Bias remains up (slightly) on longer rates
Invasion fallout does some of the Fed's work for it.
The Ukraine crisis is unfolding worse than markets were expecting. Gone are the delusions that Russian President Vladmir Putin only wanted to peel off the Donbas separatist areas along the eastern borders of Ukraine. He has mounted a full-on invasion that seems primed for regime change. If the former Soviet state rolls over, this could all end quickly.
The response of the West is key. Will Europe and the United States enact harsh sanctions, such as halting Russia’s participation in SWIFT (Society for Worldwide Interbank Financial Telecommunication that serves as an intermediary and executor of financial transactions between worldwide banks)? If that were to happen, Russia effectively would be cut of global financial markets. Or is Europe economically too close to Russia to do so, as bold sanctions could spawn a European recession?
The wide array of uncertainties surrounding these developments are challenging risk assets and global central banks, particularly the Fed and the European Central Bank (ECB). Chair Powell and his team have all but assured that rate hikes will begin next month, while the ECB has signaled plans to start tapering bond purchases in March in preparation for rate hikes later. Events related to the invasion of Ukraine may complicate those plans.
Putin may be doing the Fed a favor
A 50 basis-point inaugural Fed rate is almost certainly off the table and the terminal rate—the end point for rate-hike cycle—is potentially lower, too. While energy prices are spiking higher on today’s invasion, adding to inflationary pressures, a soaring dollar, tightening financial conditions and moderating growth that higher prices will bring should take some of the pressure off the Fed. The good news is the U.S. economy has strong momentum and is unlikely to be derailed directly by the events in Ukraine.
The ECB’s challenges are greater. Russia is its dominant supplier of natural gas, particularly in the eurozone’s largest economy, Germany, which imports 65% of its natural gas from Russia. Natural gas prices are spiking, threatening a German economy where unemployment just hit an all-time low and both services and manufacturing PMIs beat expectations. It’s difficult seeing the ECB taking any actions that would tighten financial conditions until the fallout over the Ukraine invasion becomes clearer.
What does this mean for longer rates? Our fixed income teams still see a bias higher as inflation pressures just got worse due to Putin’s actions. A flight to quality amid this uncertainty should keep rates from climbing much, if at all, over the very near term. But longer term, the moderation of global activity related to the effects of the invasion will only take some of the steam out of the inflation kitchen for the Fed. Thus, the Fed still will tighten materially, and we still expect long U.S. rates to head higher over the course of the year.