Russian invasion of Ukraine — impact on interest rate, currency, and commodity markets
Managing Partner, Board Member
Head of Europe
Real Estate | London
Hedging and Capital Markets
Real Estate | Kennett Square, PA
There has been a lot of activity already in the markets this year as central banks reacted to the inflationary pressures with a tightening of monetary policy. This has been reflected in their actions (Bank of England) and in their tone of messaging (European Central Bank). With the threatened invasion of Ukraine becoming a reality this week, the response of the financial markets has been harsh.
Impact on interest rate markets
Upon the immediate news of Russia's invasion, market volatility temporarily caused difficulty in pinning down pricing from banks on products like interest rate caps.
The key question is whether this situation will alter the course of the interest rate hikes and monetary policy tightening which the market is currently pricing in?
The forward curve is pricing in an expectation of EURIBOR rates to be above 0% by the end of 2022, getting to 0.5% by the middle of 2023. The European Central Bank (ECB) made a statement this week which seemed to be erring on the doveish front, but that has not had much impact on these rates. The dilemma facing central banks was evident in the almost conflicting statements made by ECB members. Governor Stournaras urged the ECB to continue buying assets (quantitative easing or QE) in response to the invasion. Isabel Schnabel warned that continuing them when medium-term inflation looks set to hit their 2% target and with the strongest labour market in the history of the single market, carries too much risk.
In the UK, not much has changed yet with the forward curve indicating interest rates at just below 2% at the end of 2022. With higher inflation now likely to persist longer than the Bank of England’s current forecast predicts, there is a stronger argument to hike interest rates. But central banks might need to take some time to pause and consider the potential economic downturn arising from this event.
In the U.S., market moves were met with confusion. On Thursday morning, as news of the attack was digested by market participants, yields fell 12-13 basis points across the yield curve, and at one point the Nasdaq was down 20% from its all-time high. As Thursday progressed, U.S. yields rebounded higher as did U.S. equity markets, with yields retracing the initial downward move and equities finishing the day positive.
Over the course of Thursday and Friday, U.S. market participants weighed the continued prospects of higher inflation and the associated prospect of Fed policy hikes and quantitative tightening (QT). Upon immediate reaction, market participants largely moved to price out the possibility of the FOMC hiking 50 bps in March. As time progressed, several Fed speakers (specifically Christopher Waller) indicated that some front-loading of rate hikes remained on the table.
Despite what seemed like headlines that should have led to classic flight to quality bid for U.S. Treasuries, which would drive yields lower, U.S. yields look to end the week higher than their pre-invasion levels.
At the time of this writing, market participants are pricing in nearly seven rate hikes (1.75%) over the next 12 months, including some chance of 50 bps at the March 16 meeting. Heightened market volatility and reduced liquidity heading into the weekend remained a theme.
Impact on currency markets
In the foreign exchange (FX) space, the U.S. dollar has benefited from the move to safety, with the dollar index up >1% currently. The Japanese Yen currently tops the safe-haven chart, gaining around 0.2% vs. the U.S. dollar and the only currency that has strengthened vs. the USD as news of the invasion emerged.
The Norwegian and Swedish Krone were both under pressure (the former despite the surge in oil prices), while East European currencies (PLN, CZK) were down significantly (~5% and ~3% respectively).
The level of uncertainty is driving investors to try and lock down risk exposures — even looking ahead to upcoming transactions and refinancings to consider forward hedging.
On a practical level, with some investors potentially holding FX contracts with settlements due in ruble or hryvnia, or have a financial contract where they face a Russian bank, the imposed sanctions may mean settlement risk. The market is already booming in non-deliverable forwards (NDF), as these can reduce exposure in the event of further sanctions being implemented.
Impact on commodity markets
Key commodity markets had very large moves — grain, oil, fertilizer — with wheat prices jumping to their highest level in over a decade. Russia and Ukraine account for more than a quarter of wheat and 80% of sunflower seed exports globally.
Markets continue to be wary of the potential for more severe sanctions targeting Russia's oil and gas sector, and the possibility of sanctioning or freezing assets of Putin himself. The increase in prices of these key commodities, in an already inflationary environment (which in Europe is predominantly driven by energy and food), will likely worsen the picture. In addition, the West has escalated sanctions over the weekend, and cut a number of Russian banks off from the SWIFT system. It looks like there could be more to come.
There are many scenarios which could play out. If oil and gas continue to flow, and there is an impact to energy prices but the spill-over to GDP/growth is moderate, then the rate hikes expected will likely play out. On the other end of the spectrum, if European gas supply is halted and global oil markets disrupted for a sustained period, the negative spill-overs will be substantial with recession likely. It is difficult to imagine central banks raising rates in this scenario.
For now, the interest rate, FX, and commodity markets will reflect every small piece of news being reported on the invasion, and the response of the West in the form of sanctions, and perhaps even military intervention.
The rising geopolitical risk that is on display in the current Russia-Ukraine crisis is a good reminder that investors should consider "what-if" scenarios in stress testing their capital market assumptions, and properly consider where their business models may be taking on unmitigated interest rate and foreign currency risk.
We remind our clients that during this time of market volatility, pricing may change quickly and indicative pricing from days ago is likely no longer valid.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0050
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