QE first started in Nov 2008 with CPI at 1.07% and ended in Mar 2010 with CPI at 2.31% (Fed bought $1.73trln of bonds in that time). We didn’t call it QE1 back then because no one thought we’d need to do it again. QE2 started in Nov 2010 with CPI at 1.14% and ended in Jun 2011 with CPI at 3.56% (Fed bought $600bln in bonds). QE3 started in Sept 2012 with CPI at 1.99% and ended in Oct 2014 with CPI at 1.66% (Fed bought $1.5trln of bonds). QE4 started in Mar 2020 with CPI at 1.54%. The Fed bought nearly $6trln of bonds since then, which is roughly the size of the cumulative Federal budget deficit during that period. QE4 officially ended this week with CPI at 7.9%.

Marcel Kasumovich, our Head of Research, wrote about the importance of Biden’s Executive Order on the future of digital asset infrastructure and innovation. Click here

Overall:“Defending freedom is going to cost,” declared President Biden, announcing an import ban on Russian oil. And no doubt our Commander-in-Chief is right. Everything we do comes at a cost. The goal in peacetime, of course, is to engage in activities where the beneficial returns exceed the price of our inputs. War is no such pursuit. Everyone loses. The victors simply suffer less than the vanquished. In Europe’s last major conflict, the Allies defeated Germany. Russia’s victory cost it 20-40 million lives and economic devastation, a cost indelibly etched into Russia’s psyche. War forces us to determine what we are willing to pay for the things we most value. Afghanistan’s puppet regime was unwilling to pay a penny when attacked by the Taliban. Putin expected the Ukrainians to be similarly stingy. His gross miscalculation has raised costs of this conflict, drawing us all into Europe’s latest senseless war. And so, the search has begun for what each nation is willing to pay. The costs will be wide ranging and have started with energy. “Europe consumes about 500bln cubic meters of gas per year. Russia provides 40% of that. Europe consumes about 500mm tons of oil, and Russia supplies around 30% of it, that is 150mm tons, and 80mm tons of petrochemicals on top of that,” explained Putin’s deputy prime minister, threatening to halt European exports. “It is obvious that foregoing Russian oil will have catastrophic consequences for the world market. The price surge will be unpredictable, up to $300 per barrel, or even more,” he added, sowing uncertainty, trying to frighten his adversaries. “In this case European politicians should level with their citizens and consumers about what they will face, about how the cost of petrol, electricity and heating will skyrocket,” continued Putin’s deputy prime minister. “If you want to cut off supplies of energy resources from Russia, go ahead, we are ready for that. We know where we will reroute these volumes. The question is – who benefits? And what is the point?”

Week-in-Review (expressed in YoY terms): Mon: US/Europe considering ban on importing Russian energy products, no progress during 3rd round of Russia/Ukraine talks – Putin reiterates that the war will continue until Ukraine accepts demands, SNB says ready to intervene to offset CHF strength as EURCH reaches parity, Nickel soars 66% as commodity supply concerns accelerate, China sets this year’s growth target at 5.5% - higher end of 5-5.5% expectation, China expts 13.6% (7.9%e) / impts 12.9% (12.7%e), Swiss unemp 2.2% (2.3%e), German ret sales 10.3% (9.5%e), German factory orders 7.3% (5.8%e), China FX reserves 3.214T (3.225T exp), EU investor confidence -7 (5.3e), US cons credit 6.8b MoM (24.25b exp), S&P -3.0%; Tue: Biden announces US ban of Russian energy imports / UK announces the same by end of 2022 / EU pledges to cut Russian gas imports by 2/3rd by end of 2022, rumors of joint-issue EU bonds to finance energy and defense spending, reports that Ukraine is no longer seeking NATO membership, LME halts nickel trading after it rallies over 100% on the day (250% over 2d), Poland CB hikes 75bps (50bps exp), opposition lawmakers in Peru file motion to impeach Pres Castillo, Japan real earnings 0.4% (-1%e), US NFIB 95.7 (97.3e), S&P -0.7%; Wed: Bitcoin bounces on Biden executive order for whole of govt approach to digital assets, US congressional leaders agreed on $13.6b aid package to Ukraine (surpassing Biden’s $10b request) / US rejected providing Ukraine with MiG fighter jets, Yoon Suk-yeol wins S. Korean elections, Venezuela released 2 political prisoners after discussions with US about lifting sanctions to replace lost oil imports from Russia, PBOC asked to hand over 1trln RMB in profits for fiscal boost (roughly equivalent to 50bp RRR cut), RBA gov Lowe says 2022 rate lift off is possible but in no rush, explorers found Ernest Shackleton’s lost Antarctic ship, China PPI 8.8% (8.6%e) / CPI 0.9% as exp, Hungary CPI 8.3% (8.1%e), Italy IP -2.6% (3.2%e), Brazil IP -7.2% (-6.3%e), Mexico CPI 7.28% (7.23%e) / Core CPI 6.59% (6.58%e), Russia CPI 9.15% (9.2%e), US JOLTS Job openings 11.263m (10.95m exp), S&P +2.6%; Thu: US CPI 7.9% as exp / Core CPI 6.4% as exp, ECB strikes hawkish tone and expects to end asset purchases in Q3 (previously “at least October”), Russia retaliates against the banning of US energy purchases by banning exports of certain other items, GS pulls out of Russia, high level discussions with Russia fin min Lavrov and Ukraine make little progress, rising casualties force Russia to deploy conscripted soldiers (something Putin insisted would not be needed as recently as last week), Turkey unemp 11.4% (11.2%e), Hungary hikes 50bp (65bp exp), US init claims 227k (217k exp), S&P -0.4%; Fri: Putin says there are certain positive shifts in daily talks with Ukraine, Iran nuclear deal paused due to external factors, ECB speakers emphasized flexibility of rate hike timing, Peru CB hiked 50bps as exp, US identified 5 Chinese firms that may be delisted, UN granted Russia emergency meeting to discuss their claim that US is funding biological weapon development in Ukraine, US passes $1.5trln spending bill which includes $14bln for Ukraine, India admitted to accidently firing a missile into Pakistan, Japan household spending 6.9% (3.4%e), China Agg financing 1.19T (2.2T exp) / China M2 9.2% (9.6%e), Canada chg in emp 336.6k (127.5k exp) / unemp 5.5% (6.2%e), US UofM 59.7 (61e) / 1y infl exp 5.4% (5.1%e) / 5y infl exp unch at 3%, S&P -0.2%.

Weekly Close:S&P 500 -2.9% and VIX -1.23 at +30.75. Nikkei -3.2%, Shanghai -4.0%, Euro Stoxx +2.2%, Bovespa -2.4%, MSCI World -1.9%, and MSCI Emerging -5.2%. USD rose +9.2% vs Russia, +4.3% vs Bitcoin, +4.0% vs Turkey, +3.7% vs Ethereum, +2.2% vs Yen, +1.5% vs Sterling, +1.1% vs Australia, +0.6% vs India, +0.3% vs China, +0.2% vs Brazil, +0.1% vs Euro, and +0.1% vs Canada. USD fell -2.3% vs South Africa, -1.0% vs Sweden, -0.6% vs Indonesia, -0.2% vs Mexico, and -0.1% vs Chile. Gold +0.9%, Silver +1.3%, Oil -5.1%, Copper -6.3%, Iron Ore +10.0%, Corn +1.4%. 5y5y inflation swaps (EU +17bps at 2.27%, US +11bps at 2.72%, JP +11bps at 0.73%, and UK +16bps at 4.18%). 2yr Notes +27bps at 1.75% and 10yr Notes +26bps at 2.00%.

YTD Equity Indexes (high-to-low): Brazil +17.4% priced in US dollars (+6.6% priced in reais), Colombia +17% priced in US dollars (+9.7% pesos), Chile +14% in dollars (+7.5% in pesos), UAE +13.5% (+13.5%), Saudi Arabia +12.5% (+12.4%), South Africa +6.1% (+0.4%), Indonesia +4.9% (+5.2%), Singapore +2.9% (+4%), Argentina +0.6% (+6.6%), Canada +0.5% (+1.1%), Thailand +0.1% (+0%), Turkey -0.8% (+10.6%), Malaysia -1% (+0%), Norway -1.6% (+0.5%), Philippines -2.3% (-0.1%), Mexico -2.5% (+0.1%), Portugal -4.2% (-0.1%), Australia -4.8% (-5.1%), Venezuela -6% (-11.3%), Israel -6.4% (-1.8%), UK -6.6% (-3.1%), India -6.9% (-4.2%), Taiwan -7.6% (-5.2%), China -8.8% (-9.1%), New Zealand -9.8% (-9.3%), Spain -9.9% (-6.6%), Greece -11.1% (-7.3%), S&P 500 -11.8%, Russell -11.8%, MSCI World -12.1%, HK -12.5% (-12.2%), Switzerland -12.6% (-10.7%), Czech Republic -12.9% (-8.7%), Belgium -13.3% (-9.5%), Korea -13.9% (-10.6%), Japan -14.1% (-12.6%), Denmark -14.2% (-11.1%), France -16.1% (-12.5%), Germany -17.2% (-14.2%), Euro Stoxx 50 -17.8% (-14.2%), NASDAQ -17.9%, Poland -17.9% (-11.5%), Italy -18.7% (-15.7%), Netherlands -18.9% (-15.4%), Finland -19.1% (-16.2%), Ireland -19.6% (-16.1%), Sweden -20.4% (-14.4%), Austria -20.6% (-17.7%), Hungary -21.2% (-15.4%), and Russia -41.1% (-34.8%).

Golden Eras: “The coronavirus pandemic will mark the dividing line between the deflationary forces of the last 30-40yrs and the resurgent inflation of the next two decades,” said economist Charles Goodhart, author of The Great Demographic Reversal. He sees inflation in developed economies settling in at 3-4% by the end of 2022 and remaining elevated for years. The addition of hundreds of millions of inexpensive Chinese and Eastern European workers, together with Western baby boomers and women led to a doubling of the workforce supplying advanced economies from 1991-2018.

Golden Eras II: The working-age population is shrinking across developed economies (in China by 100mm in the next 15yrs). Businesses will manufacture and invest more locally, re-designing supply chains. Global savings fall as older people consume more than they produce -- spending particularly on healthcare. US manufacturing wages are less than 4x those in China (versus 26x when China joined the WTO in 2001). With global debt at record levels and asset prices elevated, Goodhart expects central bankers will struggle to tame inflation without causing a deep recession. “A golden era for central banking is ending, life will become a lot harder.”

Squiggles: “I posted the wage growth tracker yesterday without enough explanation,” wrote Lindsay Politi, One River’s Head of Inflation Strategies. To see the chart [click here]. “I think the parallels to the early 1970s should be becoming very uncomfortable to policy makers,” continued Lindsay to our trading team on the One River internal market chat. “With the way core inflation is following headline higher with almost a perfect correlation and a lag is a relationship we haven’t seen since the 1970s and 80s,” she wrote. To see the chart Click here

Reap: Ukraine is the world’s 5th largest wheat exporter, accounting for 7% of global sales (in 2019). 71% of the nation is land is agricultural. It has 25% of the globe’s “black soil”,” which is amongst the most fertile. And still, in 1932, the nation suffered the Holodomor (Great Famine), as Stalin confiscated and collectivized farms. Today, and unsurprisingly, Ukraine announced a food export ban until the conflict ends. Russia is earth’s largest wheat exporter, accounting for 18% of global sales. So Russia and Ukraine account for 25% of global wheat sales. Prices are near record highs.

Sow: Russia’s Minister of Industry and Trade announced his nation is suspending fertilizer exports. The market is already in short supply, prices have surged. Russia is the globe’s largest fertilizer exporter, accounting for 18% of the potash market in 2017, 20% of ammonia exports and 15% of Urea. Putin said the fertilizer export ban is a move to ensure stable domestic food prices. He mentioned that fertilizer markets are deteriorating, making food a lot more expensive, and added that Russia has agreements with “friendly countries” on fertilizers.

Anecdote: Everything is connected, one moment naturally following another. And so it is tempting to think that by retracing each step we can explain why we have arrived at a particular place. Perhaps this is sometimes true, over very short periods at least. But the world is infinitely complex, and the truth is that we often arrive at a destination for reasons we can’t possibly understand, let alone have predicted. That doesn’t stop us from trying. We spin compelling tales that appear so obviously true that we come to accept them as fact. In a Feb 15 video that is making the rounds click here, Professor John Mearsheimer explains why the West and Russia are clashing in Ukraine, even as he failed to foresee an actual war. Vladimir Putin’s Feb 25 public address click here, that was a precursor to the invasion, presents his story of what led us here. Like all such tales, both are presented so as to appear logical, linear, evident, inevitable, and their authors might even believe they explain the path properly. If only it were so simple, we might stand a chance to avoid the collisions that litter history. Who knows, perhaps the issue is that we seek conflict for reasons we’ll never quite understand. But at any rate, it appears Europe’s latest conflict was unlikely to have occurred were it not for the inflation that has taken hold across the globe. Russia, after all, has a small and failing economy. It is poorly positioned to exert outsized influence but for its ability to exacerbate global energy, food, and metal price inflation. This, in turn, can inflict horrible damage on Western economies during a time when their central banks have few tools to tame inflation other than to crash their economies. It can also divide the world between rich nations and the hungry/poor. And exactly why we got to such a fragile state is itself a story we may want to tell ourselves we understand, but we will never fully know.

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.

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“Are you watching Ukraine’s President?” asked Jackson, in uniform, Facetime. We all are - the whole world. And I wonder how Zelensky’s remarkable behavior will inspire our children as they come into their own, forming ideas about how they’ll lead their lives, set the bar for themselves, and what they will demand of their leaders, as they build a better future for us all. “Zelensky is what real leadership looks like. Genuine. Inspiring everyone around him, his entire nation, even when he and his family are in real danger, fighting a far stronger adversary,” said my oldest, one of the 132-million 20-year-olds on our little planet.

Marcel Kasumovich, our head of research, published a thoughtful piece on digital assets, shifting correlations, deleveraging, and the place for such investments in institutional portfolios. Click here

Overall: “We will cause the collapse of the Russian economy,” said France’s finance minister, Bruno le Marie, international sanctions raining on Moscow like carpet bombs on Kharkiv. No doubt Bruno is right. Wars cause economic devastation, particularly in nations that lose. But they inevitably diminish our collective prosperity and well-being in ways few appreciate at their offset. Were we more aware of this fact, there would be far fewer conflicts. My alma mater estimates the post 9-11 War on Terror cost the US $8trln, which perhaps coincidentally is the rough size of the Fed’s balance sheet. The Afghanistan portion cost $2trn. Would that war have been America’s longest had politicians asked voters to fund it through tax hikes? The 7,000+ brave children we sent to fight but who never returned, and the 900,000 foreign dead, can no longer ask that question. But we can. Anyhow, it is easy to fund wars against weak adversaries in a time of structural disinflation, expanding globalization, economic optimization, hyper financialization. But that time had passed even before Ukraine’s war broke out. Structural disinflation allows governments to freely experiment with monetary magic. During inflationary periods, however, such alchemy comes at a steep cost -- in the extreme, we collectively realize money is an illusion, a mass delusion. The Russian central bank just discovered that $388bln of its $643bln in reserves are inaccessible. That’s because most reserves are deposits and securities held by Western central banks and institutions. This leaves Russia with $135bln of gold that Western dealers won’t touch, and $85bln of Chinese securities that Beijing’s state banks won’t trade. So Russia’s central bank has just $30bln in paper foreign currency with which to sustain the illusion that the ruble is real. It is hard to overstate how desperate a financial position Moscow now finds itself in. And on Saturday, Putin said, “These sanctions that are being imposed are akin to a declaration of war, but thank God it has not come to that.”

Week-in-Review (expressed in YoY terms): Mon: Ruble collapses (down ~20% on the day) as west enacts SWIFT sanctions and restricting the CB from deploying its reserves / Russia CB hiked rates to 20% and imposed capital controls (banning foreigners from selling securities in Russia), ECB’s Panetta “ECB stands ready to act”, minimal progress made as Russia/Ukraine officials meet on Belarus border, Zelensky repeated request for Ukraine to be fast tracked into the EU, Biden approval rating falls to record low, ECB’s Rehn says should fully assess implications of war before hiking too soon, Spain CPI 7.5% (7%e), Poland CPI 4.4% (3.4%p), India 4Q GDP 5.4% (5.9%e), Mexico unemp 3.71% (4.24%e), S&P -0.2%; Tue: Russia says it will continue until goals are met / 40mi long convoy approaches Kyiv, Ukraine auctions first “war bonds”, BTPs outperform on potential later end to QE, Italy CPI 6.2% (5.5%e), German CPI 5.5% (5.4%e), S&P -1.5%; Wed: Russia says ready to resume talks, Powell guides to 25bps hike in March but open to 50bps in the future, Biden closed US air space to Russia, China to suspend major activity in Moscow, Biden delivers state of the Union/ vows to control inflation, BOC hikes 25bps as exp, wheat extends to highest since 2008, EU nat gas prices set all-time high, Germany unemp 5% (5.1%e), EU CPI 5.8% (5.6%e) / Core CPI 2.7% (2.6%e), S&P +1.9%; Thur: MSCI and FTSE to remove all Russian stocks from indices, Moody’s and Fitch cut Russia to junk, Powell admits to running scenario with crude at $125/barrel, Turkey CPI 54.44% (52.5%e) / PPI 105.01% (103%e), Swiss CPI 2.2% (1.8%e) / Core CPI 1.3% (0.9%e), Hungary hikes 75bps (50bp exp), Italy unemp 8.8% (9%e), EU PPI 30.6% (27.3%e), EU unemp 6.8% (6.9%e), US unit labor cost 0.9% (0.3%e), US init clam 215k (225k exp), US serv PMI 56.5 (56.7e), US ISM serv 56.5 (61.1e), US factory orders 1.4% (0.7%e), S&P -0.5%; Fri: Russia takes over largest nuclear power plant in Europe causing a fire which is claimed to be “under control”, US NFP 678k (423k exp) / unemp 3.8% (3.9%e) / AHE 5.1% (5.8%e), Fed’s Evans sees 1.75-2% as “closer to neutral”, EU ret sales 7.8% (9.2%e), S&P -0.8%.

Manufacturing PMI (high-to-low): Switzerland 62.6 ( previous month 63.8), Netherlands 60.6 (previous mth 60.1), US 58.6 (prev 57.6), Sweden 58.6/62.2, Germany 58.4/59.8, Austria 58.4/61.5, Italy 58.3/58.3, UK 58/57.3, Greece 57.8/57.9, France 57.2/55.5, Spain 56.9/56.2, Canada 56.6/56.2, Czech Republic 56.5/59, Norway 55.9/56.3, India 54.9/54, Poland 54.7/54.5, Taiwan 54.3/55.1, Vietnam 54.3/53.7, South Korea 53.8/52.8, Hungary 53.2/50.9, Japan 52.7/55.4, Indonesia 51.2/53.7, South Africa 50.9/50.9, China 50.4/49.1, Turkey 50.4/50.5, Singapore 50.2/50.6, Brazil 49.6/47.8, Russia 48.6/51.8, Mexico 48/46.1, Hong Kong 42.9/48.9. Services PMI: Sweden 68/68.6, Ireland 61.8/56.2, UK 60.5/54.1, Spain 56.6/46.6, US 56.5/51.2, Germany 55.8/52.2, France 55.5/53.1, Italy 52.8/48.5, Russia 52.1/49.8, India 51.8/51.5, China 50.2/51.4, Japan 44.2/47.6.

Weekly Close:S&P 500 -1.3% and VIX +4.39 at +31.98. Nikkei -1.9%, Shanghai -0.1%, Euro Stoxx -7.0%, Bovespa +1.2%, MSCI World -1.3%, and MSCI Emerging +0.0%. USD rose +44.8% vs Russia, +5.0% vs Sweden, +3.1% vs Euro, +3.0% vs Mexico, +2.8% vs Turkey, +1.5% vs South Africa, +1.4% vs Sterling, +1.2% vs India, +0.8% vs Ethereum, +0.4% vs Chile, +0.1% vs Indonesia, +0.1% vs Canada, and flat vs China. USD fell -3.9% vs Bitcoin, -2.0% vs Australia, -1.7% vs Brazil, and -0.6% vs Yen. Gold +4.2%, Silver +7.4%, Oil +26.3%, Copper +10.1%, Iron Ore +15.4%, Corn +15.0%. 5y5y inflation swaps (EU +28bps at 2.11%, US +14bps at 2.60%, JP -9bps at 0.62%, and UK +3bps at 4.03%). 2yr Notes -9bps at 1.48% and 10yr Notes -23bps at 1.73%.

Feb Mthly Close:S&P 500 -3.1% and VIX +5.32 at +30.15. Nikkei -1.8%, Shanghai +3.0%, Euro Stoxx -3.4%, Bovespa +0.9%, MSCI World -2.7%, and MSCI Emerging -3.1%. USD rose +26.7% vs Russia, +4.1% vs Turkey, +1.6% vs Sweden, +1.0% vs India, +0.2% vs Sterling, and +0.1% vs Euro. USD fell -6.5% vs Bitcoin, -6.2% vs Ethereum, -3.0% vs Brazil, -2.7% vs Australia, -0.8% vs China, -0.8% vs Mexico, -0.3% vs Canada, -0.3% vs Chile, -0.1% vs Indonesia, -0.1% vs Yen, and -0.1% vs South Africa. Gold +5.8%, Silver +8.6%, Oil +10.7%, Copper +3.0%, Iron Ore -10.4%, Corn +10.6%. 5y5y inflation swaps (EU +2bps at 1.87%, US +3bps at 2.55%, JP -4bps at 0.65%, and UK -1bps at 3.94%). 2yr Notes +25bps at 1.43% and 10yr Notes +5bps at 1.83%.

YTD Equity Indexes (high-to-low):Brazil +19.9% priced in US dollars (+9.2% priced in reais), Colombia +16.3% priced in dollars (+9.3% in pesos), UAE +14.1% (+14.1%), Chile +14% (+7.7%), Saudi Arabia +13.2% (+13.1%), South Africa +6.3% (+1.9%), Indonesia +4.4% (+5.3%), Thailand +2.8% (+0.9%), Singapore +2.4% (+3.3%), Malaysia +1.9% (+2.3%), Argentina +1.8% (+7.2%), Philippines +1.2% (+3.1%), Canada +0.2% (+0.8%), Turkey -0.2% (+7.2%), Norway -1% (+0.5%), Mexico -2% (+0.1%), Australia -3.2% (-4.5%), Taiwan -4.2% (-2.6%), China -4.7% (-5.3%), Israel -5.2% (-1%), HK -6.6% (-6.4%), New Zealand -6.7% (-6.8%), UK -7.5% (-5.4%), India -8.7% (-6.4%), Venezuela -8.9% (-12.8%), MSCI World -9%, S&P 500 -9.2%, Japan -9.4% (-9.7%), Portugal -9.7% (-5.9%), Korea -10.9% (-8.9%), Russell -10.9%, Greece -11.7% (-8%), Switzerland -12.6% (-12.2%), Czech Republic -14.1% (-8.4%), Spain -14.4% (-11.4%), Denmark -14.4% (-11.4%), NASDAQ -14.9%, Belgium -16.3% (-12.8%), France -18.7% (-15.3%), Netherlands -19.2% (-15.8%), Germany -20.4% (-17.6%), Euro Stoxx 50 -20.6% (-17.3%), Italy -20.7% (-17.9%), Ireland -22% (-18.7%), Poland -23.2% (-15.7%), Finland -24.1% (-21.4%), Austria -24.2% (-21.5%), Sweden -24.4% (-17.9%), Hungary -26.7% (-20.7%), and Russia -41.1% (-34.8%).

Crack: “Finance doesn’t live in a vacuum,” said the Plumber on all fours, looking beneath the sink for the origin of a little leak. “There is no tidy scientific controlled experiment. The knock-on effects from sanctions in Russia are a stark reminder. European banks crashed more than 30% in the past three weeks, including a steep 19% decline last week. Credit default spreads are widening sharply in response. The strains emerging in European banks are tied partly to US dollar funding markets. Russia’s acrimonious exit from the financial system is not a spectator sport. It raises risks to broader financial instability.”

Crack II: “Interbank borrowing costs have jumped relative to overnight interest rates, surging to 35bps at the 3-month tenor from 5bps earlier in the month,” mumbled the Plumber, flashlight tucked between his teeth. “This is on-par with past warning signs of global strain: 2008 ahead of the financial crisis; 2011 into the European crisis; 2016 ahead of the global recession; 2018 in the repo shock; and 2020 into the pandemic. Market participants are on high alert,” explained the Plumber, my go-to-guy whenever the global financial pipes start to creak and bang.

Crack III: “Is it the next Great Financial Crisis?” asked the Plumber rhetorically. “No. Fighting yesterday’s war is futile. The GFC, like the Great Depression before it, was “Great” by way of incompetence more than shock. The role of the US dollar in the global financial system was poorly understood. The response was to build tools to repair this blind spot – the Fed was the central bank to the world, not just the US. It was very different from past experiences. Dollar funding crises in emerging markets were opportunities to instill orthodox economic programs in exchange for US dollar financing; this was a tell-tale signal for the private sector to buy EM equity assets at a steep discount.”

Crack IV:“But in the GFC, the numbers were implausibly large for a such a strategy,” explained the Plumber, no one better in the world. “New tools were needed and the Fed’s cross-currency swap line with foreign central banks was arguably most important. It brought the USD discount window to foreign banks through foreign central banks. And last week, the Fed cross currency swap lines were drawn, quietly appearing in Fed weekly balance sheet data. European banks need US dollars, and they are getting them from the Fed via the ECB. They couldn’t into the GFC because the tool didn’t exist.”

Crack V: “The shortfall of US dollar funding comes at a time when reserve balances with Federal Reserve Banks – excess reserve liquidity in a former name – are $3.9195bln,” said the Plumber, surprising me by not calculating it to the nearest penny. “This is a staggeringly large number, near record highs. Excess reserves would rarely rise above $10bln before the GFC, a time when reserve scarcity drove efficiency in funding markets. No more. The trauma of the GFC led the Fed to build tools to ensure a GFC repeat will not happen.”

Crack VI: “But that doesn’t make today’s tightening in credit conditions irrelevant, and it will be much harder to see a proactive policy response now,” said the Plumber. “Inflation is the big difference between past funding squeezes and the current one. In past periods, inflation was a footnote on the list of policy concerns for the Fed. Now, it is the headline act. President Biden declared “getting prices under control” as the top priority in his State of the Union address last week. And inflation expectations, rising sharply since the European conflict, are taking their cue from a shortage of energy and commodities, not the shortage of US dollars in global funding markets. This is different. It will limit the Fed pivot and move the “Fed put” much deeper out of the money.”

Anecdote: “Just a couple things today,” I said at One River’s internal risk meetings. “The first is an observation. Of the many Russia and Ukraine experts who dedicated decades to the study of the region, Putin, other key players, not even one expected this outcome,” I said. “Rarely when it comes to geopolitics does that happen. And when it does, it means we are entering a period of extraordinary uncertainty. So, while it is always important to approach markets and our portfolios with a great degree of humility, it is utterly critical to do so now. Don’t fool yourself into believing you can war-game this out. No one can, not even the key players, it is far too complex. People often like to say they have open minds. But the truth is very few people are capable of processing rapid change of this scale. Their thinking is anchored to the recent past, a decade, two at most. This applies equally to investors and political leaders. Therefore, we must remind ourselves that very few people who are interacting with markets and determining policy are capable of fully internalizing the range of new possibilities we must now consider. At one end of the spectrum of outcomes is a coup that replaces Putin, followed by an ending of hostilities. At the other is a nuclear conflict. There are many other possibilities we have not even considered. And during this period, assume that we will have to process information that is wildly inaccurate, intentionally deceptive, truces that come and go, cyber warfare, biological too, random volatility, etc. Our portfolios and risk management should reflect this – both market and operational risk. The second thing to keep in mind is that often in periods of great change, some very odd market behaviors appear, and these can foreshadow powerful trends that will soon emerge. The Yen is particularly weak when it would normally be a safe haven. The Chinese Renminbi is stable when it would typically be weak. Emerging market equites are surprisingly steady, Asia too. Stay attuned to unusual market divergences, prices that move in counter-intuitive ways. They don’t always lead to great opportunities, but they are the places to start looking.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.