By Michael O’Neill
“Welcome to the Grand Illusion” is the first line and title of Styx’s 1977 hit. It’s a song that things are not always as they seem.
It was a lesson the Soviet Union didn’t understand when they launched an unprovoked invasion of Afghanistan two years later. The Soviets, led by General Secretary Leonid Brezhnev, used the pretext of defending the Soviet-Afghan friendship treaty for the attack, expecting a quick easy victory over what they thought were a disorganized band of tribal nomads. Ten-years, and 18 billion rubles later, Mikhail Gorbachev (Brezhnev’s successor) ordered a retreat.
Russian President Vladimir Putin copied Brezhnev’s playbook to justify his invasion of Ukraine. On February 21, Russia officially recognized two Ukrainian regions as independent states and Putin dispatched troops into both areas, calling them “peacekeepers.”
The peacekeepers were followed by a full-scale invasion on February 24.
Western governments were outraged and have announced a blizzard of sanctions on almost everything Russian, even cats. The international Cat Federation said Russian casts are not welcome at its international competitions. The EU is discussing a ban on the import of Russian energy, which would also be a hardship for Europe.
The world leaders hope that ostracizing Russia will force Putin to have his own Gorbachev moment and shatter Putin’s “grand illusion “ of a new USSR.
Vladimir Putin is not the only misguided muppet on the planet. One just needs to look on Wall Street to find a horde of traders and analysts who appear out of touch with reality.
The S&P 500 closed at 4325 the day before Russia recognized the rogue regions in Ukraine then plunged to 4115 in the wake of the invasion. One week later, the S&P 500 had fully recouped its losses. In contrast, it took the S&P index nearly eight years to recover from the 911 attacks.
Source: Saxo Bank
US stock markets are rallying even as the era of ultra-easy monetary policy goes the way of the dinosaurs. Traditionally, a rising interest rate cycle meant investors pared back holding of riskier assets and gravitate towards bonds. But not always. JPMorgan analysts showed that from 2009, the S&P500 rises until the 10-year yield is above 3.5%, then the two diverge.
It is not a stretch to believe the 3.5% threshold may be breached. US inflation soared 7.5% in January and is expected to have risen to 7.8% in February. The steep rise in oil prices in February and in March ,exacerbated by the impact of the Russian/Ukraine war on supply chains risk even higher inflation readings.
Former Treasury Secretary Larry Summers believes the US is on the brink of a spiraling inflation as evidenced by inflation forecasts for the next couple of years, most clearly in wage data.
Fed Chair Jerome Powell and his colleagues may have been slow to recognize the insidious grind of higher prices but that is changing. Mr Powell essentially said US rates would rise 0.25% on March 16, and opined about the need for 0.50% incremental moves if inflation continued higher.
Even so, put your hand up if you believe Fed rate hikes of two, three ore even four percent will be enough to stuff the inflation genie back into the lamp.
Inflation is getting a huge boost from the over 50% jump in West Texas Intermediate (WTI) oil prices since the beginning of the year. Sanctioning Russian crude production will ensure elevated prices until production in the US, Saudi Arabia and other countries can be substantially increased, and that takes time.
The Canadian dollar is getting some benefit from the oil price surge. USDCAD jumped to 1.2870 following the knee-jerk reaction to the Ukraine invasion in thin Asian markets Feb 24 and dropped to 1.2590 in Asia after WTI touched 116.49 in Europe March 3. The BoC 0.25% helped grease the skids for the USDCAD slide.
However, USDCAD downside may be limited to the 1.2450 area, a level that contained losses in 2022 and is just below other significant support zones. One reason is because unless Canada will not see any benefit from BoC rate hikes unless they are higher and faster than the Fed.
Another reason is because the oil price rally is inflationary and cannot offset some of the pain through increased domestic production due to pipeline constraints.
USDCAD losses may be limited if risk sentiment sours dramatically sparking another rush for safe-haven currencies.
To paraphrase Styx: “So if you think the markets aren’t complete confusion, Because your neighbors got it made, Just remember that it’s a grand illusion.”