THE GAME HAS CHANGED...proceed at your own peril...From Doug Noland....try and poke a hole in it if you can...
Markets are an erratic mess: commodities, equities, bonds, currencies and, certainly, derivatives. The game has fundamentally changed. Whether it is nickel, crude, wheat or commodities more generally, producers will now approach hedging programs more cautiously (fearful of getting caught in squeezes and margin calls). Especially after the War and unfolding "economic iron curtain," supply constraints create a high-risk backdrop for getting caught in short squeezes and market dislocations.
To be sure, the derivatives dealer community active in commodities can no longer assume liquid and continuous markets. It would today be misguided to operate with the expectation of being able to readily ("dynamically") hedge derivative exposures in the markets. Wild price volatility and illiquidity dictate that those still willing to sell protection in these markets will demand highly elevated prices.
Market dynamics suggest a fundamental secular change in commodities derivative markets, with fewer players, less liquidity and significantly higher risk premiums. This points to powerful inflationary biases throughout the commodities universe. Moreover, central banks risk throwing gas on an inflationary fire when they respond to financial market illiquidity with additional QE/monetary inflation.
A key question is whether this secular shift in commodities markets portends a secular cycle downturn for financial assets? I believe it does. Financial markets - stocks, bonds, derivatives - confront risks not faced in decades. Inflation is high, while risks are tilted strongly to the upside. Meanwhile, the combination of surging inflation and unprecedented indebtedness creates the highest risk in generations for a disorderly spike in market yields.
Importantly, there's also the key issue of the Fed's (and global central banks') market liquidity backstop. Markets cannot today rest assured that "whatever it takes" still applies. At the minimum, the necessary focus on inflation risk will dictate that the Fed's response to "de-risking/deleveraging" and resulting market illiquidity will be more tentative and limited in scope than in the past.
The backdrop points to a sea change in the risk/reward profile of financial assets generally. Geopolitical risks are today of extreme nature and will likely remain highly elevated. Liquidity risks have fundamentally shifted. Wildly speculative markets confront a less certain and likely diminished central bank liquidity backstop. Importantly, writing market protection has become a much riskier proposition, a reality that will manifest into higher priced derivatives and market protection. And a shift away from readily available inexpensive market "insurance" will translate into less leveraging and risk-taking. Going forward, de-risking will require more selling of securities holdings, rather than simply buying cheap hedges.
It was a week of extraordinary contradictions. Constructive comments on negotiations from both the Ukrainian and Russian sides. The Wednesday Financial Times article, "Ukraine and Russia Explore Neutrality Plan in Peace Talks:" "Ukraine and Russia have made significant progress on a tentative peace plan…" By late in the week, the Ukrainian side said talks could last at least "several weeks," while Putin stated Kyiv was "putting forward more and more unrealistic proposals." If anything, the bombing and destruction became only more intense and brutal.
The U.S. and China appeared on a collision course, although the Biden/Xi meeting offered reason for cautious optimism. Chinese markets were at the brink, before a Beijing-induced rally elicited cries of "the bottom's in!" Here at home, another spectacular short squeeze suspended crisis dynamics. The bottom line: the world has commenced an alarming period of uncertainty and instability. And the more comfortable markets become in disregarding geopolitical risk, the more leash the Fed will have to tighten policy. A well-known market pundit said the Fed was in "fantasyland." The same can be said for the markets.