Rabobank: The Fed’s Gloves Comes Off As China Throws In The Towel

By Michael Every of Rabobank

Yesterday’s Fed minutes showed the gloves are off. The FOMC was close to a 50bp hike last month, only the war stopped them, but it won’t stop them ahead. Moreover, QT starts in May at a pace of $60bn a month for Treasuries and $35bn for MBS. As Philip Marey puts it here, “The minutes show an FOMC that realizes it is far behind the curve and desperate to catch up. The Fed is now front-loading and likely to take big steps in tightening monetary policy at the May meeting. However, as the economic outlook is deteriorating they may already be too late. The recent inversions of the yield curve suggest that this hiking cycle is going to end prematurely and could very well be followed by another recession.”

Former Fed president Dudley stated to CNBC that the FOMC needs to “inflict more losses” in stocks (and bonds) in order to rein in soaring inflation: “If stocks don’t fall, the Fed needs to force them.” Which at least shows us that Wall Street is indeed what the Fed sees as the actual economy. US 2-year yields managed to end down almost 13bp from their intraday highs and 4bp on the session at 2.47%, showing they seem to be pricing for the recession in advance; US 10s fell less intraday and closed the session higher at 2.60%.

By contrast, China threw in the towel: “All departments should study contingency policy plans in response to changes in the situation and roll out measures conducive to the stability of market expectations in a timely way,” the cabinet said. That will mean rate cuts as the Fed is hiking: 16bp to go until US and Chinese bond yields sustainably cross-over, which could happen within this week given current daily volatility. As stock and bond flows into China have already dried up, how long can CNY then pretend it is not soft pegged to the dollar again? Yet a weaker CNY would be inflationary, hitting Chinese consumers and/or firms.

Yet Chinese stimulus will force the Fed to keep going. Beijing has two choices: follow academics arguing that ‘Revitalizing Consumption Remains a Major Challenge to the Chinese Economy’ and for giving out 1,000 digital CNY per person ($157) to spend within a limited period – the kind of stimulus that won’t solve structural problems, as we saw in the US, or make CNY more stable; or, as Bloomberg extolls, and is far more likely, to build more (unneeded) infrastructure, with a $2.2 trillion a plan laid out – and then watch global commodity prices soar.

Even if the Fed tightening cycle is nasty, brutish, and short, markets also have to deal with the Pentagon confirming the Hobbesian war in Ukraine could last for years: that means persistent supply-chain and supply-side disruption. To underline the point, US Secretary of State Blinken just stated: “What is success, what is victory? It’s holding on to the sovereignty and independence of their country. And there is no scenario by which over time that will not happen.” So, Ukraine will win –over time– despite nuclear-armed Russia seeing this as an existential battle it cannot lose.

On which, we just saw a further escalation in Western sanctions against Russia, with the likes of Sberbank and Alfa-Bank dragged in, the children of Putin and Lavrov targeted, and US investment into Russia banned; and Russia just had to pay sovereign debt in roubles as a result of existing dollar sanctions – but which in many ways is a gift to it. None of these measures will change the military dynamic on the ground in the direction Blinken wants. And the next major phase of fighting is expected to begin in around five days.

Indeed, Reuters quotes Benn Steil, international economics director for the Council on Foreign Relations think tank in New York, saying:

“We are at the point where we have to take some pain. The initial batches of sanctions were crafted as much to not hurt us in the West as much as they were to hurt Russia.”

Yet is there any appetite for that in the US, alongside Fed hikes, ahead of November’s mid-term elections? Kid gloves, perhaps?

In the EU, the gloves are off… but against each other. MEP Guy Verhofstadt just vented: “You know why your strategy doesn’t work? Because progressive packages of sanctions with an autocrat doesn’t work. That works with a democracy, with democrats who have a public opinion, a real public opinion. In Russia, there is no longer a real public opinion.” He’s wrong: Russian public opinion broadly supports the war – but that actually makes his next point even stronger.

“The reality is it doesn’t work because the fifth package is, what, coal? It’s ridiculous. This is only 3% of imports from Russia. SWIFT, the ban, ridiculous. More than 50% of the financial institutions are still outside the ban. And the oligarchs,…will escape, finally, the sanctions, or lose a little bit of their money. You need to tackle the 6,000 people around Putin…

It’s time to change your strategy. It’s time to have an extra European Council as fast as possible, and to go for the full package of sanctions immediately, so that you can really make a difference. All the rest will not work. All the rest will prolong the war. [To Germany:] I expect leadership. Leading by example, and not dragging their feet as we see it today.”

As the EU talks about decoupling from Russian energy at its own pace —which is NOT how wars are fought— Reuters reports China’s SOE refineries, while honoring existing Russian oil contracts, are avoiding new ones despite steep discounts, to avoid being seen supporting Moscow; and as the US warns fellow Quad member India not to buy more Russian oil, India points out that when it followed sanctions against Iran, the US looked the other way while China consistently broke them “because markets”.

The time for muddling through is coming to an end. On rates, it’s true. On realpolitik, the demand is also for real action – and at a real cost. Just as money is no longer going to be completely free, neither are our geostrategic options. The logic is still either a full sanctions package –including energy– which will rock the economy and markets, or a prolonged war, which will rock the economy and markets. Gloves off, or towel thrown in, it ends up the same.

Indeed, time to take the gloves off or throw in the towel on all policies:

• There are more warnings about the pressure global commodity trading houses are under given huge price increases, higher volatility, margin calls, and sanctions. If we see state aid there as a result, does it come with the same kind of overarching regulation it did in other sectors, especially at a time of geopolitical tensions and ‘commodities as weapons’?

• On which, South Korea’s president-elect is asking for the US to return nuclear bombers and submarines to his country. So much for the peace attempts of his predecessor: and China will be thrilled.

• Canada announced it is to ban foreign purchases of residential property for two years to try to keep a lid on already insane prices.

• In a political stunt, Texas governor Abbot is apparently to bus illegal immigrants coming across the border from his state to Washington DC: which won’t be cheap with rising diesel prices.