The Fed’s Actions Shake Markets From New York To Shanghai And Return To Old Brazil As Well — How Money Impacted GeoPolitics This Week

Jay Powell overtly antagonized markets at his congressional testimony this week but also quietly drained confidence around the world through the Fed’s liquidity policies. Biden likely took little notice of the Fed’s balance sheet reduction as he was fêting a Eurasian autocrat, but another autocrat in America’s hemisphere clearly hates what the Fed is indirectly doing to his country. Equity markets are starting to remember the wall of worry that geopolitics proffers and the monetary fight in Brazil will help keep the bulls on the sidelines for a few days. The volatility risk premium is pointing to a range-bound market over the next few days, while my technical reading of key stocks in the S&P 500 is negative. There are several negative factors across global asset classes. Oil is pointing to declining global GDP expectations. The action in currencies signifies $US strength. Inflation expectations are rising based on measures of Treasuries and TIPS. Expect the S&P 500 to fall to support levels before rising again later next week.

Liquidity drained in the US as the Fed reduced its balance sheet by $26b in the past week, driven by a $102b decline in excess reserves. The Treasury’s replenishment took nearly $160b from the money markets which the Fed only partially sterilized. This replenishment likely continues as the Treasury’s cash holdings have typically been twice the current level over the past few years.

The Fed’s double-whammy this week of verbal hawkishness and liquidity drainage reverberated in global equity markets but also in the political games being played in Brazil. There the slimly-elected President Lula menaced the Central Bank of Brazil and violated the principle of monetary independence from politician preferences. “This isn’t a problem for the government only, it’s a problem for all society,” Lula told reporters on Thursday in Rome, where he met with Pope Francis, per Bloomberg. “The senate is responsible for holding him accountable,” Lula said, referring to Roberto Campos Neto, head of the Central Bank. “I believe this person plays against the Brazilian economy.”

Sounding more like Trump than even Jair Bolsonaro Lula is clearly uninterested or oblivious to the impact of the Fed on global rates. If the Fed is hawkish then any nation with an inflation problem can’t afford to be dovish unless it has inflation well under control. Brazil is a perfect case of a nation that must reduce inflation if for no other reason than to signal the continued break with its hyperinflationary past. How many inflationary periods Brazil has endured since 1960 is an economist’s parlor game, so even the current 4% inflation rate is too high. Lula is a statist of the leftist variety who cares little for the transactional behavior that all humans demonstrate with regard to the price level: when inflation persists people not only worry they are losing out but act accordingly and entrench inflation expectations in the economy. This leads to higher and higher inflation, and when that’s unchecked, hyperinflation. Consequently a target of 2% is prudent since it’s close to pure price stability and allows for quality improvements to take place that tend to raise prices. Jay Powell was robust in defending the 2% target this week and for the sake of Brazilians one hopes Campos Neto will withstand Lula’s minatory posture.

A stable Brazil is critical to geopolitics since it keeps out extremists like Bolsonaro and helps unify the Western hemisphere as a force for liberalism and democracy. Inflation in Brazil’s past led to military dictatorships that deeply scarred Dilma Rousseff and likely led to her intemperate actions and attitudes as President, which did her in when past corruption surfaced. The growing schism between Eurasian and the West can’t stand a large western nation flipping to the autocratic side. Lula has already defied the West in supporting Russia and his autocratic slide would easily pump other elected autocrats like Modi and Orban to limit democracy further. The markets have ignored political schisms all through the Spring but another shock like the Russian invasion of Ukraine would destroy all confidence in the global economy. At high valuations the markets are due for a major pullback as geopolitical reality sets in.

My current positions include 3M (MMM), Pfizer (PFE), and a large position in SPXU, which nets out to an extremely short position in equities.