Crisis in Eastern Europe roils markets

Financial markets had been reeling already in 2022 on the prospect of tighter monetary policy but now they will need to endure a geopolitical crisis in Eastern Europe following the invasion of Ukraine by Russian forces. Markets are moving considerably to risk-off positions with yields on benchmark developed market bonds plummeting: the 10yr US Treasury yield has fallen more than 10bps since news of the escalating crisis hit markets and has pushed well away from the 2% level reached earlier this week. Both Japanese Yen and gold, other assets conventionally viewed as safe havens, are also strengthening in the wake of the invasion.

The scale and scope of the geopolitical crisis is an unknown variable at this time, but we would expect that the US, EU, UK and other nations to respond by imposing punitive sanctions on Russia’s economy. Sanctions on Russia’s economy will hinder economic activity in the country, but they are unlikely to substantially derail global growth. Foreign holdings as a share of Russian domestic bonds have shrunk to less than 20% of total at the end of last year compared with as much as 34% at the start of 2020. Russia’s nominal GDP is smaller than Italy’s and net inflows of foreign direct investment are a fraction of its emerging market peers.

Net FDI inflows as a share of GDP (%)

Source: World Bank, Emirates NBD Research

However, Russia has an outsized influence on global commodity markets as we outlined in a note earlier this week. It accounts for fully 25% of global natural gas exports and around 12% of global crude oil exports (including refined products, its share of petroleum exports is even larger). Dependency on Russian energy imports is high in Europe: 23% of the EU’s crude oil imports came from Russia in 2020 and almost 40% of total EU natural gas imports came from Russia. Individual countries have an even higher energy dependency: almost two-thirds of Germany’s gas supply is sourced from Russia.

Sanctions from the US and EU have so far refrained from targeting flows of Russian energy or commodity products and there has been so far no interruption to flows. We don’t at this stage expect that oil and gas exports will be targeted by sanctions and that in any event the US may draw down more on its strategic petroleum reserves to offset the tightness in energy markets.

As we described in our piece on Russian commodity exports the transmission of the crisis to global markets is likely to be inflationary as commodity markets will price in supply restrictions before or even if they actually materialize. That will weigh on bond markets that have already taken a hammering from pending rate hikes and is likely to feed through to equities as well with the threat of even higher input costs for firms. Currency markets will also move toward havens supporting our view for a stronger dollar against peers like EUR for at least H1 this year. The outlook for more risk-oriented currencies, such as commodity currencies or emerging markets is more volatile as financial markets unpick the impact of the crisis.

We don’t expect that the crisis and unfolding financial market volatility will prevent the Federal Reserve from hiking rates at their upcoming March FOMC as the Fed will still want to show a strong hand on damping down inflation pressures in the US economy. Financial market volatility may result in the Fed being less aggressive in tightening, however, such as waiting to unwind its balance sheet until later this year or slowing the pace of hikes in H2. Our baseline view at this stage is that  the Fed will follow through with a hike at its March meeting.