The fear of a resumption of central bank rate hikes is roiling the financial markets. The problem is anchored to the geopolitical storm brewing in the Red Sea.

In December 2023, in a column titled: “Will 2024 Be the Year of the Supply Chain?,” I noted: “Keep an eye on the Red Sea because events there could change everything.”

In that article I wrote:

“The Fed wants to keep rates where they are for as long as it can and expects to lower them at some point, perhaps in 2024. Yet, any supply chain disruptions may trigger inflation, which will reignite the rate hike cycle. Few in the markets are prepared for this plausible turn. So, although I’m not turning bearish, I suspect those who stay alert and act accordingly will fare better.”

Just a mere three weeks later, things seem to be coming to a head.

That was then.

In late 2023, the Federal Reserve seemed to signal that it would be lowering interest rates in 2024. The apparent change of heart was revealed in thinly veiled comments from Fed Chairman Jerome Powell during his post-FOMC meeting press conference and were echoed by other members of the Fed, most notably Federal Reserve Governor Christopher Waller.

Waller’s late 2023 remarks resulted in his being dubbed a dove by the markets, prompting a year-end rally in stocks and bonds. But things may be taking a turn for the worse as the U.S. central bank has been slowly walking back its rate cut talk.

The Fed’s bullish turnabout came as the U.S. Consumer Price Index began to flatten out late in 2023. Since then, the data has been mixed with the December CPI number coming in stronger than expected, albeit coupled with a weaker than expected PPI.

Moreover, the worsening situation in the Red Sea, where forces based in Yemen have been attacking cargo ships for the past few weeks. The attacks have led global shipping companies to partially halt traffic through the Red Sea; rerouting cargo around the Cape of Good Hope, located on the tip of South Africa.

This rerouting has increased shipping costs by raising fuel and related costs, including insurance premiums, while threatening to cause sustained havoc with schedules during a period where ship capacity is already limited.

At least one major global retailer, Sweden’s Ikea, has warned analysts and customers that merchandise delivery schedules and costs will be affected; resulting in reduced product availability and longer wait times for products to become available. Other retailers are certainly factoring the emerging dynamic into operations.

Where things get interesting is in the slowly shifting talk from the Fed and other central banks along with the action in the bond market.

Central Bankers Roll Back Rate Cut Talk

Stock traders had priced in central bank rate cuts as early as March 2024. The bond market agreed. This was fueled by happy talk from central bankers in Europe and the U.S. Now, some of those expectations are fading as ECB officials change their tune to maybe there is no hurry to cut rates; at least not just yet.

On the other hand, the most recent GDP data from Germany, the Eurozone’s largest economy depicts an system which is standing still. Which is it?

Even more daunting was the market’s reaction to Mr. Waller whose remarks on 1/16/2024 were seen as potentially reversing his full speed ahead with rate cuts stance of just a few weeks ago.

oth stocks and bonds spooked by his clear support for the consensus view at the Fed that three rate cuts in 2024 will be sufficient if the data calls for it. Things unraveled further when he said there was no reason to lower rates aggressively as the Fed has done in the past.

The market had factored in as many as six rate cuts – in a hurry.

Demand for Container Ships Rises Pushing Cargo Rates Higher

The rerouting of cargo from the Red Sea has increased demand for cargo vessels. According to Freightways.com, there is an ongoing “scramble for prompt tonnage,” an industry term which defines ships which are immediately available to be hired. Meanwhile, spot rates, the amounts charged by shippers when cargo is not covered by long term contracts, is also on the rise.

According to the report, the Harper Index, an industry benchmark which measures six to twelve month charter rates is up 12% since December 2023, while the Drewry World Container Index, which measures the cost to ship cargo through the Red Sea is up over 400% since January 1, 2024.

Bonds Smell Inflation

It’s not yet at the top of the talking point list in the bond market, but traders are quietly considering the potential effects on inflation if the Red Sea situation is not remedied soon. You can see this reflected in the yield for the U.S. Ten Year Note (TNX), which is stubbornly clinging to the 4% area despite mixed economic data, which of late points to pockets of weakness.

Take the most recent Empire State Manufacturing Survey, which measures manufacturing activity in the state of New York. Its January 2024 reading is the lowest since May 2020. Inside the report new orders and shipment showed marked declines while the employment situation continued to slow. Meanwhile, prices paid rose.

The combination brings up the bond market’s biggest nemesis, stagflation.

TNX has crossed back above its 200-day moving average, a bearish development which has caused the S&P 500 (SPX, middle panel on chart) to roll over.

Where is the Money Flowing?

As the old Wall Street adage says; there’s always a bull market – somewhere. The trick, of course is to find it. And the best way to find the bull market is to follow the money. Currently, money is moving in peculiar patterns.

For example, the shipping sector, as in the U.S. Cargo Sea to Sky Global ETF (SEA) is holding steady after an initial push higher when the Red Sea situation emerged in late 2023-early 2024. Currently, though, SEA is calmly consolidating its recent gains; even as the hostilities in the region seem to be ramping up.

On the other hand, the retailing sector, as illustrated by the huge momentum run in the VanEck Vectors Retail ETF (RTH), has put on quite a show over the same period, and is also holding its own.

Combined, this price action suggests that investors may be pricing in higher prices at the retail end of the supply chain, which in turn will boost profits for retailers. When it comes to shipping stocks, for now, investors seem to be taking a wait and see attitude after the initial rally.

Digging deeper we see some subtleties developing. Upper end retailers such as Dillards Inc. (NYSE: DDS) are starting to roll over, as the specter of rising prices will likely reduce the already ailing mall traffic and cut into its sales.

Interestingly, Home Depot (NYSE: HD) is weathering the storm. This could be due to its supply chain being less affected by the Red Sea situation, given that it sources many products from China as opposed to Europe. And while anyone can put up buying a new sweater, it’s hard to live when the pipes burst due to cold weather. Think essentials instead of luxuries.

Perhaps the most perplexing action in the market is the lack of a rally in the energy stocks. The Energy Select Sector SPDR Fund (XLE) remains under heavy short seller pressure as indicated by the decline in the Accumulation/Distribution (ADI) indicator. On the other hand, the selling is clearly overdone here, so this area of the market is well worth watching.

Bottom Line

We are witnessing complexity as it unfolds in real time. The global supply chain is clearly in flux. Retailing and shipping have moved decidedly higher since the Red Sea situation took a turn for the worse in late December-early January. Other sectors have not fared well.

Central banks are quietly monitoring the Red Sea conflict as inflationary measures tick higher. This means that the markets now fear that central banks will have to resume their rate increases as costs rise and supply chains become difficult to manage. This is evident in the action in the U.S. Ten Year Note yield, which until recently was trading steadily below 4% and now seems to be creeping up.

The market is in flux. Investors are making decisions based on how this will all turn out. This is a time to be mindful.