It has always been likely that the outcome of Russia’s invasion would be binary.
Either there would be a reasonably swift negotiated settlement or the financial markets, and the world, would face the unpalatable prospect of meaningful escalation.
Unfortunately, the latter outcome now looks more likely.
Still, if there is a deal, it would cause a sell-off in oil, which is already suffering from the impact of lockdowns in China.
Brent crude oil price
Source: Bloomberg
This writer would use any sharp sell-off on “the end of Ukraine war news” as an opportunity to add to energy exposure because oil was already in a bull market before Putin launched the invasion on 24 February because of the supply constraints long discussed here.
It also should be noted that the energy sector’s weighting as a percentage of the S&P500 market capitalisation remains tiny relative to history despite being the best performing sector since the beginning of last year.
The energy sector’s share of S&P500 market cap has risen from a low of 1.8% in November 2020 to 4.3%, compared with a peak of 16% reached in mid-2008.
Energy sector as % of S&P500 market cap
Source: Bloomberg
The S&P500 Energy Index has risen by 116% on a total-return basis since the beginning of 2021, compared with an 8.6% gain in the S&P500.
What Will Make the Fed Loosen Up on the Inflation Fight
It remains clear for now at least that political pressure remains on the Fed to tighten, something which has not been seen since the 1970s when Paul Volcker replaced William Miller in 1979.
In this respect, the “inflation nation” slogan of the biased but journalistically robust Fox News has clearly got traction with voters, with opinion polls continuing to show little comfort for Biden.
US University of Michigan Consumer Sentiment Index
Source: University of Michigan
Still with consumer confidence falling in March to its lowest level since August 2011, and small business confidence having turned down, at some point this year the political focus, ahead of the Mid-Term elections, is likely to turn from worrying about inflation to worrying about the economy.
At that point, it has to be questioned whether Jerome Powell and his colleagues will maintain the hawkish line.
NFIB US Small Business Optimism Index
Source: National Federation of Independent Business (NFIB)
Still, such a moment is not now even though the yield curve has flattened.
The spread between the 10-year and the 2-year Treasury bond yields narrowed from 158bp in March 2021 to a negative 7bp on 1 April and is now a positive 36bp.
Spread between US 10-year and 2-year Treasury bond yields
Source: Bloomberg
Meanwhile, there is one hope for the Biden administration.
That is that a foreign policy win on the Ukraine front manages to shift the political tide amidst the current consensus that the Democrats are heading for a resounding defeat in the Mid-Term elections.
An end to the conflict in Ukraine would also rekindle hopes that inflation will peak sooner thereby allowing the Fed in due course to back off its current hawkish line amidst growing market talk of another Fed rate hike of 50bp in June following the 50bp hike last week.
The money markets are now discounting a further 200bp of Fed rate hikes by the end of this year.
It is worth recording that the recent sell-off in Treasuries is one of the most dramatic moves since 1980 before the bull market in bonds began.
The US 10Y+ Treasury bond index has declined by 20% so far this year and is now down 30% from the high reached in March 2020.
US 10Y+ Treasury bond total-return index quarterly performance
Note: 2Q22 performance up to 10 May 2022. ICE BofA 10+ Year US Treasury Total-Return Index. Source: Bloomberg
It is also worth noting that the US nominal 3-year Treasury bond yield has risen since late March above the China 3-year government bond yield for the first time since 2009.
The US 3-year Treasury bond yield has increased from 0.96% at the end of 2021 to 2.83%, compared with the China 3-year government bond yield of 2.40%.
US and China 3-year government bond yield
Source: Bloomberg
Can the Ruble Continue to be So Resilient?
Finally, returning to the Ukraine conflict, it has to be wondered what are the unintended consequences of the West’s decision to engage in economic warfare against Russia, including the “nuclear” option of freezing the country’s foreign exchange reserves.
Yet the ruble has rebounded by 75% against the US dollar in the domestic market since bottoming on 10 March to RUB69.4/US$ and is now 17% above the level on 23 February, the day before Russia’s invasion of Ukraine.
Russian ruble/US$ (inverted scale)
Source: Moscow Exchange, Bloomberg
Meanwhile, the Central Bank of Russia announced on 25 March that it will buy gold in the domestic market at a fixed rate of RUB5,000 per gram starting from 28 March through 30 June.
This means at the current gold price of US$1884/oz the ruble should trade at RUB82.6 to the US dollar or 16% below the current domestic exchange rate.
Still, the linkage of Ruble to gold appears to have been withdrawn on 7 April when the central bank said it will buy gold from credit institutions at a negotiated price.
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