Game Of Drones

By Benjamin Picton of Rabobank

Geopolitics is in the headlines again today. News that a drone strike on a US military base in Jordan killed three American soldiers, and wounded a further twenty-five, has prompted President Joe Biden to declare that the US will “hold all those responsible to account at a time and in a manner of our choosing.” News of the strike prompted Republican Senator Lindsay Graham (among others) to fire off a few (metaphorical) missiles of his own. Graham issued a statement calling for “the Biden Administration to strike targets of significance inside Iran”. Such an action would mean that we skip over domino number two (meaningful escalation between Israel and Hezbollah) and head straight to the final domino (direct conflict with Iran) in our foreshadowed recipe for a broader regional war.

Still smarting from the US withdrawal from Afghanistan, Biden hardly needs to get drawn into another protracted war in the Middle East. It is an election year, after all, and everything else seems to be going swimmingly (at least on the surface). The stock market is making new highs, GDP is expanding much faster than most analysts were expecting, and the core PCE deflator is printing at pre-Covid levels. With much of the heavy-lifting on the inflation fight having been done by falling energy prices and the resolution of pandemic-era constraints on international trade in goods, instability in the Middle East is an unwelcome threat to progress made.

If traders had been pricing substantial risk premium into the energy complex, the underlying market dynamic must be more oversupplied that popularly acknowledged. If that is the case we might have expected the Biden Administration to be aggressive refilling the Strategic Petroleum Reserve, but inventories have lifted only minorly since hitting 30-year lows last July. Oil prices are now moving higher as markets digest this latest news and increase the delta that the USA could be approaching the end of its patience for provocations from Iran.

Still, there are no easy solutions. Wars are expensive and difficult, and there are questions over the USA’s ability to replenish Tomahawk missile stocks if it were to respond with strikes inside Iran. The cost asymmetry of cheap and plentiful Iranian drones vs expensive and scarce Western missiles had already put a logistical half-life on Operation Prosperity Guardian. Running down Tomahawk stocks to launch air strikes against land-based targets for dubious benefit would be similarly problematic. Boots on the ground offers a potential solution, but massive US escalation may be a just-as-bad alternative to the prevailing situation of constant provocation and disruption by Iran and its proxies.

So, while every analyst forecasting an immaculate disinflation crosses their fingers and toes that energy flows through the Hormuz Strait remain relatively unimpeded, we approach the first FOMC meeting of the year. A change to the Fed Funds rate at this meeting is seen as virtually no chance at all, but what will be the signal for the March meeting? Markets have a rate cut as a 50-50 proposition, and Lagarde was unexpectedly dovish last week. Is there a possibility that the world’s top central bankers are still busy reading last year’s mail on goods disinflation and will be telegraphing imminent cuts into an unfolding supply shock?

That’s to say nothing of the signal on the Fed’s balance sheet, which will be even more interesting. After the Fed belatedly closed the Fed Funds-BTFP arb last week, and announced plans to cease making new loans via the BTFP program in March, many of us are now waiting for the next shoe to drop. The overnight reverse repo market has been sending worrying signals about a squeeze on liquidity leading to a shortage of bank reserves. What happens when all of those regional US banks with balance sheets loaded with dubious commercial real estate loans can no longer pledge underwater securities at par? The answer is more money printing, which explains the price action in the S&P500.

So, this week could go either of two ways. Are we going to see an attempted circuit-breaker from the White House or the Fed (ineffectual though they are likely to be)? Or will it just be a case of more droning-on while problems mount and enduring solutions remain elusive?