The recent OPEC+ decision to cut oil output by 2 million barrels per day is giving me a case of PTSD from a Yom Kippur long ago. In October 1973, the stock market was just getting over a case of Nifty Fifty growth stock mania. Arab armies, led by Egypt and Syria, made a surprise attack on Israel on Yom Kippur and overwhelmed the surprised defenders. The Israelis eventually prevailed in the conflict with US help. Arab oil-exporting countries responded with an oil embargo that spiked energy prices and caused a deep recession. The stock market fell roughly -50% on a peak-to-trough basis before recovering.
Fast forward to 2022. Instead of the Nifty Fifty, we have the FANG+ mania, which may be show signs of fading. Instead of a Middle East war, we have the Russo-Ukraine war. Instead of an Arab Oil Embargo, Russia has weaponized energy, mostly against the EU. Despite much lobbying by Washington, this year’s Yom Kippur brought an OPEC+ surprise. The organization made a decision to cut oil output by 2 mbpd. While the cut isn’t as bad as it sounds because a number of OPEC members aren’t producing at capacity, the decision nevertheless shows that the US and Europe have no allies within OPEC. As a consequence, Street analysts are scrambling to raise their oil price forecasts, and higher energy prices are likely to put pressure on the Fed to stay hawkish.
The Lehman Crisis loophole
Tightening in financial conditions similarly spills over to financial conditions elsewhere, which amplifies the tightening effects. These spillovers across jurisdictions are present for decreases in the size of the central bank balance sheet as well as for increases in the policy rate. Some estimates suggest that the spillovers of monetary policy surprises between more tightly linked advanced economies such as the United States and Europe could be about half the size of the own-country effect when measured in terms of relative changes in local currency bond yields.
We are attentive to financial vulnerabilities that could be exacerbated by the advent of additional adverse shocks. For instance, in countries where sovereign or corporate debt levels are high, higher interest rates could increase debt-servicing burdens and concerns about debt sustainability, which could be exacerbated by currency depreciation. An increase in risk premiums could kick off deleveraging dynamics as financial intermediaries de-risk. And shallow liquidity in some markets could become an amplification channel in the event of further adverse shocks.
In the modal outlook, monetary policy tightening to temper demand, in combination with improvements in supply, is expected to reduce demand–supply imbalances and reduce inflation over time…It will take time for the full effect of tighter financial conditions to work through different sectors and to bring inflation down. Monetary policy will need to be restrictive for some time to have confidence that inflation is moving back to target. For these reasons, we are committed to avoiding pulling back prematurely. We also recognize that risks may become more two sided at some point…Proceeding deliberately and in a data-dependent manner will enable us to learn how economic activity and inflation are adjusting to the cumulative tightening and to update our assessments of the level of the policy rate that will need to be maintained for some time to bring inflation back to 2 percent.
Mr. Williams compared inflation to an onion, with the prices of globally traded commodities such as lumber, steel, and oil, serving as the outer layer, and durable goods such as appliances, cars, and furniture serving as a middle layer. Declining commodities prices and improving supply chains should slow inflation for many goods, Mr. Williams said..
Underlying inflation pressures, or what Mr. Williams referred to as the innermost layer of the onion, have risen briskly and are unlikely to weaken without the Fed taking action to slow the economy with higher interest rates.
“Therein lies our biggest challenge…Inflation pressures have become broad based across a wide range of goods and services,” Mr. Williams said. “Demand for labor and services is far outstripping available supply. This is resulting in broad-based inflation, which will take longer to bring down.”
So, as of today, I believe the stance of monetary policy is slightly restrictive, and we are starting to see some adjustment to excess demand in interest-sensitive sectors like housing. But more needs to be done to bring inflation down meaningfully and persistently. I anticipate additional rate hikes into early next year, and I will be watching the data carefully to decide the appropriate pace of tightening as we continue to move into more restrictive territory.
In considering what might happen to alter my expectations about the path of policy, I’ve read some speculation recently that financial stability concerns could possibly lead the FOMC to slow rate increases or halt them earlier than expected. Let me be clear that this is not something I’m considering or believe to be a very likely development.
There will be pain
5 thoughts on “Why you should financial model the Yom Kippur War”
The 30-50% downside target seems realistic barring a forced pivot by the Fed. In the event of a pivot, while short term positive I wonder about the intermediate and longer term consequences if central banks are derailed from their inflation objectives. Even bigger issues down the road?
At the time of oil shock in 1973, the supply side was dominated by OPEC and energy was a much more significant part of the economy. Comparing a 2 million barrel cut in output (if it actually happens in full) to the oil shock is stretching it too far. Many more players now. Russia is supplying to India, China and African countries. That will not change. Europe is rethinking Nuclear and fracking. Gas shortages for the winter in Europe are likely to be minimal.
War in Ukraine and it’s effects are mostly priced in.
The key issue is inflation and the Fed Policy. Rightfully hawkish. The November and December hikes are well telegraphed and 2 year Treasury is almost at the target.
It’s the effects of rate hikes and QT that are harder to model. So many different outlooks out there – shows how difficult it is to price in.
I agree it’s best to be prudent and defensive. But forecasting targets in this environment is a loosing proposition.
Is the lack of liquidity the new risk?
The risks from derivatives have morphed
“Rising use of collateral creates liquidity risk. Sharp moves in prices result in large cash calls to meet current losses and higher initial margins due to increased volatility.”
Sure be open to the possibility of peace but its very, very unlikely. Zelensky just codified in law the principle of never negotiating with Putin. The war will continue for a while.
This potential S&P 2500 downside is reminiscent of what Ken had said some weeks ago…..
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