Weekly Focus: Uncertainty remains high in Eastern Ukraine

The tensions in Eastern Ukraine remain elevated, although broader market reaction has so far remained moderate. Reports of shelling were heard from both sides on Thursday, and US has continued to accuse Russia of building more troops by the Ukrainian border, as well as staging a false-attack to justify an invasion. Russia was clearly not satisfied by the security proposals made by the west earlier, and continues to threaten with ‘military-technical measures’. That being said, US’s Blinken will meet Russia’s Lavrov late next week, which has been interpreted as lower risk of near-term escalation. Overall, markets still seem very headline driven, with little concrete insight into the how the situation is evolving. Despite the volatility, rouble has appreciated moderately since Monday, and while Russian assets continue to trade with a risk premium, market does not seem to be in a panic mode. Oil prices, which rose last Friday on the back of rising sanctions fears, have also calmed down somewhat throughout the week.

Inflation remains a key theme for the markets, and this week markets have generally pulled back slightly on the central bank rate hike expectations. FOMC minutes did not provide strong signals for favouring either 25 or 50bp hike in the March meeting, market prices in around 30-35% risk of the latter. We updated our Fed call, and now look for a 50bp hike in March followed by a 25bp hike in every meeting of 2022. Despite market already pricing in several rate hikes for this year, US financial conditions remain expansionary relative to pre-covid levels, and we believe that stronger tightening will be needed to bring down the current inflationary pressures. We also think ‘active QT’ or outright selling of bonds to reduce the size of the balance sheet will be a key part of Fed’s playbook. Read our in-depth take in Research US: How the coming Fed hiking cycle will differ - and why it matters, 18 February. For ECB, markets still price 40bp worth of hikes this year, and a total of 100bp by the end of next year, which we see too aggressive, as we expect ECB stop hiking at zero. Overall, we believe the tightening liquidity conditions will support broad USD and weigh on scandi currencies.

China took a pause in its easing cycle, as PBOC refrained from cutting the Medium Lending Facility rates this week. We think the easing will likely continue with further rate cuts and reserve requirement reductions in coming months. Chinese January PPI continued to decelerate, providing some hope on easing global inflationary pressures. However, China’s strict covid-policies continue to create risks of further supply chain issues, and the renewed policy easing is likely contributing to the recent rise in commodity prices.

Next week, markets continue to keep a close eye on the developments by the Ukrainian border. On the data calendar, Markit’s February Flash PMIs for Euro Area, US and UK will be released on Monday and Tueday. Easing covid-restrictions could spark an uptick in the figures, but the key focus will be on how the supply chain issues and price pressures continue to develop. US PCE will be interesting following the strong retail sales released earlier. The Reserve Bank of New Zealand meets on Wednesday, and while another 25bp hike seems like the most likely option, risks are tilted to the hawkish side amid the global push for faster tightening.

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