Don't Poke The Bear?

Jesse Pound and Yun Li of CNBC report the Dow drops 500 points, Nasdaq sinks more than 2% on fears of a Russian attack on Ukraine:

Stocks slid on Friday as increased tensions between Ukraine and Russia sent oil spiking and led investors to dump risky assets like equities.

Shares were mostly flat on the day until Ukraine-related headlines in afternoon trading caused traders to dump stocks and buy Treasurys.

The tech-heavy Nasdaq Composite fell nearly 3%, while the S&P 500 was down 2.1%. The Dow Jones Industrial Average dropped 527 points, or 1.5%.

Stocks moved sharply lower in afternoon trading after a jump in oil prices that appeared to be tied to increased concerns about Russia taking military action against Ukraine.

With about 2 hours left to the trading day, U.S. National Security Advisor Jake Sullivan said at a White House briefing that there were signs of Russian escalation at the Ukraine border and that it was possible that an invasion could take place during the Olympics, despite speculation to the contrary.

Both the U.S. and U.K. have called for their citizens to leave Ukraine as soon as possible.

Sullivan noted that the U.S. is not certain that Russian President Vladimir Putin has made a final decision to invade Ukraine. But “it may well happen soon,” he said. Stocks came off their lows and oil and bond prices retreated from their highs of the trading session following that comment from Sullivan, which countered a bit an earlier report that had sent markets reeling

The Ukraine headlines did have a “a little bit” to do with the sell-off, said Art Cashin of UBS. He said some traders would jump on those headlines ahead of the weekend. “I think it’s really because the Fed doesn’t seem to have a plan.”

“I don’t think it’s going to happen,” Cashin said of an invasion. “A rumor  without a leg to stand on will find a way to get around.”

Some defense stocks moved higher after Ukraine headlines crossed. Northrop Grumman jumped about 4%. Lockheed Martin added more than 2%.

Energy stocks moves higher alongside the price of oil with the Energy Select Sector SPDR gaining 1.8%. Diamondback Energy rose 2.2% and Devon Energy added 2.6%. Exxon Mobil and ConocoPhillips gained 1.8% and 1.3%, respectively.

Shares of travel stocks like airlines dropped sharply. Shares of American Airlines fell 6%.

Friday’s moves followed a sharp sell-off in bonds and stocks in the previous session. Treasury yields spiked in reaction to data that showed consumer prices surged more than 7% last month, the highest gain since February 1982.

The 10-year Treasury yield on Thursday jumped above 2% for the first time since 2019, while the rate-sensitive 2-year yield soared more than 26 basis points at one point in its biggest intraday move since 2009. The 10-year yield was volatile on Friday, falling below 2% in afternoon trading.

The hotter-than-expected inflation reading prompted St. Louis Fed President James Bullard to call for accelerating rate hikes — a full percentage point increase by the start of July.

However, Fed officials contacted by CNBC’s Steve Liesman said that they don’t expect a 50-basis-point move in March would be appropriate. A basis point is equal to 0.01%, and the Fed typically moves in 25-basis-point increments. The presidents of the Atlanta, Richmond and San Francisco Feds pushed back against the idea of a double hike.

Futures market repriced rate-hike odds as CME data pointed to a 70% chance of a 50-basis-point increase at the March meeting, showing that traders were less confident in a larger hike than they were on Thursday afternoon.

Nothing like a Friday afternoon press conference warning of an imminent Russian invasion of Ukraine to rattle markets.

Last week, I looked at whether wage inflation will clobber equities and ended with this ominous warning: "And God forbid Russia invades the Ukraine and oil soars to $200 a barrel, then all hell will break loose!"

Oil prices are now flirting with $100 a barrel and look likely to break above this level any day now.

An invasion of Ukraine by Russian forces will ensure higher oil prices and stoke already high inflation expectations much higher. 

Higher rates are bad for risk assets, especially high growth stocks which is why the Nasdaq sold off today.

However, while the US government is warning of an imminent  Russian invasion, I agree with Harun Yilmaz, a researcher focusing on Ukraine, a large-scale military operation does not fit into Moscow’s cost-benefit calculus, and there's more than meets the eye here (there always is):

When Russia intervened in Ukraine in 2014, following the pro-democracy Maidan revolution against Ukrainian President Viktor Yanukovych, it took a similar cost-effective approach. It did not launch a massive invasion of its much weaker neighbour. Instead, it deployed forces without insignia, while denying doing so, to the Crimean Peninsula, where the strategic military assets it wanted to secure were located – namely the headquarters and facilities of its Black Sea Fleet.

It then undertook a relatively bloodless takeover of this Ukrainian territory by setting up a referendum and presenting the annexation of Crimea as fulfilling the “will of the people”. It did not go any further in trying to conquer Ukrainian territory. A full-scale war was not the method and the occupation of Kyiv was not the goal.

Instead, to punish and subdue the new government in Kyiv, it set up separatist forces in the eastern part of the country, funded and armed them and sent some troops for support. It relied heavily on mercenaries and Russian soldiers not wearing insignia in order to deny its involvement and present the events on the ground as a spontaneous uprising. Thus, Moscow earned leverage over Ukraine at a minimum cost.

Today, eight years after the start of the conflict, Russia is amassing a large number of troops along the border. Has it changed its approach? That is unlikely. Despite Western predictions of an imminent invasion, it is questionable that the intended target of the Russian military mobilisation is Ukraine.

Moscow has not lost its leverage over Kyiv in the Donbas region, as it is nearly impossible for the Ukrainian army to end the separatist movement there while it enjoys Russian support. If the Kremlin wants to pressure the Ukrainian government, it could simply do so by escalating the conflict in the east, which does not necessitate a large deployment of Russian troops.

In fact, just the large military presence along the border is already doing enough damage to Ukraine: severely undermining its economy. Furthermore, the Russian authorities do not see a threat emanating from a “democratic Ukraine”, as the Maidan by now has lost its appeal within Russian pro-democracy circles.

Therefore, the amassing of troops along the Russia-Ukraine border is not targeting Kyiv, but the West. Moscow wants to force Western countries to finally sit down for negotiations on issues of European security. And this strategy seems to be working. Since 1991, this is the first time the West has engaged seriously with Russia to discuss European security.

Russian officials undoubtedly understand that Ukraine will not enter NATO, as there is no enthusiasm for it within the military organisation right now. What the Kremlin worries about is whether the US will deploy missiles or missile defence elements on Ukrainian soil.

Moscow wants arrangements to be made on several issues, including halting the deployment of intermediate-range ballistic missiles in Europe and limiting military exercises in close proximity to Russian borders. On December 17, it put out a proposal outlining its demands to both NATO and the United States.

So what happens next?

Until the Kremlin feels that it has received the necessary security guarantees, it will likely continue to keep military pressure on the Ukraine border. It might deploy intermediate-range ballistic missiles in Belarus or even escalate in other hotspots in its immediate neighbourhood, such as Georgia. It may organise war games closer to Western Europe, as it did with recent naval exercises near Ireland. It could even show off military capabilities closer to US borders, by deploying hypersonic missiles on its submarines or setting up long-range missiles in Venezuela, for example.

All these measures, however, will fall within Russia’s cost-effective calculations. That means that a large-scale invasion or war is highly unlikely.

Another expert, Mark Galeotti, director of Mayak Intelligence, a professor at University College London, and an expert on Russian security affairs, recently spoke with Vox's Dylan Matthews stating this:

The thing is, we’re not talking about Russia. If you look at the opinion polls, Russians themselves have no enthusiasm for any kind of a war.

Crimea was a particular chunk of territory that pretty much every Russian, whether they love or hate Putin, thought was rightfully Russian. It was Russian until the 1950s when it was transferred to Ukrainian control. But that was a one-off. Everyone thought that [annexing Crimea] was right and proper. Frankly, most Crimeans actually genuinely wanted to become part of Russia.

This is totally different. Donbas [the eastern region of Ukraine where Russia is backing separatist militias] isn’t special for them. Instead, they do see the Ukrainians as their ... I don’t know ... cousins, part of the family. And the idea of seeing Ukrainian cities burn is really not something that people are enthusiastic about.

So it’s not about Russia. It’s about Putin. And it’s about this small circle of people around him who dominate this country. If you look at them, they are essentially the last gasp of Soviet elites, the people who didn’t just have their early childhood education in the Soviet times, but also their early career experiences. They were made. They thought they knew the way their life was going to be. And then all of a sudden the whole thing collapsed.

Whether or not Russia invades, one thing is for sure, geopolitical risks matter and they add to an already volatile market environment.

The big story this week was once again surging inflation and how the Fed will react:

Let me reiterate what I've been stating, despite what Bullard, Gundlach or anyone else publicly states, the Fed will move gradually because the truth is it missed its window to raise rates and the US economy is slowing.

Are real rates ridiculously low? You bet. Should the real feds funds rate be a lot higher? You bet.

But rates are creeping up and with the 10-year Treasury note yield near 2%, it's starting to impact the housing market:

And the economy goes the way the housing market goes, so no, I don't see the Fed raising rates aggressively no matter what any guru claims publicly.

With inflation pressures a lot stickier than previously thought, the Fed is in a tough spot and it's a lose-lose situation for equities.

Earlier today, I watched a replay of Francois Trahan's inflation conference call which he presented earlier this week.

It's not an easy one to follow but he did some great research showing why even if headline inflation abates a little over the next year, core inflation pressures will remain because services and shelter CPI will rise:

Take the time to carefully go over Francois's conference call, it's something I need to go over again because he covers a lot in detail and it's important material.

In his weekly market wrap-up. Martin Roberge of Canaccord Genuity notes this about an atypical mid-cycle transition:

One key takeaway from our discussions with clients lately is how atypical is this mid-cycle transition. On one hand, companies enjoy good early-cycle revenue growth as the economy exits the pandemic. But on the other, businesses must cope with late-cycle cost pressures owing to a tight labour market and supply disruptions. The latter are usually not restraining factors at the mid-cycle stage and a more benign inflation backdrop makes it easier for central banks to engineer a soft landing. This was especially true over the last two mid-cycle transitions, in 2004 and 2012, when a stealth growth relapse was the risk factor for stocks as the memory of the tech-led and housing-led recession was still fresh in the mind of investors. As such, we have to go back to 1994 to find a mid-cycle playbook which could resemble that of 2022, where inflation is the primary risks for stocks. Like today, the Federal Reserve under the reign of Allan Greenspan kept policy rates too low for too long after the 1990-91 recession. As a result, inflation expectations spiked in 1993 forcing the Fed to play catchup in 1994 with six rate hikes. As our Chart of the Week shows, the Fed began with three 25bps hikes, then two 50bps and a final 75bps coup de grâce. None of these rate hikes helped to navigate through markets. Rather, it was the sequential change in core inflation that dictated market gyrations, with stocks rallying when inflation dropped from the psychological level of 3% and vice-versa. While we start from a much higher level of inflation in this cycle, the sequential declines are coming in Q2. Thus, if the 1994 playbook is any guide, investors should resist the temptation to sell stocks upon a re-test of January lows.

Martin might be right on that call, so far the Nasdaq is holding above its January lows but don't kid yourselves, it remains very fragile, especially if rates keep creeping up:

Alright,let me wrap it up there, it's been a long week. 

Below, Sam Stovall, CFRA Research chief investment strategist, joins 'Closing Bell' to discuss what's driving the prices in the markets.

Second, Ian Bremmer, Eurasia Group, joins 'Closing Bell' to discuss what to expect from the chat between president Biden and Russia's Vladimir Putin on Saturday.

Third, CNBC's Steve Liesman joins 'Squawk Box' to report on the chances inflation could cool later this year, and the risks that it doesn't.

Lastly, Jeffrey Gundlach, CEO of Doubleline Capital, joins 'Halftime Report' to discuss credit spreads and emerging market debt. Listen carefully to his comments.