildup of bottlenecks. The fear of central banks has been “that the longer these supply shocks continue, the greater the risk of longer-term inflation expectations becoming unanchored,” they wrote.
Market-based measures of inflation expectations all moved higher Thursday morning, with 5-, 10- and 30-year breakeven rates all climbing, though the moves were rapidly changing, according to data from Tradeweb. This came as global stocks sold off, with Dow industrials
off by more than 700 points in the New York afternoon; Treasurys rallied, sending yields lower across the curve; and fed funds traders reduced their expectations for an aggressive start to the Federal Reserve’s rate-hike campaign in March.
The “kneejerk” reaction from financial markets reflects a “flight to quality, given the uncertainty around the situation in Ukraine, combined with a positive inflation impulse,” BMO Capital Markets strategist Ben Jeffery said via phone. Inflation is back in focus because of the risk that the attack on Ukraine increases energy costs and “flows through to inflation in a way that monetary policy is not equipped to combat.”
The concern is that higher prices, combined with heightened geopolitical uncertainty, could “ultimately be stagflationary,” he and strategist Ian Lyngen wrote in a note.
The Ukrainian situation alone is resulting in further significant intensification of the “binary risks facing policy makers as cost push price pressures surge… and downside risks to growth mount,” according to Rabobank’s strategists. They see greater scope for traders to price out policy action in the U.S. than in Europe, where the rate market remains reticent to do so.
“The gulf between the opposing risks faced by central banks just got notably wider,” McGuire said in an interview.
However, “the downside risk to demand on the back of tighter policy is more palatable than the risk of letting the inflation genie out of the bottle,” he said. “As a consequence, any speculation of a reversal of the recent hawkish pivots is likely to ultimately be disappointed even if some degree of caution prevails over the immediate term.”