How has the outlook for global fixed income and currency markets changed since Russia invaded Ukraine? Dagmara Fijalkowski, Head of Global Fixed Income & Currencies, shares her expectations around inflation and tightening credit spreads. Dan Mitchell, Portfolio Manager, explores how rising commodity prices and sanctions against Russia are affecting U.S. dollar strength.
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What possible scenarios are you considering for fixed income markets over the medium term?
February 24 was the day the world changed – when Russia invaded Ukraine. I think about it as the beginning of Cold War II. Headlines are coming fast and furious and we certainly don’t claim to possess any superior knowledge on what Putin might do.
Many of the moves we have seen since sanctions were announced have been driven by forced liquidation and risk reduction.
Setting aside the short-term dislocations, I keep a list of things I think I know, things that with high degree of confidence will be the aftermath of this war. The first two items on this list are: higher inflation due to higher commodity prices, and Europe’s turn towards looser fiscal policy and tighter integration.
Both, higher commodity prices and looser fiscal policy, are bond negative in the longer term. They have been offset in the short term by risk aversion, pushing yields lower in recent weeks.
When we create scenarios for the next 6 months, we use the worst case scenario yield on 10-year U.S. government bonds of 2.5%, which is worse than what’s implied by forwards of 2.05%. If we got to 2.5% by the end of July, that would be 99th percentile of all 12-month moves since 1990. That worst case scenario shows a 6-month total return on the Canadian bond universe of -1.5% from rates and yield, while the scenario implied by forwards shows total return of 90 basis points. The question is, what would happen to credit spreads?
With risk aversion driving markets, spreads are becoming more attractive. Total returns can be improved with any spread tightening. The longer your time horizon, the more attractive the current spreads are.
Scenario analysis tells us that risk rewards from here are looking better than in a long time.
How has the Russia/Ukraine conflict impacted global currencies?
We would normally evaluate currencies and come up with a currency outlook based on factors like the trajectory of relative interest rates, currency valuation, or country-specific factors like trade and fiscal deficits.
Now those factors have really fallen by the wayside in late February when Russia invaded Ukraine and as investors flock to the safety, security, and liquidity of the U.S. dollar.
Those fundamental factors will come back to being important. But for now, markets are grappling with understanding how three relatively major changes have really altered the currency landscape.
The first of those is the steep rise in commodity prices, both oil and industrial metals. And we’re certainly seeing that distinction between the strength of commodity exporters and the weakness in currencies of commodity importers.
The second is, this fight for stronger currencies really is a way of boosting purchasing power and fighting the impact of inflation. And that’s a real departure from where we were 10 years ago when the term “currency wars” was used to characterize countries that were trying to weaken their currencies in order to gain that extra competitive edge in global export markets.
Now the third and most important one is really the sanctions that were imposed on Russia after their invasion. Now these sanctions go well beyond just targeting individuals or corporations, but also focus on the Central Bank, which effectively freezes the country’s foreign exchange reserves. Countries accumulate these foreign exchange reserves really as a form of national savings that can be used to support economic growth or to support their currencies in times of crisis. And what we’re seeing now is, if those reserves can be frozen, then their usefulness and their availability for those purposes is really being put in question.
The world has some 13 trillion in global FX reserves right now, 60% of which is allocated into the U.S. dollar. And so, if there’s some reduction in these savings, if investors decide to reallocate away from the U.S. dollar and toward other alternatives, whether that’s cryptocurrencies or gold or even a more diversified basket of currencies, then that should really be a pretty major headwind for the U.S. dollar going forward.
So while the U.S. dollar has gained in the short term and seen some of that temporary strength, and perhaps even delayed the eventual long-term decline that we expect, there are good reasons to expect why the greenback should soften in the longer term.