Dow slips as Russian jet downed US drone, but recovered

Wall Street Futures and Gold surged, while USD slid Tuesday on the Fed bailout of regional banks (SVB, Signature Bank) and in line with expectations inflation data. But Wall Street Futures led by Dow soon stumbled after a statement by the U.S. Military that a Russian fighter jet collided with the propeller of a US military "reaper" drone, forcing the US to bring it down over the Black Sea:

“Two Russian Su-27 aircraft conducted an unsafe and unprofessional intercept with a U.S. Air Force Intelligence, Surveillance, and Reconnaissance unmanned MQ-9 aircraft that was operating within international airspace over the Black Sea today.

At approximately 7:03 AM (CET), one of the Russian Su-27 aircraft struck the propeller of the MQ-9, causing U.S. forces to have to bring the MQ-9 down in international waters. Several times before the collision, the Su-27s dumped fuel on and flew in front of the MQ-9 in a reckless, environmentally unsound, and unprofessional manner. This incident demonstrates a lack of competence in addition to being unsafe and unprofessional.

Our MQ-9 aircraft was conducting routine operations in international airspace when it was intercepted and hit by a Russian aircraft, resulting in a crash and complete loss of the MQ-9. In fact, this unsafe and unprofessional act by the Russians nearly caused both aircraft to crash. U.S. and Allied aircraft will continue to operate in international airspace and we call on the Russians to conduct themselves professionally and safely.

This incident follows a pattern of dangerous actions by Russian pilots while interacting with U.S. and Allied aircraft over international airspace, including over the Black Sea. These aggressive actions by Russian aircrew are dangerous and could lead to miscalculation and unintended escalation.”

Meanwhile, the NSC spokesman Kirby followed up by saying the US aircraft posed no threat to anyone, and that it was operating in international airspace. He additionally confirmed it was brought down in international waters. Presumably, there may be a recovery operation underway. Kirby stressed in a briefing, "If the message is that they want to deter or dissuade us from flying and operating in international airspace over the Black Sea, that message will fail-- intercepts of planes and drones are common, but this is the first time an intercept resulted in a splashing of one of our drones".

On the other side, a military journalist source tweeted: “Russian Su-27 aircraft struck and downed a #US MQ-9 Reaper drone, spying on #Russia over the Black Sea. The two Russian Su-27 returned to their baser in #Crimea after destroying a $32 million, for the latest versions of MQ-9, #US drone”.

The market was concerned about escalating geopolitical tensions between Russia-Ukraine/U.S./NATO after a recent admission by Canadian FM that the long-term goal of the Ukraine conflict is to change the Putin regime in Russia.

In any way, late Tuesday, Dow Future also recovered briefly after the Russian defense ministry stated that Russia didn’t destroy the U.S. drone. The Russian Defense Ministry said nothing about the Pentagon's allegations that a Russian Su-27 aircraft dumped fuel on the MQ-9 drone, but instead blamed the MQ-9’s erratic maneuvering for the collision:

“On the morning of March 14, a U.S. UAV flight was detected near the Crimean peninsula in the direction of the state border of the Russian Federation. Russian fighters did not use onboard weapons and did come into contact with an American drone. US drone MQ-9 fell into the Black Sea on Tuesday morning due to its own sharp maneuvering, Russian fighters did not come into contact with it and did not use weapons.

As a result of sharp maneuvering around 09:30 Moscow time [06:30 GMT], the unmanned aerial vehicle MQ-9 went into an uncontrolled flight with a loss of altitude and collided with the water's surface. The Russian fighters did not use airborne weapons, did not come into contact with the unmanned aerial vehicle and returned safely to their home airfield.

The Russian fighters had been scrambled in response to the drone being picked up on radar on the morning of March 14, the airspace control of the Russian Aerospace Forces had recorded the flight of US unmanned aerial vehicle MQ-9 over the Black Sea in the region of the Crimean peninsula in the direction of the Russian state border---the UAV had been flying with its transponders turned off while headed towards Russia's border.

The flight of the drone was carried out with transponders turned off, violating the boundaries of the area of the temporary regime for the use of airspace, established for the purpose of conducting a special military operation, communicated to all users of international airspace and published in accordance with international standards.”

But Russia is also accusing the U.S. ignoring military-to-military protocols related to the war in Ukraine, established to avoid inadvertent clashes between the two biggest military superpowers, which may cause WWW-III (nuclear war) amid lingering Ukraine-related geopolitical tensions. But for the time being, both sides choose to de-escalate as neither has confirmed any direct collision/shootdown incident and effectively kept open for reconciliation (in line with respective domestic political compulsion).

The U.S. Senate Majority Leader Schumer said Russia's Black Sea drone incident was another reckless act by Putin and his military, while Pentagon said:

·         The state department is raising concerns over the incident to the Russian government

·         The Defense Department officials have not spoken so far with Russian officials about the incident

On Tuesday, all focus of the market was on inflation data for February, which may guide Fed about rate hike action on 22nd March and further down the month. The BLS data shows the annual (y/y) inflation (CPI) rate in the U.S. eased to 6% in Feb’23, from +6.4% sequentially (Jan’23), the lowest since Sep’21, and in line with market consensus. In February, the headline CPI was dragged by food & fuel, used cars & trucks, while boosted by electricity, and shelter costs.

On a sequential (m/m) basis, the headline CPI in the U.S. eased to +0.4% in Feb’23 against +0.5% in Jan’23 and is in line with market expectations (seasonally adjusted). On a seasonally not adjusted basis, the sequential CPI was +0.6% in February against +0.8% in January. In Feb’23, the sequential CPI was boosted by the shelter, food, recreation, household furnishings & operations, and airline fares, while dragged by natural gas, fuel oil, and used cars & trucks.

The annual (y/y) U.S. core CPI eased to +5.5% in Feb’23 from +5.6% in Jan’23, in line with market expectations and the lowest since Dec’21.

On a sequential basis (m/m), the U.S. core CPI increased +0.5% in Feb’23 from +0.4% in Jan’23 and higher than market expectations of +0.4% on a seasonally adjusted basis. The seasonally non-adjusted sequential core CPI was +0.7% in Feb’23 against +0.6% in Jan’23.

Looking at the core CPI trend, it eased from +6.6% in Sep’22 to +5.5% in Feb’23; i.e. 1.1% decline in 5 months. At this run rate, core inflation may fall to around +4.50% by May-June’23. Thus Fed may hike by another +25 bps on 22nd March, 3rd May and 14th June for a terminal rate of 5.50%, so that the real rate would be positive by at least +100 bps. After June’23, Fed may pause till at least Dec’23 to bring down core CPI towards +3.50% ensuring a stable economy and employment.

Conclusion:

After SVB/regional banks' fiasco, the market is now expecting a +25 bps rate hike on 22nd March and a pause. Further, some market participants are now also expecting Fed may prefer financial stability over price stability and may not even go for any hike on 22nd March. A few market participants are also expecting rate cuts to the tune of -75 bps by Dec’23 for the sake of financial (Wall Street) stability. Thus Wall Street Futures and Gold jumped, while USD slumped. Apart from regional banks, Fed is itself now bankrupt, at least theoretically with a negative net worth currently around -$1.1T. As a debt manager of the U.S. government, Fed along with Treasury has to ensure lower borrowing costs, whatever may be the narrative, and thus US10Y bond yield of around 4.25-4.50% is a red line for Fed.

U.S. is now paying almost 10% of tax revenue as interest on public debt and CBO projected around 13% and 15% for 2023-24 even after assuming an average 10Y US bond yield of around 3.80-3.90%. This is a red flag for U.S. fiscal math. China and the EU’s debt interest/tax revenue is currently around 5.5%, while Japan’s is 15%.

As a debt manager of the government, every central bank including Fed has to ensure lower borrowing costs for deficit spending, whatever may be the narrative. Thus Fed will take a balanced approach to control inflation, employment, and bond yields. Fed may not allow a US10Y bond yield above 4.25-4.50% under any circumstances (recent high around +4.08%) whatever may be the narrative.

Fed also has to ensure a softish landing, if not soft (mild employment/economic recession and 2% price stability); i.e. financial and price stability at any cost, If Fed does not hike on 22nd March for SVB/small banks crisis, it may affect its credibility and show Fed is panicking.

On Tuesday, regional bank stocks recovered, while Facebook owner Meta jumped after it said it would cut 10,000 jobs in a second round of mass layoffs.