Macro & FICC Research Published: 2022 03 04 06 55
SEB FI & FX Strategy
The fog of war
Summary:
In market focus: War in Ukraine; Sanctions; Energy; Inflation; Macroeconomic implications; Fed; ECB.
Global macro and risk appetite: Increasing risks of a long war. It is difficult to predict the duration and outcome of the war in Ukraine but risks for an extended and more destructive conflict have increased over the past week. In this report, we discuss scenarios and the implications for the economy and financial markets. We conclude that while risks are increasing, a US recession can be avoided this year while recession risks in the euro area are substantially higher.
Energy: Skyrocketing prices. Oil prices, natural gas prices and coal prices are skyrocketing. The war in Ukraine is leading to a sharp reduction in energy exports from Russia – even though energy exports are exempt from sanctions, shippers are refraining from taking Russian cargoes in fear of possible sanctions and reputational risks. The global economy is facing energy starvation. Fossil fuel prices could go even higher in the short-term, but demand destruction will set a limit to the upside eventually.
ECB: The Ukraine crises keeps the ECB in wait-and-see mode. The highly uncertain economic effects of the crisis in Ukraine will encourage the ECB to keep its current policy stance at its 10 March meeting, despite the Governing Council’s increased worries on inflation and the hawkish communication prior to the Russian invasion. The crisis will delay the ECB’s steps towards policy normalization but to what extent remains uncertain. For now, we maintain our view that the ECB will raise the deposit rate in December.
EUR rates: Near-term downside risks. Negative macroeconomic effects of the conflict in Ukraine are much more direct and larger in the euro area than in the US. The uncertainty over the severity of effects remain unclear but have potential to be substantial. Near-term risks are on the downside, but as long as our main scenario of the ECB raising short rates to above zero in 2023 remains intact, we stick to our end 2022 forecast of 0.40% for the German 10y yield. We will revise our forecasts as more information becomes available.
Fed: Chair Powell confirms March rate hike - high bar to change course . At his testimony to Congress this week, Mr Powell confirmed the need to act against inflation, meaning that the Fed expects to continue to tighten policy this year. Our interpretation is that the Fed has a high bar to change course but will be quick to react to significant changes to the economic outlook and/or financial developments and that it will decide policy on a meeting-by-meeting basis. We continue to expect a total of 125bps of rate hikes by end 2022.
More here.
USD rates: Downside risks have increased, even in the longer term. US rates markets have been pricing in stagflation for some time and it will take months before we can conclude whether markets will start discounting a more positive growth scenario or a recession. High inflation, the Fed’s urgency to tighten policy, and escalating geopolitical tensions could tip the scales towards a more negative outcome. For now, we stick to our “muddling through” scenario for US rates, where markets remain concerned on the economic outlook but recession can be avoided, and maintain our end 2022 target of 2.10% for the 10y yield.
EUR/USD: Lower levels yet to come. There are three distinct groups in G10 FX since the start of the war, where commodity-linked (AUD, NZD, CAD and NOK) and “safe-haven” (USD, JPY, and CHF) currencies are strong, while euro area-related currencies (EUR, GBP and SEK) suffer. The fall in EUR/USD has been in line with our earlier projections but we now expect yet lower levels for longer due to the impact of the war.
Scandies: NOK/SEK sharply higher. NOK/SEK has risen sharply since the start of the Ukraine war because the SEK is suffering from falling risk appetite while the NOK has been supported by a sharp rise in oil prices.
Regarding the three regimes mentioned above, the NOK has traded on its commodity link rather than exposure as a European currency. Read more on SEK, the Riksbank and a possible risk premia in What’s up Sweden and on the NOK in What’s up Norway.
China: Tight balancing act. China has avoided taking sides over Ukraine. We expect China to walk a tightrope to limit the impact on its own national interests. Despite stronger ties between Beijing and Moscow in recent years, there are limits to China’s friendship. Amidst recent bouts of volatility, the yuan has been very resilient.
As the greenback is weaponized, the lure of the yuan as an alternative reserve currency is rising. For now, we hold on to our year-end USD/CNY forecast of 6.30.
Trade update: Bullish seagull options strategy in Sep22 Euribor futures. Sell 100 put and buy 100.25- 100.375 call spread. We reiterate the trade that was initially recommended on 18 February. See tables at the end of the report for a full list of trades.
Forecasts. Find comprehensive forecasts here.
Russian invasion of Ukraine: Humanitarian tragedy with far-reaching implications The Russian invasion of Ukraine began on 24 February and is primarily a humanitarian tragedy.
In this report, we update the assumptions we made on 18 February in SEB FI & FX Strategy: What if the crisis in Ukraine escalates? Our base case then assumed that a full-scale Russian invasion of Ukraine could be avoided but that the risk of a war was real. Now that a war has started, predicting its duration and outcome is obviously very difficult, so we outline two scenarios – for a short war and for a long war. These scenarios have been formulated in cooperation with Thomas Thygesen, Head of Equity Strategy, and Bjarne Schieldrop, Chief Analyst Commodities.
Two scenarios: Short and long war
The initial price reaction to the invasion suggests that markets had initially discounted a short-lived campaign. The S&P 500 rose in the first days following the invasion and the first set of relatively mild sanctions. Since then, sustained resistance from Ukraine and more far-reaching sanctions on Russia have weakened the rouble by more than 30% against the dollar and the Brent crude front contract has surged to above USD 110/bbl.
At the start of the invasion, we assumed that the probability of a short or a long war was about 50 50.
However, the risks for an extended and more destructive conflict have increased. A quick end to hostilities would limit damage to physical capital and loss of human life and would also avoid sanctions to prevent Russia continuing to supply energy. A more protracted war would increase the risk of substantial damage and would likely trigger a full exclusion of Russia’s gas supply from European markets, something that sanctions so far have not done. In that scenario, oil prices would probably to rise towards USD 150 per barrel and trigger a global recession.
Scenario 1: Short war, no pipeline damage
- Sanctions, but avoiding energy sector, spot supply is lost, contracts fulfilled.
- EUR 120/MWh (USD 240/boe) LNG price peak for 2022.
Scenario 2: Long war, pipelines damaged, comprehensive sanctions - US/EU relations to Russia undermined, massive sanctions both ways.
- Nord Stream 2 terminated, no spot volumes and no contractual volumes.
- TTF price rises to EUR 150/MWh (USD 300/boe) peak in 2022.
Russian oil exports virtually frozen. While Russian crude oil in theory is open for exports, they are almost frozen for fear of energy sanctions and reputational risk, and there has been a sharp tightening in the physical oil market following the substantial sanctions on Russia. Sanctions have exempted Russian energy exports but the fear of sanctions on energy is preventing shippers from taking oil cargoes from Russia. This has created a sharp tightening of a physical oil market that was tight even before the war and sanctions. If the rebate offered on Ural’s crude is large enough vs. Brent crude or other crude, it will at some point
outweigh the risk of getting stuck with the cargo. Therefore, the flow of Russian oil will probably only resume when the rebate is large enough, whilst there is an ongoing risk that oil and gas pipelines in Ukraine may be damaged in the fighting (more here).
Markets pricing softer central banks. Over the past few days, markets have reduced rate hike expectations both in the euro area and the US, indicating expectations that monetary policy will ease to absorb some of the blow. This seems realistic in the case of the euro area, where we foresee the ECB adopting a wait-and-see stance at its meeting on 10 March. In the US, it is a different story with the economy more isolated from the direct shock with an urgent need to tighten policy due to high inflation and a relatively strong economy. In his testimony to the Congress earlier this week, Chair Powell used hawkish language on the economy, the labour market and inflation and confirmed an urgency of policy tightening. The Fed sticks to the plans for a March hike, though by a smaller 25bps hike, while more aggressive steps of 50bps still on the table for later, if inflation stays persistently high (more here).
Cumulative change in short rates priced by forwards
US rates markets pricing in stagflation. Since last autumn, US rates markets have been increasingly discounting a stagflation scenario where the Fed is foreseen taming inflation with rapid rate hikes in 2022 and early 2023 that would depress economic growth. Our main scenario for 2022 is that a recession can be avoided, but that Fed rate hikes and growth uncertainty continue act as a drag for long yields for a large part of this year. The table below shows our scenarios in order to illustrate the potential range of outcomes.
Stylized macro and financial scenarios for Fed, US rates and global stocks for 2022
Source: SEB Equity Strategy and SEB Macro & FICC Research
The “reflation” scenario as depicted in the table would involve Fed hiking rates more cautiously than currently is priced in, which could be the case if inflation pressures start easing. This in turn could move markets into pricing in a longer recovery, a higher terminal rate and lift long yields. A more unlikely path to the
“reflation” scenario would be the Fed raising rates more slowly despite inflation pressures continuing to mount.
US recession still not our base scenario for 2022 but risks are increasing. While a US recession is still not our main scenario for this year, downside risks have increased due to the war in Ukraine. A recession could be triggered by severe financial market reactions and/or a further escalation with even more severe energy price repercussions. We still regard the US as more resilient than the euro area to rising energy prices.
However, even in our main scenario, where recession is avoided this year, recession risks further down the road are rising because soft landings have always eluded the Fed and will be exceedingly difficult with strong underlying inflation forces combining with supply shocks from energy. We are seeing an increasing probability of US growth slowing below trend in 2023.
Our base case is that the Fed is now aiming to get the rate at a “safety distance” from zero by a series of rate hikes in the coming three meetings beginning on 16 March, to at least 0.75% 1.00% before pausing to evaluate the effects and proceed more slowly thereafter. The first hikes of the Fed are well priced in and are unlikely to cause a recession but beyond that, it will be a balancing act. If inflation does not start to abate the Fed may have no choice but to kill the recovery even if markets start signalling recession risks through a curve inversion.
The Ukraine crises keeps the ECB in wait-and-see mode. At the March meeting, the Governing Council faces the geopolitical crisis, even higher near-term inflation but also negative economic effects due to high energy prices, war-related sanctions, weaker real household income and, not least, general economic and market uncertainty. We think that economic and political considerations will result in the ECB remaining in a wait-and- see mode in March, essentially reiterating its previous policy decisions on key policy aspects including net asset purchases, sequencing, and preparedness to act as necessary. The ECB will also state that it will safeguard ample liquidity conditions and counteract fragmentation as necessary, but also repeat the data dependency and the readiness to proceed towards policy tightening as warranted once the current uncertainty abates. The crisis will delay the ECB’s steps towards policy normalization but to what extent remains highly uncertain. For now, we maintain our view that the ECB will raise the deposit rate by 25bps in December, followed by two hikes of the whole rate corridor in 2023. We will publish our comprehensive ECB preview ahead of the 10 March meeting later today.
Downside risks to our forecast on long rates. Assuming some easing of current stagflation fears later this year, we have been targeting the US 10y yield rising to 2.10% in end 2022. With our end 2022 fed funds target range forecast of 1.25 1.50% and forecast of further rate hikes in 2023, we are projecting the US 2y yield of around 1.90% at the end of this year. Our main scenario thus foresees the US 2y 10y yield curve flattening to 20bps in end 2022 but downside risks to our USD rates forecasts, especially for long rates, have increased.
In the euro area, negative macroeconomic effects of the conflict in Ukraine are much more direct and larger than in the US. The uncertainty over the severity of effects on the euro area economy remain unclear but have potential to be substantial. On 18 February we anticipated (see What if the crisis escalates: EUR & USD rates) the German 10y yield declining to below zero in case of an escalating conflict. In the near-term, downside risks to German long yields remain. As long as our main scenario of the ECB raising policy rates to above zero in 2023 remains intact, we stick to our end 2020 forecast of 0.40% for the German 10y yield.
We will revise our forecasts as more information becomes available.
EUR/USD: Lower levels yet to come
EUR/USD was already, in line with our forecasts, heading lower before the war in Ukraine, but the speed of the decline has increased since the war started. G10 currencies may be divided into three groups for which the impact of the war is similar: the commodity currencies AUD, NZD, CAD and NOK are strengthening on the back of higher commodity prices, and the safe haven currencies USD, JPY and CHF are strengthening as risk appetite is falling. Meanwhile, the euro area-related currencies EUR, GBP and SEK are weakening on a combination of being risk-sensitive in general, but especially as Europe stands to have the largest impact of the war.
G10 FX development since 23 Feb 2022, equally weighted
EUR/USD is generally positively correlated with risk appetite, so as long as risk appetite falls or remains low one should not expect a soon return higher. Our risk appetite index is currently 2.9 standard deviations below its risk-neutral level, which is the largest since the initial impact of the Covid 19 pandemic back in March 2020 and a level which seldom is sustainable. However, in the current situation, it is highly uncertain where the index will be heading as it is dependent on the war in which an escalation or indication of a long war would continue to assert downward pressure on the index, and indirectly on EUR/USD. Since 2001, there have only been 11 occasions in which our risk appetite index has fallen by more than two standard deviations. On 10 of these occasions, EUR/USD had fallen one month after the breach of two standard deviations, which also indicate that one should expect EUR/USD to continue lower. The only occasion where EUR/USD had headed higher after one month was the most recent occasion during the early phase of the pandemic in March 2020.
Risk appetite index with few observations below two standard deviations
In a structural macro framework, presented in our Macro Trading Strategy report on Wednesday, we conclude that currently we are in a strongly USD-supportive “mature” state. Drivers are strongly in favor of USD vs EUR and can be expected to remain so particularly if the aggression in Ukraine continues.
Please see our EUR/USD chart package for more charts.
China: Tight balancing act
As Western economies intensify sanctions on Russia, China has avoided taking sides. By advocating peaceful negotiations between Russia and Ukraine, China is signifying its discomfort over Russia’s military actions.
Moreover, China has reiterated that it respects the “sovereignty and territorial integrity of all countries”. Even so, Beijing has refrained from calling Russia’s actions as an “invasion”. It was no surprise when China abstained to vote on a UN Security Council resolution to deplore Russia’s aggression against Ukraine. Thus far, China has not indicated an intention to take direct action against Moscow and has historically opposed unilateral actions like sanctions against nations. It has been consistent in its view that sanctions are not effective in resolving issues.
There are limits to China’s friendship. Despite stronger ties between Beijing and Moscow in recent years, there are limits to China’s friendship. While Russia is an increasingly important source of energy, its total trade with China pales in comparison with China’s trade links with the US and the EU. Among China’s top trading partners, the EU accounts for 15.3% of China’s total trade, followed by the US with 12.5%. As sanctions against Russia mount, there are reports that some of China’s largest state-owned banks are already limiting financing for transactions of Russian commodities. Although sanctions have so far stopped short of Russia’s energy trading, Chinese banks may have already stopped issuing USD-denominated letters of credit related to Russian commodities. Even so, CNY-denominated financing for Russian commodities may still be available albeit with a higher level of scrutiny. Large Chinese banks would be reluctant to lose access to dollar transactions, in our view. In the past, China’s big four banks have complied with US sanctions against Iran and North Korea in a bid to maintain access to the dollar clearing system. More on our China views here.
Money market monitor
The chart below shows market pricing for short money market rates in terms of OIS 1m, With OIS 1m rate closely related to central banks’ policy rates, OIS forwards can be used as in indication on policy rate changes priced by the markets. For SEK and NOK forward levels are based on our estimates as there is no active OIS market.
Central bank expectations: Cumulative change in short rates
The following chart shows market pricing for 3m libor rate levels.
3m libor: History and forwards
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: Bloomberg, SEB
Open trade recommendations
Systematic currency strategies
Closed trade recommendations in 2022
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Elisabet Kopelman elisabet.kopelman@seb.se
Bjarne Schieldrop bjarne.schieldrop@seb.no
47 9248 9230
Karl Steiner karl.steiner@seb.se
46 70 3323104 Eugenia Victorino
eugenia.victorino@seb.se 65 65050583
