Renewed Ukrainian tensions could spook the markets

While this week we have certainly seen what looks to be some diplomatic progress in the Ukrainian crisis with the meeting between the presidents of Russia and Ukraine, events ‘on the ground’ unfortunately seem to be moving in the opposite direction. On Thursday at noon, Ukrainian president Petro Poroshenko said that Russian troops have been brought into Ukraine.

Hence, over the past couple of days, media reports indicate that the fighting between the rebels and the Ukrainian military has moved westwards. More worrying, the Ukrainian government claims that regular Russian troops are directly involved in Ukraine and the rebels have indirectly acknowledged this by saying that Russian troops ‘on leave’ have joined the rebels fighting in Ukraine. The Russian government has not confirmed this.

On Thursday, the US said that Russia is ‘directly involved’ in the fighting in eastern Ukraine. The EU and NATO have delivered a similar message. In our view, this is a stepping up of the rhetoric from the western powers and it is likely that markets will once again start speculating about new sanctions against Russia. The Russian markets today reacted negatively to the apparent military escalation. In the Russian stock market, it is particularly the banks that are hit – this is likely to reflect fears of EU and US sanctions directly against the Russian banking sector.

From a market perspective, we continue to argue that investors should be positioned for more rouble weakness and a re-escalation of geopolitical tensions is likely to spill over negatively to the other CEE FX markets. However, for now, we do not see any reason to change our CEE FX forecasts in a more negative direction.

Will we finally get a Polish rate cut?

We have consistently argued since early 2012 that Polish monetary policy is overly tight and monetary easing is (badly) needed to curb deflationary pressures. Poland now has outright deflation and the Polish central bank (NBP) is therefore significantly undershooting its official 2.5% inflation target. Indeed, one could argue that the NBP effectively agrees that monetary policy is too tight. Hence, the NBP has now for some time forecast inflation to undershoot its own inflation target for the next three years. Furthermore, the escalation in the Ukrainian and EU/US sanctions against Russia and the Russian counter-sanction are now directly affecting the Polish economy negatively.

We are now ready to forecast that the NBP will finally cut its key policy rate by 25bp to 2.25% at the Monetary Policy Council meeting. We acknowledge that this is a brave call and few other analysts agree with us (consensus is for unchanged rates). However, the market is on our side. It is essentially already priced for two 25bp cuts towards the end of the year. Whether or not we get the cut next week, it is becoming increasingly hard for the NBP not to cut rates. Overall, we find the market pricing (for rate cuts) to be correct and we could even see market pricing in more cuts going forward.