Geopolitical Developments: The Global Financial System Is Now In Putin’s Crosshairs Though He Never Foresaw It

The irrationality and malevolence of Putin and his advisors was never expected to pose a risk to the global financial system akin to the early days of COVID or the GFC from 2008, but it’s clear from yesterday’s action we are now in the middle of a redux of those uncertain times. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is bearish. There are several negative factors across global asset classes. Gold is trading as a risk-off asset. Oil is pointing to stagflationary conditions. The US yield curve is rising and in the current context that is bearish. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to fall over the next few days.

Putin’s destruction can be contained and partly reversed if his inner circle take him out in the next few weeks; the other possible outcomes are unremittingly terrible. If Putin is allowed to hang on he will find he can survive despite his myriad mistakes and consequently derive a perverse confidence from this. Or if a lesser group of Russians somehow seize control that creates another geopolitical nightmare, namely the stability of the sprawling Russian Federation. I predicted the positive outcome last week and other than a few hints in the media, there is no evidence that I will be correct. The terrible outcomes that are more likely have both geopolitical and macroeconomic consequences that are well documented, but the financial fallout is being seen every minute in the markets, though less understood due its arcana.

ING summarizes the key developments as follows: “As can be said for many other financial instruments, developments in FX are bordering on the disorderly…e.g. an indiscriminate purchase of implied volatility and continued heavy pressure in global equity markets as global growth forecasts are cut further.”

Now that a Chinese tycoon is reportedly suffering from the massive runup in nickel due to his short position, there is the possibility of deeper Chinese economic effects than what I wrote about yesterday, namely the impact of dimming global trade. But beyond commodity market disruption and Chinese firms and banks taking losses there is also the possibility of Commodity Exchanges (or Central Counterparties) having to tax members to make up for missed margin calls among other short sellers. When Commodity Exchanges become vulnerable there are contagion effects. And the fear that contagion could come from many sources is driving high levels of risk aversion that feeds on itself and ends up in the FOREX market in the form of shortages of the safe haven asset — the $US. ING further notes:

“In other signs of stress in the market, the USD FRA-OIS spread (a measure of interbank credit stress) continues to widen, and on Friday afternoon the 3m EUR cross-currency basis swap again moved out to the wides. One could argue that dollar funding should not prove a problem given lots of excess dollars in the US banking system and a variety of new Fed tools to provide dollar liquidity. Yet presumably there is enough uncertainty out there that financial institutions will be reluctant to let go of dollar balances. We will be interested to see whether any of the Fed's 7-day USD swap lines get used a lot more this Wednesday. Last week's ECB 7-day dollar auction saw European banks drawing $272.5m dollars via this swap line.”

Finally there are some exotic effects of Russia’s punishment boomeranging back to hurt the West. ING notes how Germany is facing many negative impacts from hostility towards Russia:

“There will also be much uncertainty here as March 12th sees seven Russian banks removed from SWIFT. European fixed income markets have already seen some stress here - the German MinFin last week had to issue extra 2024 bonds, allegedly because the freeze of Russian assets had tied up holdings in these particular bonds.”

For Putin’s inner circle to take him out they must be certain the West will hold firm: consequently Germany is key and Biden, Macron, Johnson and Stoltenberg must convince Germany to weather the multifaceted storm enveloping the global financial and economic system. I believe they will but it’s taking a terribly long time to iron out their differences. In this time the market is set to head much lower.

Yesterday I sold my positions in Amgen (AMGN) and Johnson & Johnson (JNJ). My current positions include a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.