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Thursday, March 3, 2022

Waiting For Diplomacy

Back when I was in university — at the tail end of the Cold War — I turned into a “power politics diplomacy nerd.” Although I could probably write lengthy pieces on the invasion of Ukraine, I think that would be a mistake. I just want to stick to my knitting, and make some observations that do not fit the news flow that I am seeing.

Although I am working with obviously incomplete and biased information, I view the possibility of the cessation of hostilities within a few weeks to be unlikely. Military and economic developments could easily mean that a peace agreement is reached within months, but that lengthy a process will likely have far-reaching economic effects.

I will first offer some relatively obvious comments on financial market implications, before offering some observations on the diplomatic situation.

Rates Story Simple…

Rates trading involves guessing how discount rate curves and/or volatility cubes will evolve. Although volatility is more complex, rates can either go up or down, so no matter how complex the economic environment is, the implications have very few degrees of freedom.

The Bank of Canada just hiked rates, and my opinion is that the Fed will follow suit. (Disclaimer: I am writing this before a wave of Fed speeches.) It would be insane to hike by 50 basis points, so the question is whether the Fed hikes by 25 per meeting, or at a more gradual pace. We would not have to cross that bridge for another six weeks or so after the March meeting, and the situation will be clearer by then. Of course, that does not help the people trading STIR futures, since they have to position now.

Other Markets Not…

The sanctions, war disruptions, and a Western private sector that is cutting ties to Russia means that we are facing an extremely rapid unravelling of commercial and financial flows between the West and Russia and Ukraine. Although some opportunistic firms might want to find ways to act as covert intermediaries, that would take time.

For risk asset markets, the effects of this collapse in linkages will have wildly different effects at the firm level. Some firms will be wiped out, others will end up making windfall profits. It will be a stock pickers’ market — but since I am not a stock picker, I will conclude my discussion there.

The inflation market (e.g., index-linked bond inflation breakevens). The mechanical effect of spiking commodity prices will show up on the front end of the curve. Furthermore, already strained supply chains are getting massive new disruptions. I made the decision to be an “observer” (stealing from Jim Grant) and not a “forecaster” when I moved into consulting/writing, but even if I were a forecaster, I probably would just throw my arms up in the air. The uncertainty around the front end inflation forecasts are likely going to make forward breakevens largely useless. Inflation bulls will buy short-dated inflation, inflation bears will sell long tenors. Assuming that relative value players do not want to allocate large amounts of risk to smoothing out the forward curve, implied forward inflation could easily end up stupidly priced.

Although sanctions may be in place between the NATO-aligned industrial democracies and Russia, commodity flows out of Russia are likely to resume. For things like wheat, they will be going to somewhat non-aligned countries (NATO countries tend to be exporters of grains), so I have little doubt that arrangements will be made for flows to resume.

Nevertheless, the disruptions to logistics — and the cutting off of Ukrainian production — will be added strain on already disrupted global supply chains.

Will People Yapping about Reserve Currencies Finally Shut Up?

Recent events have blown up many of the nonsensical narratives about “reserve currencies.” If we were lucky, we would not hear about them any more. Unfortunately, given the people pushing those narratives, this probably will not happen.

Foreign exchange reserves held in a trading bloc (e.g., the trading bloc arranged around the United States) are only useful to guard against financial disruptions to trade with that bloc. As soon as you get involved in foreign policy adventurism, those assets are just hostage to the host country. For those of you with a long memory, that was the premise of the “New Bretton Woods” theory that popped up during the era of rapid accumulation of U.S. dollar reserves by China. Holding U.S. Treasuries as reserves is only useful as a political tool if the objective is to remain in good standing under the American nuclear umbrella — e.g., Japan.

We are even seeing the limitations of gold as a reserve asset. Gold is only useful for a government if they use it to barter with domestic suppliers of goods, or if it is in place within a trading bloc. Shipping large amounts of gold by sea when you do not have undisputed control of the sea could easily lead to events that would make really cool action films. (I am unsure of the details, but I recall reading an article that noted that Japan ran into this issue either in the 1800s or 1907.)


The current situation in Ukraine has many unfortunate precedents (Vietnam, Afghanistan): we see a nuclear power in conventional conflict with a weaker country, with another great power supplying weaponry to the weaker country. The end result is a proxy war without nuclear powers having regular troops facing each other.

Diplomatic negotiations have started, and the focus of military operations for each side is to get the outcome they want. Based solely upon what I am seeing in public declarations, each side’s stated war aims are incompatible with what the other will accept. Realistically, that will be the case until there is a “sudden” peace agreement announced; without access to the talks (and the various diplomatic back channels), it is not going to be possible to assess how far apart the two sides are.

Right now, Russian troops have supremacy on the open terrain they have occupied, and they pose a major threat to major cities via artillery bombardment. If that were enough to force a peace agreement that meets Russian objectives, the negotiations would end rapidly. Otherwise, ground troops will need to occupy the major cities to change the “facts on the ground.” Urban warfare is tilted in favour of defence, which explains why I do not believe this would result in resolution within a couple of weeks.

No matter how Russia re-draws the borders, it is hard to see the gains of a victory in the Ukraine as offsetting the diplomatic losses across the rest of her Western borders (with the exception of Belarus, which is being locked further into the Russian orbit). One can only hope that this calculus will help bring a speedier end to the conflict.

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(c) Brian Romanchuk 2022

1 comment:

  1. Brilliant piece Brian. I can only concur with your conclusion.


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