Rabo: Any Optimism At This Stage Involves Fighting The Hot War, The Cold War, And The Fed

By Michael Every of Rabobank

In the last Cold War there was a prevailing US geopolitical/military assumption known as Domino Theory. As Wikipedia summarises it for my tired eyes this morning thus: “posited that if one country in a region came under the influence of communism, then the surrounding countries would follow in a domino effect. The domino theory was used by successive US administrations during the Cold War to justify the need for American intervention around the world.” Remember the Vietnam War and the US destabilization of Chile? Domino Theory. But why mention this today? Three reasons.

1) Because we are back in a Cold War, even if saying that gives people in markets and the great offices of state kittens – “because markets.”

I won’t make the argument myself again today, but I recommend reading another excellent article from Niall Ferguson (who is on a roll at the moment) on Bloomberg titled ‘Putin and US Misunderstand History in Ukraine’. He talks about the new Cold War vibe in the White House, and argues the US is in no rush to end the war in Ukraine because it is seen as bleeding Russia out. Notably, however, the point is made that this may prove wildly optimistic – as was yesterday’s latest ‘trading desk geostrategy expert’ quoted by other trading desks as a reason to expect the war to be over imminently: Kyiv is today quoted as underlining it will not make any territorial concessions. Ferguson says this may mean devastating consequences – and not only for Ukraine, which Russia may (or may not) have the physical heft to flatten.

Consider this shocking clip from Russian TV: Vladimir Soloviev, a Kremlin propagandist, hyperventilates that Moscow could next consider a nuclear strike against EU, the invasion of Poland and the Baltics, or the creation of a permanent land-bridge from Belarus to Kaliningrad, i.e., an attack on the Suwałki Gap. Is this hyperbole? One hopes so – because all of the above scenarios are WW3. Yet they are openly being discussed on Russian TV, not the peace deal our ‘trading desk geostrategy experts’ are all over.

NATO will meet tomorrow, and we will see what they say – suggestions are they will have strong words about these kinds of threats, and a further warning to China about helping Russia. There, on one hand, the US admits Beijing has not sent any weapons to Moscow since it was warned not to: on the other, yesterday saw Bloomberg report ‘Beijing Tells Chinese Firms in Russia to Help Fill Economic Void’:

“China’s top Russia envoy urged Chinese businesspeople in Moscow to seize economic opportunities created by the crisis, a strategy that could help soften the blow from international sanctions. Ambassador Zhang Hanhui on Sunday told about a dozen business heads to waste no time and “fill the void” in the local market… While [making] no mention of sanctions or sanctions compliance, Zhang described the situation as an opportunity. “The current international situation is complex. Big companies face major challenges or even disruptions in payment and supply chains,” Zhang said, according to the post, which included photos of the meeting. “This is a moment where private, small- and medium-sized enterprises could play a role.””  

Does that cross a US Cold War red line for secondary sanctions against China? I don’t know – but it is solely the US that gets to decide.

Relatedly, this week will see the 27 EU leaders rethink their China ties in a special Council meeting that will have US President Biden and Japanese PM Kishida attending. This will reportedly discuss the “new global context” for EU-China relations, “in particular the Russian military aggression against Ukraine.” Furthermore, this week already saw the launch of the EU’s ‘Strategic Compass for Security and Defence’, where the executive summary begins:

“The return of war in Europe, with Russia’s unjustified and unprovoked aggression against Ukraine, as well as major geopolitical shifts, are challenging our ability to promote our vision and defend our interests. We live in an era of strategic competition and complex security threats. We see conflicts, military build-ups and aggressions, and sources of instability increasing in our neighbourhood and beyond, leading to severe humanitarian suffering and displacement. Hybrid threats grow both in frequency and impact. Interdependence is increasingly conflictual and soft power weaponised: vaccines, data and technology standards are all instruments of political competition. Access to the high seas, outer space and the digital sphere is increasingly contested. We are facing increasing attempts of economic and energy coercion. Moreover, conflicts and instability are often compounded by the threat-multiplier effect of climate change.”

It goes on to say that by 2030 the EU will:

• Be able to act rapidly and robustly whenever a crisis erupts, with partners if possible and alone when necessary, and develop an EU Rapid Deployment Capacity that can swiftly deploy up to 5,000 troops into non-permissive crisis environments (which is far too small a force to matter except in very weak countries).
• Enhance the ability to anticipate threats, guarantee secure access to strategic domains, boost intelligence capacities; create an EU Hybrid Toolbox against foreign information manipulation and interference; and further develop EU Cyber Defence Policy.
• Spend more and better in defence, including next-gen high-end naval platforms (aircraft carriers), future combat air systems (fighter jets), space-based capabilities, and tanks via the European Defence Fund, while also creating a new Defence Innovation Hub.
• Reinforce strategic partnerships with NATO and the UN; boost cooperation with partners sharing the same values and interests (such as the US, Norway, Canada, UK, and Japan), while developing tailored partnerships in the Western Balkans, Africa, Asia and Latin America.

2) On that latter note, a key element of Domino Theory I raised yesterday is the importance of building global alliances.

In the last Cold War, the US roped in everyone from liberal democracies to crypto-fascist banana-republic strongmen and absolute monarchies against the USSR – and even China. This time round, the White House is embracing liberal democracies and tsk-tsking everyone else. Yes, they are still enormously powerful in economic and military terms –if only the US, France, and UK for the latter– but they are not the world. To focus only on them is a losing Cold War strategy unless the West is going to pull up the drawbridge.

As Russia, Belarus, and China cut off fertilizer exports, pushing prices of these vital farm inputs higher and higher, China just signed a $7bn agreement with Algeria –right next to Europe, and with its historic links to France– to produce 5.4m tons of fertiliser for it; Russian mercenary group Wagner has influence in many key African states; and China’s economic heft sways many states who still prefer ‘The American Way’ in their hearts and defence ministries. In WW2, the Brits said “Loose lips sink ships”; in 2022, we are talking about blocking Russian ships, and our loose political lips send none laden with fertilizer, oil, LNG, or industrial metals to EU or US supply chains, or those bearing staple food to the parts of the world who now cannot access or afford Ukrainian and Russian commodities. That will have huge ramifications.

So, yes, the EU’s Strategic Compass is a good start, and Western unity is to be celebrated. But Domino Theory says the diplomatic part cannot wait until 2030. Tectonic plates are shifting now.

3) Bringing this back to markets, I would posit that we are also seeing a Domino Theory play out there.

The geopolitical die has been cast with the war in Ukraine, whether one is a ‘trading desk geostrategy expert’ in de-escalation or not.

We have already seen wild swings in the first domino to be toppled, commodity markets. Yes, there is now some tentative calm returning – for example, LME nickel finally managed to get down to around $28,000 yesterday without having to close trading and give people their money back. Yet the key metal is still almost three times above its long-run trend price. Moreover, our energy strategist, Ryan Fitzmaurice, continues to underline that oil prices are likely to test above their record high of $147 a barrel ahead; and our agri commodity specialists, Carlos Mera and Michael Magdovitz, underline the continuing price pressures across their complex… as the WEF unhelpfully talk about people having to change to ‘more sustainable diets’. (And I hum the Motörhead song “Eat the Rich”.)

The next domino to fall was the bond market, as central banks realize the supply shock we face is not going to fade, but is growing: do you want to bet against a peak of double-digit US inflation if oil and food continue to rise? As such, we just got another round of hawkish Fed speakers stressing they could move faster and/or in 50bp steps, on top of Powell’s warnings that no soft landing is guaranteed. The result has been a staggering shift higher in yields: US 2s are up from 0.73% at the start of the year to 2.18%, and nearly 88bp of that is since the start of February; US 10s are up from 1.50% to 2.41%, with 72bp of that since early February. And there is still no end in sight to the war, and hence to broader sanctions risks, and hence to commodity prices, and hence to the supply shock, and hence to the rates shock – at least in the US, even if the ECB and RBA lag.

The next domino to fall will arguably be the FX market, e.g., when markets realize the Fed is going to keep going and the ECB aren’t, and then, if there is any logic in markets at all, finally the solipsists specializing in irrational exuberance and presuming bad news is good news because The Establishment will never let them fail – equities.

Yes, Putin doesn’t care one jot about markets, or is willing to use them to destabilize the West; yes, the base-level physical economy is reeling, and we see a headline today that ‘Dallas Fed Warns Cut-off of Russian Energy Could Cause Global Recession’; and, yes, any optimism at this stage involves fighting both the war, the Cold War, and the Fed. But ‘trading desk geostrategy experts’, who no doubt find dominoes a mentally-taxing game of strategy, will continue to look on the bright side “because markets”.