Hello there,

A terrific Thursday to you as markets take a turn for the worse amidst concerns that the Ides of March (a date when ancient Romans used to settle debts) may finally be upon us as investors worry about everything from the continuing Russian invasion of Ukraine to the prospect of tighter monetary policy.

In brief (TL:DR)

• U.S. stocks were lower on Wednesday with the Dow Jones Industrial Average (-0.19%), the S&P 500 (-0.63%) and the Nasdaq Composite (-1.21%) all down amidst worries over a growth slowdown.

• Asian stocks mostly fell Thursday on concerns about Chinese data and regulations.

• Benchmark U.S. 10-year Treasury yields were at 2.35% (yields fall when bond prices rise) as traders expect more aggressive interest rate hikes to deal with inflation.

• The dollar held a retreat.

• Oil dropped sharply with May 2022 contracts for WTI Crude Oil (Nymex) (-5.67%) at US$101.71 on signs that the Biden administration is considering a massive release of crude from U.S. reserves to combat inflation.

• Gold was lower with Jun 2022 contracts for Gold (Comex) (-0.43%) at US$1,930.70 as traders took a more sanguine view on inflation.

• Bitcoin (-0.60%) was flat at US$47,137 while other risk assets declined and traders sitting mostly on the sidelines.

In today's issue...

1. Investors Should Keep an Eye on U.S. Treasury Market Machinations

2. Why aren’t markets reacting more violently to Russia’s invasion of Ukraine?

3. US$600 million in Stolen Cryptocurrency – Good Luck Spending It

Market Overview

Global stocks are on track for their worst quarter in two years amid concerns about a growth slowdown, with the war in Ukraine driving volatility in commodity markets.

Investors are also unnerved by the prospect of a sharper withdrawal of stimulus, as the fastest inflation in a generation forces central banks to become more aggressive with interest-rate hikes.

Markets now see a strong chance the U.S. Federal Reserve will lift rates by a half point at the May meeting while the U.S. Treasury yield curve appears to portend that traders expect the economy may be poised for a recession.

Asian markets were mostly lower Thursday with Seoul's Kospi Index (+0.40%) up, while Sydney’s ASX 200 (-0.20%), Hong Kong's Hang Seng Index (-1.07%) and Tokyo's Nikkei 225 (-0.73%) were all down in the morning trading session.

1. Investors Should Keep an Eye on U.S. Treasury Market Machinations

• Liquidity in the U.S. Treasury market has declined to its lowest level since March 2020, when the pandemic roiled investors and gummed up the market until the U.S. Federal Reserve intervened as a buyer of last resort.

• And a lack of liquidity has exacerbated price swings for the world’s most-traded sovereign debt, leading to conflicting market signals.

Liquidity is one of those things – often taken for granted except when you need it the most.

And the massive US$23 trillion market for U.S. sovereign debt is about to figure out whether it has the liquidity to cope with rising interest rates and a central bank determined to runoff its balance sheet.

Liquidity in the U.S. Treasury market has declined to its lowest level since March 2020, when the pandemic roiled investors and gummed up the market until the U.S. Federal Reserve intervened as a buyer of last resort, according to data from Bloomberg.

And a lack of liquidity has exacerbated price swings for the world’s most-traded sovereign debt, leading to conflicting market signals.

Typically, U.S. Treasuries move inversely to U.S. equities, with a rise in the price of one typically correlating with a price increase in the other – Treasuries and equities are negatively correlated, moving opposite to each other.

But the pandemic and a flood of liquidity by central banks have upended traditional correlations and over the past 24 months, equities and Treasuries have moved in lockstep.

Despite geopolitical uncertainty, such as the Russian invasion of Ukraine, typically serving as a catalyst for heightened demand for haven assets, U.S. Treasuries are on track to post their worst quarter since 1973.

Key to the poor performance of Treasuries of course has been the U.S. Federal Reserve’s interest rate hike this month of 0.25%, its first since 2018, and inflation running at its fastest pace since 1982.

The U.S. Treasury market has also grown increasingly volatile, given the lower levels of liquidity, raising serious questions on the proper functioning of a market that forms the bedrock of global finance, determining the interest on everything from mortgage rates to stock prices.

Treasuries typically rally during times when markets are jittery, with traders stashing their cash in the safest assets.

But the typically in-demand U.S. Treasuries have seen their allure languish as interest rates have risen and as the Fed is preparing to become a seller of these government securities.

Not helping matters is that the financial institutions which have been traditional market makers for U.S. Treasuries have been forced to pull back from that role ever since stricter capital requirements were implemented post-2008 in the aftermath of the financial crisis.

And while hedge funds and high-frequency traders have stepped in to pick up some o the slack, they are a fleeting presence, only hanging around long enough or often enough to clock in profits and exacerbate volatility, rather than moderating the swings in the market.

But the bigger implication of volatile Treasury markets is that it could worsen already tightening financial conditions.

Because a firm can’t (at least in most cases) borrow at a rate that’s lower than what it costs the U.S. to borrow at, it could become harder for companies and consumers to obtain financing cheaply, and that could pose a drag on the U.S. economy, adding to recessionary pressures that higher interest rates are already contributing to.

2. Why aren't markets reacting more violently to Russia's invasion of Ukraine?

• The Russian invasion of Ukraine isn’t the only headwind for global equities.

• Russia’s invasion of Ukraine might turn out to be that inflationary crack in the dam which sets off a chain reaction triggering a waterfall of aggressive rate hikes that then takes down a financial system lulled into complacency on the promise of indefinitely easy monetary policy as a safety net.

When the first and second Gulf War hit a key global producer of oil, Iraq, the fallout from that conflict was expected to be limited given Iraq’s tiny impact on the global economy.

True, Iraq was and is a major oil producer, but it hardly compares to Russia’s output, and unlike Russia, Iraq is a one-trick pony, with only oil to provide, whereas Russia brings industrial metals and agricultural commodities to the global market.

Now throw in the impact of Ukrainian wheat not making it to the bakeries and Western sanctions effectively isolating Russia, the world’s 11th largest economy from the global marketplace, and global equities have taken the shock of the Russian invasion very much in their stride.

Which begs the question, why?

By one measure of global equities, after initially deepening the global stock market selloff, the MSCI All-Country World Index has now recovered to its pre-invasion level and the Vix volatility index, a commonly used proxy for how much fear is in the markets, has slipped below its long-term average, suggesting that investors remain relatively sanguine.

And what’s confusing analysts even more, the Russian invasion of Ukraine isn’t the only headwind for global equities – a combination of bearish factors, from soaring inflation to rising interest rates, debt problems in emerging markets and an ongoing pandemic, have yet to dampen global demand for stocks.

That the market hasn’t crashed already is surprising, and that’s even without the invasion.

But could toxins be building up in the global financial system that participants simply aren’t and can’t be aware of?

Thus far, the financial system has only suffered minor pullbacks, without a full-scale contagion and part of the reason could be that investors believe central banks can always reverse course on monetary policy, standing at the ready to rescue markets should contagion breakout.

Russia’s widely-expected sovereign debt default also didn’t come to pass as more than US$117 million in interest payments due to overseas creditors was paid up, despite the debilitating Western sanctions that continue to be imposed on the country.

The crisis in China’s biggest real estate developers, has also failed to implode the Chinese economy or cause widespread malaise, contrary to many analysts equating China Evergrande to the country’s “Lehman” moment.

Even the US$10 billion fallout of Archegos Capital Management, wasn’t enough to ruffle more than a few feathers on Wall Street, with the market as a whole not so much as batting an eyelid at the affair, which just over a decade ago could have stoked systemic contagion.

All over the global financial system, challenges abound and risks are increasing, so why is nothing coming unglued?

To be sure, leverage is a lot lower in the system than it was just over a decade ago.

The aggregate net leverage of hedge funds, according to data from Goldman Sachs, was just 48% at the start of this year, whereas in 1998, Long Term Capital Management was levered 25 times against its capital.

Investors have already priced-in exclusion of the Russian economy from the global marketplace, and Russia was never that integrated anyway – overall foreign lending exposure to Russia is estimated at around US$120 billion, significant, but nowhere close to systemically debilitating.

Ironically, the global financial system did learn some lessons from the last financial crisis and the regulatory framework that’s been put in place, with banks loaded with reserves and buffers and capital, have helped prevent the sort of panic selling or credit market seizure that has often marked other previous crises.

So if the global financial system isn’t where the contagion risk starts, where could the hidden dangers be residing?

In the price of everything from bread to booze, nickel to nitrates.

While Russia may not be systemically important to the global financial system, it is significant in the world of natural resources.

And the problem is that even as the prices of commodities rise, which affect companies that use them for manufacturing, cutting interest rates at a time of high inflation or stimulating the economy with more liquidity doesn’t make things better, it makes things worse.

Because central banks only have so many tools at their disposal, the risk remains that higher commodity prices become the real harbinger of economic malaise at a time when central banks can’t do much about it.

Periods of prolonged price increases, especially for food and energy, have also often triggered political upheaval in countries that were just holding on to their political systems by a thread.

In other words, investors shouldn’t be looking to the financial markets for the first signs of trouble, but to the real economy, because that’s where the next shock could come from/

Almost 60% of rich countries are experiencing inflation over 5%, from zero, just one year ago, increasing the pressure on central banks to hike interest rates far more aggressively than they would like and increasing the risk of setting off an unintended recession.

Which is why the real risks can’t be discerned from the financial markets, but rather the one that matters to everyone, the real economy.

Russia’s invasion of Ukraine might turn out to be that inflationary crack in the dam which sets off a chain reaction triggering a waterfall of aggressive rate hikes that then takes down a financial system lulled into complacency on the promise of indefinitely easy monetary policy as a safety net.

3. US$600 million in Stolen Cryptocurrency - Good Luck Spending It

• Given the sheer volume of blockchain protocols, bridges have become a necessary but increasingly vulnerable means by which users can use different cryptocurrencies across different networks.

• While Axie Infinity’s token did take a hit in the immediate aftermath of discovering the hack, it’s since recovered, with Axie Infinity’s creator Sky Mavis, “fully committed” to reimbursing players who were victims of the hack.

Over US$600 million in cryptocurrency was stolen from the Ronin network, a blockchain closely associated with the popular game Axie Infinity.

Although the hack occurred on March 23, it wasn’t until two days ago that Axie Infinity came to be aware of the compromise.

Demonstrating the risks associated with “bridges” – software that allows blockchains to communicate with one another and send assets across different blockchains, the hack of Ronin comes hot on the heels of the US$300 million hack of Wormhole, another “bridge” and which has the backing of Jump Crypto.

Computers that act as nodes operated by Axie Infinity creator Sky Mavis and the Axie DAO that support the bridge were hacked, with some 173,600 Ether and 25.5 million USDC tokens stole in two transactions.

Given the sheer volume of blockchain protocols, bridges have become a necessary but increasingly vulnerable means by which users can use different cryptocurrencies across different networks.

For instance, it’s not possible to use Bitcoin on the Ethereum network, without first using a bridge that converts the Bitcoin into so-called “wrapped Bitcoin” or wBTC that conforms to the Ethereum network standard.

Bridges play an important role in decentralized finance or DeFi and are a tool that allow users to port cryptocurrency that operates on one blockchain to another, often using an “escrow” type smart contract.

The problem of course is that most bridges use open source code of vaporware (copies of open source software) that may be riddle with bugs or unknown vulnerabilities and many of which are unaudited, allowing hackers to exploit vulnerabilities.

Bridges are also often run by anonymous developer communities or even individuals and there isn’t exactly a customer service hotline to dial up should issues arise.

And even if there’s a vulnerability in the smart contract of the bridge, once hammered into the blockchain, it’s there permanently and can still accept deposits to the smart contract address.

While Axie Infinity’s token did take a hit in the immediate aftermath of discovering the hack, it’s since recovered, with Axie Infinity’s creator Sky Mavis, “fully committed” to reimbursing players who were victims of the hack.

But even though the hackers made off with substantial amounts of cryptocurrency, they made some inexplicable choices in the getaway vehicle, transferring the stolen amounts to accounts at just two major centralized cryptocurrency exchanges, according to blockchain forensics firm Elliptic.

Sending the stolen crypto to exchanges which have been beefing up KYC and AML requirements makes absolutely no sense and is akin to robbing a bank, and then making your getaway by taking a bus at the bus stop just outside the bank.

Typically, hackers would send their stolen crypto to any number of “mixers” which would attempt to obfuscate the flow of the ill-gotten proceeds and rarely, if ever, would the first destination of choice be a major centralized cryptocurrency exchange.

Huobi, FTX, Binance and OKEx have already issued statements stating that they would work with Axie Infinity in the aftermath of the attack, making it virtually impossible for the hackers to ever enjoy the proceeds of their robbery.

Last year, the Poly Network hacker gave back the over US$600 million in cryptocurrency that they had stolen, which many suspect had more to do with being unable to spend the cryptocurrency rather than because of an attack of conscience.

The Axie Infinity hacker could well have to suffer the same fate.

Unlike in 2018, a blossoming cottage industry of expert blockchain analytics firms have sprung up to serve this specific purpose – monitor hacks and keep tabs on the flow of funds, making efforts to steal cryptocurrency a far less profitable proposition than it used to be.

With dozens of expert firms watching the every move of these cryptocurrency wallets, it’s akin to robbing a convenience store with the cops watching your every move thereafter, waiting for you to spend that money to pounce on you.