Russia-Ukraine Risk Premium - Transcript

Jason Daw:

Hello, and welcome to Macro Minute. My name is Jason [Daw 00:00:07] and I'm the head of North America Rate Strategy and your host. During each episode, we'll be joined by RBC Capital Markets experts to provide insights on the latest developments and financial markets and the global economy. Please listen to the end of this recording for important disclosures.

Jason Daw:

Two weeks ago, the main themes that were dominating financial markets was inflation and central bank hawkishness, and this was pushing up tightening expectations and also long end yield. Inflation remains a key theme for markets, being exacerbated by the Russia, Ukraine situation, sanctions, and the growing frictions between the west and Russia, resulting in fairly sticky pricing for central bank rate hikes in most economies. But risk assets, they are under pressure. Notably, we've seen a decent wobble in equities yesterday, and the risk aversion is sweeping through markets has pushed long end yields lower. Some funding stress has become visible, volatility is elevated. In some cases, like oil prices today, the price action can be parabolic.

Jason Daw:

So to help us navigate this rapidly evolving situation in geopolitics, economies, and asset markets, we have a full slate of experts joining our call today. [Helima's 00:01:20] going to be speaking on geopolitics, Peter on the impact of the Russia invasion on European markets, politics, and policy, Elsa on the Euro and spreading risk-off dynamics in commodity currencies, Tom on what it means, if anything, for the Fed, Blake on US funding stress and the trending treasury market, Simon on the [POC 00:01:42] path in [QT 00:01:43], and myself on asset market correlations and the tug-of-war between flight to safety and inflation. So with that, over to Helima to kick it off.

Helima:

Great, good morning. I mean we are clearly watching this situation in Russia, Ukraine. Russia is now the most heavily sanctioned country in the world, passing Iran and North Korea. European governments have basically still expressed extreme reservation about going down the route of energy sanctions or an energy embargo, the United States is moving though in the direction of a formal oil embargo, pushed by the US Congress. The United States is not a major importer of Russian oil but we think it sends a very important signal to the market about the direction of travel on sanctions and leaving the door open for a much more punitive path when it comes to energy as Russia continues to wage such a gruesome war in Ukraine.

Helima:

Nonetheless, even without formal energy sanctions, the self-sanctioning process continues to gain steam. We just had overnight the decision of Shell to essentially say they will be doing no business with Russia. They took so much criticism for the decision to take those discounted Russian barrels on Friday and so we really do estimate now that what we could be looking at is a buyer strike that could lead to three to four million barrels of Russian oil exports coming off the market. There are essentially very few companies, trading houses, shipping companies that are willing to take the product or move the product. This really does lead to questions now about who can fill what looks like is going to be a very significant Russian export gap when it comes to oil exports?

Helima:

The White House has been making trips to countries like Venezuela, talking about potentially removing sanctions from that country. That could lead to maybe 300 to 600,000 additional barrels coming onto the market, but those talks are in very early stages and Venezuela's oil sector will require billions of dollars in new investment to get really back up on its feet, hence what we would highlight to clients, the most important strategic outreach from the Biden administration will be to the government of Saudi Arabia. Saudi Arabia is the country that is sitting on installed for capacity, there is a potential for Saudi Arabia to be maybe able to ramp up by two million barrels in 30 to 60 days. So far, the Saudis have said they are not willing or they're reluctant to essentially break the OPEC+ [inaudible 00:04:06] formula. However, if the Biden administration were serious about an outreach in terms of crafting a new security framework with Saudi Arabia, providing additional defense support to Saudi Arabia, potentially help with a civilian nuclear program, but also President Biden would actually have to call the Saudi crown prince.

Helima:

He would potentially even have to visit the kingdom of Saudi Arabia for Saudi Arabia to basically bring more barrels onto the market. But if Saudi Arabia does the two million, we're essentially talking about a situation where we will have almost no spare capacity buffer. That is the situation we're in right now. In terms of the geopolitics, one thing we'd be clearly watching for in this conflict would be any signs that Russia would be moving the conflict to an actual NATO member. Baltic states have expressed extreme concern about the situation, the potential threat to them. If there was any type of Russian action involving Lavia, Estonia, Lithuania, any NATO member, but particularly the Baltic states are the ones in clear peril, that would essentially internationalize the conflict because of Article 5 obligation. And so happy to answer any questions on this, but I will hand it over now to the next speaker.

Jason Daw:

Okay. Thank you, Helima, for setting the stage on the geopolitical side and the oil market, now over to Peter for the region that's being most impacted by the Russia, Ukraine war.

Peter:

Thank you, everyone, and good morning. So what I have in mind for my three allocated minutes is I will speak, first of all, of the transmission channel into our economies. Secondly, I'll speak about the central bank reaction. And then thirdly, I want to give a medium term outlook of what it means for the Euro area in particular and for the EU politically. So first of all, when we look at the transmission channels into our economies, they are quite widespread. The direct impact trade with Russia, trade with Ukraine is actually manageable. When you look at the trade balance, we think it's probably going to cost the Euro area only about 0.2, 0.3 of GDP, so that's really manageable. Even if you add another point too on top of the slowing growth from the direct neighbors in Eastern Europe, Poland, Hungary, and so on.

Peter:

Much more important are the indirect channels, and here I would mention three. The first one is a financial channel. We're seeing European banks to a not negligible amount being invested in the region and they're having to take losses, and we've seen particularly bank equity, bank credit spreads being under pressure, so there's a significant financial tightening coming through here. The second one, I would argue, is one that is probably the most opaque. We find out now that there are quite a few input goods going into the European production chains that are simply not available at the moment, and some of the European automakers, for instance, have already halted production, and we'll probably find out over the next couple of weeks that there are more and more goods that are missing into the production chain. It's very difficult to quantify what that means and how long it will last, but certainly something to watch.

Peter:

And then there is the absolute most important channel that I would highlight, which is the consumption channel. When you think about our oil prices are obviously going up, our gas prices are going up significantly more than they're going up in North America, and on top of that, we have a significant rise in food prices. And one of the big contrasts in Europe comparison to North America is that our wages are not really rising, so it's quite conceivable that disposable income, particularly of the low income brackets, that have to consume food, that have to consume oil and gas in various forms in their consumption basket is basically going to be shot to pieces. So discretionary spending is-

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Peter:

Basically going to be shot the pieces. So, discretionary spending is going to come down, and we reckon that this will really decimate our consumption. So, how big is the impact going to be? We have just taken a downgrade of our euro area GDP, roundabout to the tune of 1% of GDP, which would bring us very close, just not into recession. But clearly, the risk is to the downside. Now, the second big question that comes is, what are central banks going to do with that? Because the other side of the ledger, of course is, that this is increasing inflation. And central banks, as Jason was just saying, when he started the call, were in a tightening environment already, because of high inflation. But now, you have even higher inflation on the one hand, but lower growth on the other. So, you've got a stack inflationary impulse.

Peter:

We think here, the response is probably going to be a little bit different between the ECB on the one hand, and the Bank of England, the two big central banks. The ECB, which meets on Thursday, we think will not be in a position to high grades. There was a post on this meeting that's coming up, to announce an end of the asset purchase program, which they probably won't be doing. And we have taken out all of our rate tax for this year.

Peter:

Now, the Bank of England is slightly different, because they were very concerned about inflation. We think the UK is slightly less exposed to the situation, for various reasons. And therefore, we think that the Bank of England will probably continue hiking, certainly in March. We think they'll probably take another step later in the year to 1%. But we are still significantly below where the market sees them, which is about another 125 basis points of rate hikes until the end of this year. So, the big question, that's also the big question that I'm getting from pretty much every client that I'm speaking to is, which side of this impact is the central bank's main focus, inflation or growth? And I hope we'll get an answer to that, at least from the ECB, on Thursday.

Peter:

Now, I want to make one last point before I let you go. There is also in my mind a positive outcome, if we can say that in the current situation, as far as EU is concerned. Because what we have is, we have, I think a much stronger unity now. We had before a North/South conflict. That's probably going to fall by the wayside, because the political threat from anti-European, anti-EU forces, is going to come down. We had an East/West conflict. That's probably going to come down, because the Western countries will have to support the Eastern countries, Poland, Hungary, much more financially, to cope with the refugee situation.

Peter:

And you can already see, so if the external threat is galvanizing forces... And there was an article today, and I think this is a story that will come through, that the European funds that are already out there, could either be increased, or could be used for defense, as well as energy policies, going forward. So, that's a medium term story, but at least there's some silver lining for the EU. I'll probably leave it here, but there is much more to say. And I could probably fill a half an hour to an hour with my thoughts alone. But I'll leave it here, and hand over to Elsa.

Jason Daw:

Okay. Thank you, Peter. So, now over to Elsa to speak about FX, which has finally started to get interesting after a long period, where the asset class wasn't reacting, at least the moves in the rates market. So Elsa, over to you.

Elsa:

Thanks, Jason. I want to say out, I always thought FX was interesting, but maybe that's fair. Maybe we haven't been that interesting for some time. And yet, for the last few weeks we've really seen the euro being used as the most liquid hedge for a lot of the fears out there in the market. But I think we're at an interesting moment right now. If you look at year to date performance, no surprise, the ruble is the worst performing currency. And then, the EU satellites, the likes of Poland and Hungary, and to a large degree, Sweden. And they're not far behind the euro. And all of those down around 10%, or close to 10%, against the US dollar.

Elsa:

But in the last 24 hours, we've seen an interesting pivot in markets. And euro has actually been holding up reasonably well, despite hearing the Russian energy minister and deputy prime, Novak, threatened to cut off gas supplies to Europe for the first time. And again, he said no decision has been made, but clearly it's there on the table.

Elsa:

So, I want to make just three points. The first is that, while we are watching energy prices, and in particular long dated contract, if this is going to spill into a broader global growth slowdown, then it will be high commodity prices. In particular, the high cost of energy that drives it. In the very early stages of the crisis,, this was impacting the very short dated contracts in crude, and in gas prices. It was much more of a European impact. But if this is going to spill over something broader, it will come from energy prices. If that's happened, then actually it's all about what is left to price out in terms of hikes. And in that regard, the euro doesn't look too bad, in that it's the central bank that was never expected to tighten the [inaudible 00:13:15] to start with.

Elsa:

The second point I want to make, and this comes from someone who used to work for the European Commission, and I followed the eurozone crisis first hand. So, I'm very painfully aware that it always takes the crisis to force action from the EU. And those of you who listened to our macro call 10 days ago, a week ago, will have heard me say the same. After the first wave of sanctions, which looked very underwhelming, it was followed then by that second wave over the weekend, and then the selective cutting off from SWIFT, because again, it always takes the crisis to force those bigger, previously unthinkable decisions. Well, on that front, we've heard this morning that the US considering mutualization of liabilities, massive stimulus package of energy and defense spending. Again, still a long way from this becoming reality, but we do have a leader summit later this week. And again, it will just be causing people a little bit of force for thought.

Elsa:

And then finally, we have the ECB coming up this week, as Peter mentioned. There's very little that they can do, and fully on board with Peter's outlook, that they're certainly not going to be aggressively hiking rates in the face of higher inflation, given all the concerns around demand. But we do expect to hear questions on the currency. And while it's a long stretch to imagine any outright intervention, certainly nowhere near there yet, I wouldn't be surprised to hear a little bit of jaw burning on the currency. Because it certainly wouldn't hurt the ECB to have a slightly stronger euro in the face of these imported inflationary pressures.

Elsa:

So, all of that to say, while it's made a lot of sense, shorting euro, we've actually been long CAD against the Swedish Krona, which for some people it's a posh version as one client put it, of euro CAD. We took that trade off at the tail end of last week, and we've actually rolled into a tactical euro sterling [inaudible 00:15:04]. And again, for those interested, there's further details in our published research, and in our Trade of the Week, out yesterday. I'll leave it there, and pass it over back to you, Jason.

Jason Daw:

Okay, great. Thank you. The first topic I want to discuss is asset market correlations, and specifically the high co movement that we've been seeing between equities, credit, bond yields, gold, and the dollar, at least against the euro, ever since the Russian invasion on the 24th of February. So, during major risk events, this type of trading pattern is not unusual. And I do suspect that this strong co movement will probably remain the case for at least sometime, until there's a clearer path towards Russian deescalation, and diminished tail risks of direct NATO Russian conflict. But until then, asset markets, they will be hostage to news flow, and changes in the geopolitical risk premier, and probably less influenced by top down macro, or idiosyncratic drivers. And...

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Jason Daw:

... macro or idiosyncratic drivers. And frustratingly, this type of market setup creates kind of an unfavorable trading environment for many strategies, not least directional macro. The second topic I wanted to discuss is the rapid increase in oil prices, when this has occurred previously, and what that's meant for economic activity. So oil prices, they've doubled in the past year. This is a rare occurrence. And to put that in perspective, this is only the seventh time since 1970, looking at quarterly data. Now in four of the cases, the spike was associated with armed conflict in oil regions. So in 1973, 1980, 1990, and now the Russian invasion of the Ukraine.

Jason Daw:

I think importantly, in previous episodes, when oil prices have doubled over a one year timeframe, it's typically either been associated with economic activity weakening in the future or exacerbating a down turn already underway. So it's tempting to think that the market might be focusing on weaker oil induced growth as a reason why long end bond yields are lower. In recent weeks in places like Canada and the US, but that's probably not the important driver in my opinion, which leads me to my third observation, which is the tug of war between inflation and flight to safety.

Jason Daw:

So historically we see more times than not, when we have these big oil price spikes, it has led to higher bond yields, at least until the growth slowdown or recession starts. But since the Russian invasion began bond yields, at least in Canada and the US, they're actually lower. So the market's been grappling with two opposing forces, the flight to safety bid on the one hand and the inflationary impact of surging commodity prices on the other. Now, given the unique situation of the Russian invasion, where unlike in previous oil kind of conflicts back in 1970, there is now a tail risk that it could lead to direct US or NATO conflict with Russia, which means that it's not really that surprising that the flight to safety bid is winning out for now.

Jason Daw:

And I struggle to see how this is going to go away anytime soon, regardless of how high commodities could go, at least until the situation with Russia significantly deescalates. So there is a number of places where we think there's fundamental misalignments in some markets, such as Canada five year swap rates or 10 year cash rates being too high versus the US, or too much priced into the front end of the Canada curve, but adding or initiating risk in these trades probably needs to wait until volatility and risk premium starts to decline. And similarly from a tactical perspective, positioning for reversals and some things that have moved a lot in recent weeks, such as the flattening in the two fives curve or the two fives tens fly in Canada. That probably needs to wait for another day also. So with that, over to Tom, to tell us about the FOMC meeting next week, the path beyond, and whether the Russia situation could derail the tightening cycle.

Tom:

Thanks, Jason. So I think look, for the Fed next week, it's automatic pilot. I mean, when have we ever seen a setup... I've been doing this for 25 years. I've never seen an FOMC meeting preempted by a Fed chair speaking out a testimony. I mean, we know exactly what's going to happen next week. I think he's been pretty clear about that. I think he's also been pretty clear about his intentions beyond the March meeting. He wants to keep on raising rates. I mean, kept on talking about sort of consecutive beatings or successive rate hikes. And we take that to mean that really they have sort of blinders on right now as it relates to inflation. And look, if that's the focus, if that is the lone focus, then yes, we think inflation will remain elevated for the next handful of months.

Tom:

Particularly at that headline level, we put out a daily deck yesterday that it basically showed sort of what the impact is going to be not just from energy, but from food prices as well. But I think what we have to keep in mind is there's also an economic hit from this. And we showed that from an energy perspective, right now today, just snapshot today, you're looking at about a percentage point drag from the rise that we've seen in energy prices at this point. And I think, and again, something else we've highlighted in other daily decks, just keep in mind. The low end consumer is feeling the pinch from the draw down and all of that excess liquidity that we've been highlighting. Wage pressures we think are actually going to start slowing to some extent. I think the past payroll report, the underlying detail, were pretty useful in that regard.

Tom:

If you look at the small business survey, which we got the full report today, I think there's some additional signs there. So the Fed is going to be raising rates in the context of higher inflation, but also in the context of economic activity that is slowing down now. So we think they're in a really tricky spot. We don't doubt they;ll resolve, but they do want to try to sort of push this hiking cycle along for as long as they can, but they're going to bump up against some of these more meaningful headwinds that we've been highlighting, not the least of which is you have already lopped off a percentage point from growth, just given what we've seen thus far from an energy price perspective. Well, with that, I'll turn it over to Blake.

Jason Daw:

Okay, great. Thank you, Tom. So Blake, over to you on funding stresses and the treasury market.

Blake:

Yeah. First, just a real quick on treasury markets. I mean, this is a very difficult time, I think, to have a directional rate view or curve view. I think both, there's a lot of uncertainty about the outcome. You have to have some kind of view of how this ends. You're at high risk of kind of tape bombs hitting at any given time. And then even if you have that piece right, I think we've been seeing some very interesting movements in markets that don't always align with the macro direction of the headline. So I think you have to not only have a view about the outcome, but then also have to be right about which way the market's going to react to that news.

Blake:

So very difficult time. I think for the most part, you have to stay very nimble, very short term tactical positions, things with kind of tap downside, very tight stops. But I do think, and this is kind of to what Tom's saying. I think longer run though. At some point, in this year, we still get back to a point where higher rates and flatter curves are still the correct move. And I think longer term, those kind of positions for people who can kind of withstand this near term stress, that's the right way to be positioned. I think at this point, we don't fully buy recession or full blown stagflation theme. If anything, I think this slow down Tom was talking about almost kind of reinforces our original Fed view coming into this year, which was for a more longer, more gradual hiking path.

Blake:

I think what this has done has really taken off the table this kind of fast and furious shock and awe, very quick rate hikes that quickly burn off and turn into a cutting cycle. I think what we're going to see is that as we get out of this, the Fed is able to still move accommodations. It's just going to happen at a more gradual pace. So just wanted to say that on treasury markets before I get into the funding piece, but now kind of turning to the funding piece, we've definitely been seeing signs of stress this week. Three months CP, front month for [inaudible 00:23:38] have both widened out about 20 basis points. Overseas in Euro cross currency basis, that's traded near negative 40 basis points. These are certainly signs that there's some stress going through, but I think at this point it's still more like modest year end type of pressure than a full blown funding crisis like we saw in March of 2020, or even something like 2008. So not-

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Blake:

Or even something like 2008. So not five alarms here, but certainly something to keep an eye on. I think it's worth noting I don't think this is due to any kind of negative supply shock and dollar supply as a direct result of the sanctions. I think coming into this week, there was a lot of angst that Bank of Russia was a participant in providing dollar funding and then losing them due to the sanctions was going to cause a lot of funding pressure, that's not what I think we're seeing here. I think what we're really seeing is, one, a in surge demand. I think March of 2020 is very fresh in a lot of corporate treasuries, financial treasurers' memories. I think their holstering kind of precautionary cash balances, they want to have a lot of cash on hand. This is kind of typical hoarding behavior it's very much like you see all the store shelves go empty ahead of a hurricane prediction. I think it's even worse with quarter end ahead, and also you've got a lot of year end funding that's been rolling off the last few weeks of February and early March. I think all of those things have led to a big surge issuance.

Blake:

But I think even on the supply side the investors in that paper, the people who provide that dollar funding, I think over the last few months there's been a large amount of buying of fixed rate paper as hikes got priced into the curve. Those in investors were trying to boost their current income by locking in some of those higher interest rate payments now, rather than doing some kind of fixed rate investment. Many of those positions were underwater coming into this week and I think because of that, and again with memories of 2020 and how illiquid everything be became, a lot of those investors had to get bailed out in 2020 by of Fed facilities that came in to provide liquidity, I think there's a big hesitance to add. So even though we've gotten to levels that look very attractive relative to the last year so. I think a lot of the investors in that paper have been hesitant to get involved.

Blake:

The last thing I would say is IBOR reform might also be playing a role here. For issuers, I think they're unable to hedge broad funding market risk with new LIBOR risk because of IBOR reform. I think that makes them more likely to actually boost their cash position instead of kind of putting on some perhaps derivative LIBOR positions, they can't do that anymore and without that kind of hedging tool, I think probably more likely to just raise the cash and hang onto it into the potential funding stress.

Blake:

And then on the investor side for anybody investing in sulfur based products you can't really rely on the index anymore to compensate for these kind of broad funding market stresses in the way that LIBOR did. What that means for an investor is that concern if you're concerned all about any kind of widening out funding rates, you have to incorporate that into the initial spread. You're not going to get compensated when LIBOR simply moves up so you really have to think about those funding stresses ahead of time, get that locked into the spread. And because of this, I think we're seeing those signs of stress and seeing widening out of spreads at the very front end, much more aggressively and a bit earlier than we would've if we were still living in a solely LIBOR world. So a few things to think about, and we'll definitely be keeping an eye on those funding conditions over the next week or so. And that's it for me.

Jason Daw:

Okay. Thanks Blake. Over to Simon on Bank of Canada and quantitative tightening.

Simon:

Hi everyone. So last week we saw the bank hike on strong fundamentals. So on the growth side, Q4 printed earlier in the week plus 6.7% annualized, so a bit above expectations, but a also a very strong initial look at Q1 with the January GDP now cast in positive territory despite Omicron in the month. But more so inflation is the primary concern from the bank, moving higher and the bank also highlighted increased concerns around the interim expect de-anchoring. Not that has happened yet, but that there are increased risks there. And they continue to see a series of hikes emphasizing that it's not a one and done scenario. We have three more hikes this year in our forecast with upside risk to this, so three to four. So still below market is priced.

Simon:

For QT details, Governor Macklem discussed these in the Associated Economic Progress Report, signaled a near term move on this, saying that was the next logical step now that they have lifted off. We're looking for April timing for this along another 25 basis point hike at that meeting. What QT should look like and of secondary market purchases, the government was quite clear on this in the progress report. Uncertain on option purchases, these have already been reduced in the reinvestment phase, but he noted that they may keep a small amount for technical or market functioning reasons, or they may decide to eliminate them altogether. So that's something we'll probably only find out at the meeting itself.

Simon:

In terms of trade, we still like swap spread tightening over the meeting term, but as has been mentioned, wider funding spreads for OIS has taken a hit, and we have been stopped out of our 10 year swap spread tightener trade. We also think off the run long look too cheap here, and we don't think QT should be as negative for them as is being priced.

Simon:

In terms of direct comments on Russia-Ukraine, the bank really was focused on upside inflation risks given where that inflation is already higher, that it's where they need to be focused on. But they also noted global growth and supply concerns. And I'd also add that Canada is an exporter of many of the commodities that have seen price increases of late, so that's kind of an additional factor for Canada around an improvement in terms of trade that needs to be taken account of. That's it for me and I'll flip it back to Jason.

Jason Daw:

Thank you for joining us today or on Macro Minutes. We'd like to thank you for tuning in. I'm Jason Daw, and I look forward to seeing you next time.

Speaker 1:

This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.

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