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Ukraine conflict risks market fallout worse than Cuban missile crisis

  • February 15, 2022
  • , Nikkei Asia , 3:21 a.m.
  • English Press

YOICHI NAGAI, NQN senior staff writer


TOKYO — As tensions surrounding the Ukraine situation mount, Russia finds itself once again in a familiar, if coincidental, pattern of playing a crucial role in years that end in “2” throughout the annals of history.


In 1812, Napoleon embarked on his doomed expedition to Russia. In 1922, Russians formed the Soviet Union. And in 1962, the U.S. and Moscow faced off during the Cuban missile crisis.


Sixty years later, military tensions between Russia and the U.S. have been stoked once more, this time around a potential invasion of Ukraine. The uncertainty has prompted higher oil prices and a downturn in the equity markets, setting the stage for an extended global financial crunch that could surpass the fallout of the Cuban missile crisis.


Although the timing is nothing more than historical coincidence, it would be hazardous to underestimate the knock-on effect of the Ukraine dilemma. Trends over the past 100 years or so show that the magnitude of the geopolitical risks to the U.S. stock market is predicated on inflation.


In the aftermath of World War I and during the 1973 oil crisis, consumer prices rose faster than nominal interest rates. Real interest rates fell, ushering in stagflation and bear markets.


But during the second World War, the U.S. Federal Reserve kept interest rates low. That, combined with the effects of price controls, limited inflation to a temporary phenomenon. Even during the Cuban missile crisis, nominal interest rates and inflation held steady, and stocks remained healthy.


On Friday, risk-averse investors on Wall Street moved to sell stocks and buy up U.S. Treasury notes. That lowered Treasury yields, which move inversely to value.


But the Treasury purchases are not expected to last long. In the event that an international conflict sparks a run on inflation, it would lead to lower equity prices, higher yields and a weak dollar.


Russia is an oil-rich nation, while Ukraine is a key source of agricultural staples. The military tensions between the two commodity powerhouses have put upward pressure on the prices of crude oil and wheat.


Of particular concern is the possibility that investors will move out of equities and into commodities. That dynamic would lead to inflation and higher interest rates, fueling a vicious cycle of further stock dumps and commodity buys.


Investor money has started hedging against inflation. In the U.S. futures market, the value of gold has risen 3% since the end of January, while the price of Bitcoin has gained more than 10%.


Central banks in western and emerging economies are pivoting toward tighter monetary policies. But inflationary pressures have outmatched such efforts to the point that central bankers are engaging in a game of cat-and-mouse. This poses the risk of policy overkill leading to global recession.


The anxiety can be seen in the spread between long- and short-dated yields. Long-term bond yields are normally higher than short-term yields, and yield inversions have been known to presage a recession.


The spread between 10-year and two-year U.S. Treasury yields has shrunk to the slimmest margin in roughly 18 months, according to the interdealer broker Tullett Prebon. The yield spread for British government bonds is the narrowest in almost two years, while the gap in South Korea shrank by nearly 50 basis points over the past year.


Brazil has been in inverted yield territory since November. The spreads in Hungary, Poland and other countries in Central and Eastern Europe have sharply contracted since fall of last year.


Meanwhile the Bank of Japan has found itself in a dilemma since it serves a country that depends on energy and food imports.


The BOJ’s open market operations, including the fixed-rate purchasing operations of Japanese government bonds, are tailored to ease concerns at Japanese financial institutions that hold large sums of JGBs.


Those financial groups face deteriorating portfolios, and most close their books at the end of March. At the same time, the BOJ operations risk triggering capital flight.


Russia is a gamechanger that demands special attention. If the energy rally persists, there is no ruling out the potential impact it will have on decarbonization efforts in the West. For investors, the consequences would run deeper than the Cuban missile crisis.

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