Re: Oil/Inflation/Geopolitics - Squid Game Tug-of-War.
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Re: Oil/Inflation/Geopolitics - Squid Game Tug-of-War.
The Clash of the Titans between the Fed & OPEC+ could cause a toxic tug-of-war between Inflation and Deflation with a "Squid Game" outcome.
The Clash of the Titans between the Fed & OPEC+ could cause a Toxic Tug-of-War between Inflation and Deflation with a "Squid Game" outcome.
I will build my case with several key observations.
Observation 1: The Fed remains hawkish after 10 rate hikes.
This week the Fed raised the Fed Funds Rate for the 10th time in a year to 5-5.25%, and rather than the “Dovish Hike” everyone (especially the markets) expected, what we got was a “Hawkish Pause.”
I heard a Jay Powell who was unexpectedly HAWKISH especially given the stress in the regional banking system. The money phrase for me was: “We recognize that Inflation erodes the purchasing power of those least equipped to bear it."
He is, of course, 100% correct. I have been saying for the better part of two years now that Inflation is the most REGRESSIVE tax of all that affects 100% of people versus the ~1.5 mm to 2 mm jobs he is seeking to remove from the ranks of the employed (what it would take to take unemployment from 3.4% to 4.6%).
What should give the “Fed Pivot” crowd pause:
He went out of his way to highlight how “resilient” the labor market remains, citing that it was “even tighter than before we started hiking.” The strong NFP report Friday, coupled with a new low in the Unemployment Rate of 3.4% corroborates his comments.
When overtly asked about rate cuts, he said , “We don't think Inflation will be coming down quickly...and in that world, it would not be appropriate to cut rates."
When asked about regional banking stresses, he uttered the ominous “THIS TIME IS DIFFERENT” phrase and seemed almost nonchalantly confident in being able to ring-fence contagion.
KEY TAKEAWAY FROM POWELL’S PRESSER:
WHILE A PAUSE IS POSSIBLE, FORGET ABOUT IMMINENT RATE CUTS; THE MARKETS HOPED FOR A “DOVISH HIKE,” AND WHAT IT GOT WAS A “HAWKISH PAUSE.”
Observation 2: OPEC+ acted prematurely last month, and Oil has collapsed.
Last month, I wrote about how OPEC+, in an effort to avert short-term pain, likely sacrificed longer-term gain by pushing off the SUPPLY/DEMAND SINGULARITY and that it would likely be a WASTED EFFORT when the Fed was not yet done with its Inflation Fight.
Even I did not anticipate that the cuts would not even stick around for one month, however!
Oil rebounded 4% on Friday along with all Risk Assets, but I have serious doubts about lasting strength going into 2H’23.
Observation 3: There are already many reasons for China to devalue, and Oil’s collapse increases that likelihood.
I have already written at length about China’s Debt Bomb here:
OPEC+’s failure to support Oil prices simultaneously makes CNY devaluation more palatable for the PBOC while keeping policy uncertainty high for an already-hawkish Fed.
In my “China Shop” Substack post, I used the classic “Scylla vs. Charybdis” myth to illustrate the PBOC’s quandary:
When the repercussions of importing Inflation are diminished given SPR stocking, increased Supply Elasticity, and continued demand destruction, it makes the decision to turn the ship towards the “Scylla” of WEAK CNY that much easier for the PBOC to swallow — especially when China needs to keep its export-driven economy from imploding.
The reason why Oil prices are not holding despite OPEC+’s recent cuts is because of the DOWNWARD DEMAND SHOCKS FOR ALL GOODS & SERVICES (again, explained in my “OPEC+ Fantasyland” post) experienced by China and also the rest of the world. China, however, is particularly susceptible to downward demand shocks because its entire GDP is based almost entirely upon EXPORTS to the West.
There are other factors at work as well that might exacerbate the pressure on CNY as well.
I highlight several key charts:
This timely tweet above points out the potential FLIGHT TO SAFETY TO THE USD in times of stress — ESPECIALLY when “policy rates stay high.” Note in particular the simulated performance of BRICS currencies: BRL, RUB, INR, CNY, ZAR.
I dispelled the BRICS/De-Dollarization hyperbole here:
What about the Debt Ceiling drama leading to massive FLIGHT OUT OF USD/USTs?
I don’t buy it at all, and neither does the market. Not to be a Pollyanna, but I think the whole “X-Date” fear is akin to “Y2K” — a big NOTHINGBURGER.
In fact, in a global Risk-Off environment, the world continues to flock to USTs/USD, Debt Ceiling shenanigans notwithstanding:
Michael Cembalest of JP Morgan, who I regard as a top-notch Macro thinker and strategist, recently put out a paper entitled: “Oh, The Places We Could Go: on the US dollar, reserve currencies and the South China Morning Post,” in which he pours cold water on De-Dollarization hyperventilation as well.
He covers roughly the same ground as my “BRICS-a-Brac” Substack post above, but he adds several other key points:
The third chart on the right is key and makes me think that CNY is even closer to its Minsky Moment that I previously thought.
Cembalest: “China’s money supply is very high; if China fully opened its capital account, possible outflows could crush the RMB and cause a collapse in Chinese equity/real estate markets.”
The PBOC Governor recently gave a speech in which he claimed that 99+% of households were “unconstrained” by the annual $50k limit on capital outflows. Yeah, right.
Take a look at what happened to ARS (Argentinian Peso) when these divergences happened:
What about the whole notion of CNY replacing USD as GRC because the Chinese Economy now rivals/exceeds the US Economy in size?
There are many problems with this argument, not the least of which is the previously mentioned EXPORT-DRIVEN nature of China’s economy. How does their GDP hold up when Western economies are slowing down?
Finally, Cembalest makes a great point here:
NOT ONLY DO I THINK CNY HAS NO SHOT AT SUPPLANTING USD, BUT I VIEW DEVALUATION OF CNY AS A NECESSARY BUT NOT NECESSARILY SUFFICIENT CONDITION TO CURTAIL GDP SLOWDOWN FOR CHINA.
EUR and GBP strength have been the primary drivers of recent DXY weakness, but I continue to think that it will be difficult for other CBs to out-hawk the Fed, and this week’s FOMC presser decreased the probability of Powell out-doving anyone either.
Germany, in particular, seems to have learned a “bad lesson” from Mother Nature’s gift of a warm winter this time around and has shuttered its nuclear reactors. If Europe gets a harsh winter this year, the ECB will be crippled in its Inflation Fight.
The normalized comparison above of EUR, GBP, JPY and CNY already belies the relative weakness of CNY against the other major currencies.
Imagine what happens if the USD actually STRENGTHENS in a global Risk-Off?
Observation 4: OPEC+’s incentives are now Economically and Geopolitically aligned.
Despite Oil not holding up post-cuts, what happens when April CPI numbers come out much HOTTER than anticipated, because it likely captures the price UP SPIKE from the surprise OPEC+ cut but not the DOWN SPIKE?
I believe that OPEC+ knows this and might actively game this dynamic to box the Fed in; what’s to keep OPEC+ from executing another “surprise cut” to goose the next CPI print to keep Fed Policy tight?
Given the failure of the cuts to stick, OPEC+’s Economic incentives are now even more aligned with its Geopolitical incentives (to stick it to Biden). Not only do they maintain control of the market (through increased Spare Capacity) on the upside, only additional OPEC+ cuts can stymie the continued downward whoosh of demand destruction given an intransigent Fed.
OPEC+’s Geopolitical motives may very well drive its decisions in the short- to medium-term now and be designed to stoke Inflationary flames in order to force the Fed into causing a HARD LANDING heading into an Election Year. That may sound counter-intuitive to its longer-term Economic motives, but it’s the only reason I can think of that would justify what seemed to be a nonsensical and premature cut.
Because of the enmity MbS harbors for the Biden Administration, I would not be surprised to see another OPEC+ cut to goose Oil prices just when the CPI data and/or employment data show signs of cooling Inflation.
I could very well be reading too much into this. The Occam’s Razor explanation is that they panicked too early. Either way, OPEC+ is in control now, and it’s a “Clash of the Titans” between the Fed and OPEC+, as I wrote back in April.
The implication is that Fed Policy is now somewhat at the mercy of OPEC+, which could easily box them into a “Higher For Longer” regime with well-timed cuts to manipulate CPI — especially since Oil is the primary feedstock for so many other inputs to Inflation.
It was Oil Inflation that started it all, in my opinion, and it only takes OPEC+ keeping the embers hot to keep the Inflation party going drive the Fed to stay “Higher For Longer” than most expect.
Conclusion:
THE WORLD IS NOW FACING A TOXIC TUG-OF-WAR BETWEEN STICKY INFLATION (SPURRING A STUBBORNLY HAWKISH FED) CAUSING A DEFLATIONARY NEGATIVE FEEDBACK LOOP INTO OIL DEMAND THAT MAKES IT MORE LIKELY FOR CHINA TO DEVALUE; THIS IN TURN SPURS A GEOPOLITICALLY AND ECONOMICALLY MOTIVATED OPEC+ TO DEFEND OIL, THEREBY STOKING INFLATION AGAIN.
I don’t know how what side “wins” yet, but it sure reminds me of another game of Tug-of-War with less than ideal results for all involved.
Re: Oil/Inflation/Geopolitics - Squid Game Tug-of-War.
I agree that the "X" date isn't real and the announcement timing seemed more like a move by Yellen to influence the vote at the FOMC meeting where it appears to me that Powell had to make concessions to the doves in the Committee's statement. Yellen has tools like those used in the past to stretch out funding for a while. What has me bothered is the politics this time around. I know it's problematic to say this time it's different, but it seems that way to me. McCarthy's speakership is at the mercy of the Freedom Caucus, who can get rid of him with 1 member calling for a no confidence vote. Some of them like MTG strike me as having the "burn the house down" philosophy of government that Steve Bannon articulated. This could mean that McCarthy can't even get the votes to kick the can down the road to buy more time for a deal. On the other side, while I believe Biden believes in the system and maintaining its integrity, he's under a lot of political pressure not to give in from his fellow Democrats. They remember the 2011 budget "cap" deal Obama cut, only to have the Republicans ask for more concessions in 2013. Can't tell you how many Dems I've talked to trying to explain the downside of not compromising to get the debt limit increase passed who quote the Who's song lyric "Won't get fooled again" (OK they were all Boomers, but connected party officials in NYS, and they were all adamant about not giving any ground). I believe this why you see the White House floating the use of the 14th amendment to declare not raising the debt limit unconstitutional. It seems to me the Dems want to show the Republicans they don't feel boxed in and that Biden has called for a negotiation to say he tried, before resorting to "unconventional measures". If the Dems go that route, I'd bet that when it gets up to the Supreme Court that argument goes down in flames, given the dominance of the conservatives on the Court. What also struck me was the recent poll on who would be blamed if we default. It follows the usual breakdown in how Americans vote. So what's the political downside when you can blame the other side for the economic chaos that might ensue from a default and the party loyalists will vote for you again in the primaries and the general election (which most will win given how gerrymandered Congressional Districts are today). Nobody thought Brexit would happen, but the politics of that time were misjudged by the experts. So perhaps we ought to add some level of probability to the potential for a default?
Thank you Michael. I appreciate your insights and perspectives. Having just finished reading Charles Goodhart’s “The Great Demographic Reversal”, I am curious to know how you see demographics playing a part in the current geopolitical mosh pit?
When I think about a global tug o war, its in the form of a venn diagram of energy, economy and demographics. Formulaically: GDP=Employed People x productivity. You either grow GDP by having more people produce, or each person becoming more productive. I see the productivity part as exogenous energy and intellectual capital, and is reliant on (relatively) cheap access to fossilized carbon. This aligns with your OPEC thesis. The people part is demographics - high working age population, young population relative to both young and especially older dependents. We know Japan’s working age population topped with the Nikkei in 1989, and their only saving grace has been to offshore production to better demographic lands. China’s one child policy has left it with a demographic time bomb, with fewer employed gradually supporting a supermajority of seniors. The US is in a slightly better demographic position, but along with most of the developed west, is in demographic decline (decreasing worker to dependent ratio). Poor demographics is by nature inflationary (young and elderly consume but don’t produce). Goodhart’s hypothesis is that the last few decades have been deflationary by nature due to the improving demographics, but the next few decades will be structurally inflationary due to the declining world demographics. This seems to align with the “sticky “ and “higher for longer” inflation. Thoughts?