Increasing Risk of Stagflation In View of Current Geopolitical Conflicts
On 24 February 2022, Russia launched a multi-pronged attack by sending its infantry units, paratroopers, tanks, fighters jets, attack helicopters and other specialised military equipments into Ukraine which kickstarted the Russo-Ukrainian War under the direct order of Russian President Vladimir Putin who coined it as a ‘special military operation’ on the pretext of demilitarisation and denazification of Ukraine but with objectives of taking over the Donbas region and capital, Kyiv, as well as to install a pro-Russian leader in the shortest time possible.
Prior to that, although the United States (US) and its allies including the North Atlantic Treaty Organization (NATO) member countries had warned that the Russian invasion was imminent citing intelligence sources, the unprovoked act of war itself by the Russian armed forces had still caught many by surprise.
Global food and energy prices have skyrocketed post invasion. Inflation has reached multi-decade highs. The US economy is still running full steam ahead despite the recent blip of negative growth in the first quarter of 2022. With all that is happening in the background, the fallouts from the Russian invasion of Ukraine and its implications to the bond market will be discussed in this research paper.
|2 International Response and Sanctions|
Following Russia’s invasion of Ukraine, the US, United Kingdom (UK) and European Union (EU) have imposed a variety of punitive and expansive sanctions in order to cripple Russia’s ability to finance its war against Ukraine. Some of the more pronounced sanctions include: -
- Cutting off the SWIFT international banking payment system from most of the Russian banks.
- Germany’s suspension of the certification of the Nord Stream 2 gas pipeline.
- The US ban on Russian oil, natural gas and coal imports.
- The EU ban on Russian oil and coal imports.
- The UK phasing out Russian oil and coal imports by end of 2022.
- Ban on new investments in Russia.
- Ban on all Russian flights from the US, UK, EU and Canadian airspace.
- Sanction and freezing of assets of individuals including Russian leaders and oligarchs deemed close to the Kremlin.
- The passing of the Ukrainian Lend-Lease bill by the US that allows US military aids for Ukraine to bypass bureaucratic hurdles in the future.
|3 Inflationary Pressure|
As Ukraine and Russia are both major exporters and producers of sunflower oil, wheat, corn and barley in the world, the war has definitely disrupted global food supplies and sent food prices soaring. Meanwhile, Russia is also a major exporter of hydrocarbon resources (natural gas, oil and coal). The sanctions that had resulted in a ban of imports of Russian hydrocarbons have also caused prices of natural gas, oil and coal to spike. Some EU countries like Germany are highly dependent on Russian gas for its energy consumption. That said, EU countries are still committed to moving away from relying on Russian hydrocarbons as soon as possible.
Besides, US had also witnessed a sustained increase in average hourly earnings that has surpassed 6% since October 2021. Increase in labour cost was attributed to the labour shortage brought on by the Covid-19 pandemic. Some workers opted for early retirement while some quit the workforce due to stimulus payments received from the US government amid a soaring equity market in 2021. Businesses and corporations have to compete for talents worldwide by increasing salaries and wages. This has in turn caused inflationary pressures to spiral further upward.
Chart 1: Inflation and Average Hourly Earnings Growth Rate
Additionally, the US Federal Reserve (Fed) balance sheet size has almost reached USD9 trillion at the time of writing. It hovered around USD4 trillion before the quantitative easing (QE) programme was introduced to rein in the economic slack that had emanated from the Covid-19 pandemic. Coupled with an ultra-low benchmark interest rate near zero, the monetary system was flushed with excessive liquidity. That said, the Fed had already ended the QE and kickstarted the interest rate hike cycle since the Federal Open Market Committee (FOMC) meeting in March 2022 in order to put a shackle on the runaway inflation.
|4 Unemployment Rate and Sahm Rule|
As a yardstick for economic performance, the unemployment rate plays a major role in the Fed monetary policy decision making. For instance, the Fed has been relying on the Phillips Curve, named after the New Zealand economist William Phillips, which measures the inverse relationship between unemployment rate and wages growth (proxy for inflation rate). In short, when the umployment rate is low, inflation tends to be higher and vice versa. This inverse relationship has enabled the Fed to adjust the benchmark Fed funds rate effectively over the years. When the unemployment rate is low and inflation is high, the Fed raises interest rate to cool down the economic growth and rein in the inflation.
However, there were instances when the inverse relationship broke down in which the unemployment rate was high but the inflation also stayed elevated. This was the infamous stagflation that happened in the 1970s. With inflation trending higher as discussed earlier, the next question that needs to be answered is whether the US economy is entering into a recession (defined as two consecutive quarters of negative economic growth), which would result in the dreaded stagflation.
Chart 2: Sahm Rule and Unemployment Rate
As seen in Chart 2, the US unemployment rate has dropped below the 4% threshold recently, which is a rare occasion in itself. Coupled with the rising average hourly earnings, the labour market has yet to show any signs of slowing down. To substantiate the claim, a more objective indicator called the Sahm Rule recession indicator is used to assess the likelihood of recession. Invented by economist Claudia Sahm, the Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate rises by 50 basis points (bps) or more relative to its low during the previous 12 months. Since April 2021, the Salm Rule recession indicator has stayed below the threshold 0.50%, which indicates recession is not imminent.
That said, the Sahm Rule is still a lagging and not a tell-all indicator. In reality, consumers tend to reduce spending and businesses tend to curb fixed investments when inflation is high.
|5 US Treasury Yield Curve Inversion|
Under normal circumstances, the US Treasury (UST) yield curve is an upward sloping curve in which the yields for longer term bonds are higher than shorter term bonds. However, in a distressed market, the yields of shorter term bonds can be higher than longer term bonds. Hence, the inverted yield curve. In the UST market, the spread of the 2-year and 10-year UST does a remarkable job in predicting a recession in the near future, which is when the yield curve inversion (negative spread) is first spotted.
Chart 3: UST 2Y-10Y Spread and Real GDP Growth Rate
As shown in Chart 3, whenever the UST 2Y-10Y spread falls into the negative territory, the real gross domestic product (GDP) will embark on a negative growth within a short span of time. For instance, the said spread briefly entered into negative territory in August 2019 and soon thereafter, we then see the US GDP growth contracting in the first quarter of 2020, partly due to the global Covid-19 outbreak at the time. Recently, in early April 2022, the UST 2Y-10Y spread has also inverted. This sparked widespread concerns on an imminent economic recession.
On 4 May 2022, the US Fed raised the benchmark Fed funds rate by 50bps to between 0.75% and 1.00% in view of the persistent inflationary pressure. Additionally, the Fed will also embark on a quantitative tightening (QT) programme to reduce the size of its bloating balance sheet.
As the sanctions imposed on Russia will not be lifted anytime soon, it is high time for the Fed to raise the benchmark interest rate. Some market players believed that the Fed is behind the curve in bringing the runaway inflation in check, but the Fed has to tread carefully to avoid sending the economy into a tailspin.
By and large, the US labour market is still doing relatively well despite the heightened inflationary pressure and the recent flashing of the inverted yield curve. At this juncture, the Fed still has tools at its disposal if the economy falls into a recession amid a high inflationary environment.
Source: [BPAM] Increasing Risk of Stagflation In View of Current Geopolitical Conflicts (2022, 13 May). BPAM MARKET AND PRODUCT RESEARCH. Retrieved from BPAM
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