What The Invasion Means For Rates

Click To Unmute

What You Missed: Long-term interest rates and equities traded within recent ranges amid Ukraine-driven, volatile markets. The 10-year Treasury yield peaked at 1.99% mid-week, only to fall to 1.96% at week’s end as the tug-of-war between invasion-driven, safe haven flows versus expectations of looming Fed rate hikes whipsawed rates across the yield curve. The real action was in short-term interest rates, where the 2-year Treasury touched a two-year high of 1.60%. Elsewhere, the price of a barrel of West Texas Intermediate crude oil fell to $91.03 from $91.58, as oil futures broke $100 per barrel for the first time since 2014. Natural gas in the Netherlands climbed as much as 59% in one day last week, the biggest intra-day rise on record. The US dollar surged as the world turned risk-off, and Gold eased off a nine-month high. Treasury yield volatility, a key but unseen driver of the cost of rate caps and swaptions, fell on the week, but remained near a two-year high.

Russia invaded Ukraine – what’s it mean for interest rates? Global investors piled into the longer-end of the Treasury curve, lowering long-term yields, amid fears Russia may attempt to take more of Ukraine and inflation will worsen as a direct result of rapidly rising energy costs and renewed supply chain snarls. Asian investors sheltered in the 10-year part of the US Treasury curve while others sought safety in the 30-year bond. Conversely, short-term yields remained near multi-year highs on the back of solidifying Fed rate hike expectations. The dynamic flattened the Treasury yield curve even further, with the difference between the 2 and 10-year Treasury yields at their narrowest since the pandemic began back in March 2020.

Our take: Old certainties have now evaporated. Just a week ago, markets were fretting about the Fed hiking too much. Now they’re worrying about the impact of sanctions on one of the world’s largest producers of oil and gas. The flattening yield curve offers borrowers unique but temporary opportunities to achieve the goal of:

1) creating the longest stream possible of known interest expense, and

2) to lower interest expense over time.

Most of the time, these goals are mutually exclusive. However, there are times when they’re not, and organizations must act strategically to take advantage of opportunities to accomplish both goals when they exist, such as now.

The need to hedge future term financing has come back vigorously, and fortunately, recent financial market conditions – including ever-flattening yield curves – allow for a much better way to hedge the risk of rising interest rates by employing lesser used derivatives like Swaptions and interest rate Collars, which haven’t looked this favorable in years. In the current world of higher and rising interest rates, smart borrowers aren’t fearing the flat yield curve, they are examining how the flat yield curve can work for them. Talk to us and learn how.

Commodity prices surged amid fears of supply disruptions – what’s it mean for inflation? Russia is a key producer and exporter of not just energy, but metals and grains as well. Supplies were already tight ahead of Russia’s invasion, meaning there is little ability to absorb any output cuts. Aluminum prices jumped on Thursday by more than 3% to hit a record high of $3,450 per ton on the London Metal Exchange. Nickel is now trading at the highest level in more than a decade, at around $25,000 per ton. Platinum jumped more than 2% while palladium surged more than 6%. Russia is a key producer of all four metals. The country supplies 35% of the world’s palladium and 10% of its platinum, according to data from CRU. Aluminum, nickel and crude steel production stands at 6%, 5% and 4%, respectively. Wheat prices jumped to the highest level in more than nine years, while corn futures also advanced.

Our take: The pandemic has left the global economy vulnerable at two critical points: rising inflation and wobbly financial markets. Both might be intensified by the invasion’s aftershocks. There is also a threat to economic growth. Households that spend a growing proportion of their income on gasoline and heating will have less money to spend on other products and services. Financial market losses would only add to the drag, reducing consumer’s wealth and confidence and making it more difficult for businesses to access capital for investment.

The Fed and other central banks are likely getting nervous, as their main job of managing inflation and keeping the growth motor humming just became harder. As we see it, the situation will likely take one of three paths.

In the first scenario, a quick conclusion to the conflict would prevent a further upward spiral in commodity prices, keeping the US and European economies on track. Instead of scrapping their plans, central bankers would have to merely adjust them slightly. The Fed would likely look past the transitory price shock and proceed with its plans to raise interest rates in March, but not by 50 basis points as some expect.

In a second scenario, a prolonged conflict, a tougher response from the US and its allies, and disruptions to Russia’s oil and gas exports would result in a larger energy shock and a huge hit to global markets. Such a scenario could spark a jump in headline inflation to 9% in March and keep it close to 6% by the end of the year. The Fed would be torn between helping markets avoid additional financial turbulence and softening the blow of a weakening economy. This would have no impact on the widely expected March rate hike, but it would slow down the pace of expected rate hikes in the second half of the year.

In a third, worst case scenario, Russia cuts off Europe’s gas supplies in retaliation of facing maximal sanctions from the US and Europe, resulting in a European recession, which then overflows into the US. The US would see much tighter financial conditions as a direct result, and the Fed’s priorities would shift from pulling back on stimulus to preserving economic growth. If increased prices lead to consumers’ and companies’ inflation expectations being entrenched and prolonged, crimping their consumption, then the worst-case scenario for the Fed would emerge: the need to hike rates sequentially in a sluggish economy.

What to Watch This Week: Data on tap in the week ahead will help the Fed find the right policy balance between the need to tighten monetary conditions and soften any inflationary blow stemming from Russia’s invasion of Ukraine.

A red-hot jobs market (initial jobless claims, Thursday) and lingering supply bottlenecks feeding high and rising inflation (Institute of Supply Management’s manufacturing survey, Tuesday; and services survey, Thursday; construction spending, Tuesday; vehicle sales, Tuesday) begs for a hiking response from the Fed. On the flip side, the escalating Russia-Ukraine conflict has market on edge, which, if its drags on, could transform into a drag on economic growth. The always important jobs report for February (ADP, Wednesday; nonfarm payrolls, Friday) will likely show a continued brisk pace of hiring, and the February Consumer Price Index (released next week) could surprise higher than the 7.5% expected, both confirming a need for tighter monetary policy, and soon.

Fed Chair Jerome Powell may clarify which way the Fed is leaning (semiannual testimony to Congress, Wednesday and Thursday), and will be the last such Fed official to speak publicly before the Fed’s mandatory blackout period begins ahead of the March 16th policy meeting. We expect Chair Powell to sound the alarm once again on inflation but maintain his gradualist approach to rate hiking rates amid the current geo-political environment.  Will the Fed hike 50-basis-points in March?  In our view, no. Chair Powell & Co. will be slow and steady in pulling back the punchbowl, hiking a mere 25 basis points on March 16th, at most.

Three gauges to watch as Russia concerns rip through markets: Concern that Russia’s invasion of Ukraine may constrain liquidity in the world’s financial system is becoming evident from several gauges, all of which will be useful to watch over the coming days.

  • The Ted Spread: The spread between three-month LIBOR rates and the comparable Treasury bill yield has widened to about 25 basis points. The differential is a measure of counterparty risk and a signal that institutional lenders fear that a default in interbank loans is rising. The smallish move doesn’t imply that a real problem is brewing somewhere, but rather is a signal of growing caution among credit traders. For some perspective, the spread reached 150 basis points during the first wave of the pandemic.
  • Cross Currency Basis Swaps: While we’ll spare you the winky jargon here, know that the effects of the US Dollar’s recent surge against nearly every other major currency is showing up in other markets. Demand to swap future US dollar funding needs is done via cross-currency swaps, where the cost to lock in future funding for Japanese yen and Euro based investors is at its highest in months. The sustainability of US dollar funding costs will depend on how long the Ukraine crises goes on and what central banks do to ease the pain. It’s highly likely that the Fed will unveil measures soon to ensure that there is ample liquidity in the system.
  • The FRA-OIS spread: This spread is the difference between LIBOR and the Fed funds effective rate, and serves as a gauge of risk and liquidity in money-market securities. It has recently gone from less than five basis points at the end of January to almost 21 basis points now, which suggests a higher level of stress, but not an overwhelming one just yet.

Big Picture: If you’re like us in any way, you’ve probably thought: Does Ukraine really matter? After doing a little digging, we’ve concluded that yes, indeed it does. Here’s some stats to ponder.

Ukraine is the second largest country by area in Europe and has a population of over 40 million – more than Poland.  For industrial metals, Ukraine is:

1st in Europe in proven recoverable reserves of uranium ores.

2nd place in Europe and 10th place in the world in terms of titanium ore reserves.

2nd place in the world in terms of explored reserves of manganese ores (2.3 billion tons, or 12% of the world’s reserves).

2nd largest iron ore reserves in the world (30 billion tons).

2nd place in Europe in terms of mercury ore reserves.

3rd place in Europe (13th place in the world) in shale gas reserves (22 trillion cubic meters)

4th in the world by the total value of natural resources.

7th place in the world in coal reserves (33.9 billion tons)

For Agriculture, Ukraine is:

1st in Europe in terms of arable land area.

3rd place in the world by the area of black soil (25% of world’s volume).

1st place in the world in exports of sunflower and sunflower oil.

2nd place in the world in barley production and 4th place in barley exports.

3rd largest producer and 4th largest exporter of corn in the world.

4th largest producer of potatoes in the world.

5th largest rye producer in the world.

5th place in the world in bee production (75,000 tons).

8th place in the world in wheat exports.

9th place in the world in the production of chicken eggs.

In industrial heft, the Ukraine is no slouch. It’s:

1st in Europe in ammonia production.

Europe’s 2nd and the world’s 4th largest natural gas pipeline system.

3rd largest in Europe and 8th largest in the world in terms of installed capacity of nuclear power plants.

3rd place in Europe and 11th in the world in terms of rail network length (21,700 km).

3rd place in the world (after the U.S. and France) in production of locators and locating equipment.

3rd largest iron exporter in the world

4th largest exporter of turbines for nuclear power plants in the world.

4th world’s largest manufacturer of rocket launchers.

4th place in the world in clay exports

4th place in the world in titanium exports

8th place in the world in exports of ores and concentrates.

9th place in the world in exports of defense industry products.

10th largest steel producer in the world (32.4 million tons).

Current Select Interest Rates:

Rate Cap & Swap Pricing:

LIBOR Forward Curves:

1-month Term SOFR:

10-year Treasury:

Source: Bloomberg Professional