BlueBay AM: Russia’s strategy seems to be playing out so far

28 januari 2022

This week’s Federal Reserve meeting saw Chair Powell affirm a path towards policy tightening, with a first rate hike widely anticipated at the March meeting. 

By this time, the taper of asset purchases will have been completed. Comments at the press conference also suggested that QE will give way to QT by the summer, with the Fed actively shrinking its balance sheet by ceasing the reinvestment of maturing securities as a first step. In the wake of the FOMC meeting, money markets now price five Fed hikes in 2022, taking the Funds rate to 1.25% by the end of this year.

This trajectory is not far from our own views in 2022. However, we believe that the market continues to underestimate the outlook for inflation and growth on a forward-looking basis, therefore we continue to disagree with pricing of the rates trajectory into 2023.

In this context, market projections for a top in rates in this cycle of around 2% appear 100 basis points too low, in our estimation. We would also observe that the Fed itself thinks that policy will move beyond its assessment of a 2.5% neutral policy rate over the course of this cycle.

From this standpoint, we maintain a bearish view on the direction of yields over the medium term. However, in the short term we would not be surprised if the recent trend higher pauses for some consolidation. In the coming months, Omicron may lead to softer economic releases. Risk assets are also becoming more sensitive to higher rates. This infers that self-correcting price action in the wake of a flight to quality is becoming more likely, should financial conditions tighten too quickly.

In addition, the military build-up on the borders of Ukraine seems poised to create a flashpoint.

Nevertheless, having realised gains on approximately half of the duration short we have maintained, we would look to add to conviction on a move lower in yields, as we think that this will ultimately prove difficult to sustain.

On a global basis, concerns with respect to inflation show few signs of diminishing. Talk of chip shortages surfaced again this week and it was notable to observe that Ford stopped accepting new orders for one of its most popular models. Oil breached USD90 for the first time since 2014 and, notwithstanding hopes for supply pressure easing, the queue waiting to unload at the Port of Los Angeles exceeded 100 ships in the past week.

Omicron continues to be a factor creating short-term worker shortages, but this should normalise before too long. However, with China and parts of Asia fighting to maintain a zero-Covid policy, it seems inevitable that this will mean further disruption, at least until policy changes course and there is acceptance of a move from pandemic to endemic.

With risk assets on the back foot, credit spreads have trended wider since the start of the year. At an index level, spread widening has been relatively contained, though higher-beta names have witnessed more significant spread performance as the 2021 trend towards credit compression starts to unwind.

Given the broadly constructive growth outlook, we continue to view credit quality as broadly well supported in 2022. We believe that recession risks remain low and default rates can remain depressed.

Meanwhile, a rotation that can favour sectors such as banks, as yields move higher, should also be supportive for subordinated financials. Notwithstanding some losses in this sector at the start of the year, a trend higher in bank equity prices reaffirms the underlying constructive trend in credit quality.

In FX, the US dollar has traded stronger over the past several days in the wake of a relatively hawkish Fed. The ECB is also likely to move more hawkish in March, but for now has been careful not to signal moves in this direction for fear of adding to pressure on spreads in the EU periphery.

Italian presidential elections are ongoing and although the election of Draghi may lead to the installation of a caretaker prime minister, it seems unlikely that markets will be quick to price out Italian political risk with elections looming next year.

Meanwhile, any risk of early elections could lead to a more rapid widening in spreads in Italy and across the periphery more generally. From a sovereign standpoint, we observe that, fundamentally speaking, Italy has outperformed Spain during the pandemic and but for political risks in Italy, we could see BTPs and Bonos trade closer on yield. However, in general it seems there is little to drive spreads tighter but several risks that could see them move wider in the coming weeks.

In emerging markets, newsflow from Russia has been the principal driver of volatility over the week. However, as the world holds its breath, it has also been interesting to see increased signs of divergent performance at a country level.

Chile has recently been a solid performer as political fears subside. Meanwhile, we see countries that are energy importers with large current account deficits as increasingly vulnerable against the backdrop of rising prices. This is true for Turkey, but also countries such as India and the Philippines.

Elsewhere, policy easing in China has supported sentiment, with bonds in the property sector bouncing from their lows. However, it may be premature to call a bottom in that space, given ongoing structural issues and highly elevated property prices relative to domestic incomes suggesting that prices could have some way to fall before the market is properly back in balance.

Looking ahead

There will be plenty of scrutiny around upcoming data releases, given the Fed’s data-dependent approach to policy on a forward-looking basis. However, we doubt we will see much information that will lead to a revision in views over the next few weeks, particularly noting the potential for Omicron distortions.

From that point of view, the catalyst for the next leg up in yields could come as we move into March. At this time, we think that any temporary slowing due to Omicron will fade. The economic outlook looks robust, although inflation fears may remain elevated.

In this context, the more time we stay with inflation well above target, the greater the risk of a de-anchoring of inflation expectations.

We think that the Fed will materially raise inflation forecasts, as well as its forward-looking dot-plot in March. In part, it may have wanted to lift forecasts more back in December, but also wanted to communicate a measured approach to revisions, for fear of spooking the market.

Consequently, we think the March FOMC may be the catalyst for 10-year yields to breach 2% and move higher in the months to come. We would reassert that any monetary tightening in 2022 will only make policy less accommodative, not restrictive. Real policy rates will remain deep in negative territory come the end of this year, based on our view that inflation should remain at 3.5%–4.0%.

From this perspective, February may be a quieter month following a pretty volatile January. Price action in the Nasdaq this week, when a 4% intra-day drawdown was fully reversed, has helped push indicators such as the VIX above 30. We now think that a range stabilisation could be ahead of us in the next few weeks.

Absent material new information from data or central banks, we see a Russian conflagration as the greatest risk to this view. Predicting Putin’s next steps are uncertain, though we are doubtful he will want to back down unless he receives material concessions from NATO, which we doubt will be forthcoming. The US Administration has made hawkish comments with respect to sanctions, though Europe’s dependence on Russian gas puts it in a weak position.

Within Europe, it appears Boris Johnson may soon be ejected as Prime Minister; Putin doesn’t care what Macron thinks; and in Germany, the government is more inclined to a conciliatory path, having banned any arms assistance for Ukraine.

Vlad the Bad must be rubbing his hands at a divided EU and a fracturing NATO. He is winning popularity at home as a ‘tough guy’ and making money on the back of surging oil and gas prices. If the US tries to restrict access to the USD, then it seems the Russians will transact with the Chinese instead in CNH terms, to the strategic detriment of the US. Therefore, the Russian strategy of chicken Kiev seems to be playing out well in the Kremlin for now…