Extreme volatility continues across asset classes. Russia-Ukraine war remains investors' focus, overshadowing nonfarm payrolls. Commodities continue to surge higher

Markets were extremely volatile last week as investors grappled with the implications of the Russia-Ukraine conflict.  Friday saw further weakness in equities, especially in Europe, big falls in government bond yields, and higher commodity prices.  The EUR remains under pressure, falling below 1.10 to its lowest level since mid-2020, while the NZD and AUD have rallied on the back of surging commodity prices.  The NZD ended the week around 0.6860, approaching its highs for the year.  The NZ 2-year swap rate hit a new cycle high on Friday despite consumer confidence falling to recessionary levels.

Risk aversion remains elevated amidst the ongoing Russia-Ukraine war.  On Friday, markets were rocked by news that Russia had attacked a Ukrainian nuclear facility, the largest in Europe.  The headlines caused a wave of risk aversion during Asian trading hours, with markets possibly worrying about the risk of a nuclear catastrophe (which ultimately proved unfounded as the reactor and other sensitive equipment were reportedly unaffected).  The 10-year Treasury yield fell as much as 15bps in a liquidity vacuum, briefly trading below 1.70%, while EuroStoxx futures fell more than 3%.

There wasn’t much recovery in either rates or equities through the remainder of the session, even after it became apparent that the nuclear facility hadn’t sustained any damage to its core operations.  The US 10-year rate closed the session down 11bps, at 1.73%, while the German 10-year rate dropped back into negative territory, falling 9bps to -0.08%.  The S&P500 was down 0.8% on Friday and 1.2% on the week but the big regional underperformer among equity markets was, unsurprisingly, Europe, with the EuroStoxx 600 closing down 3.6% on Friday, bringing its loss on the week to 7%.

The situation in Ukraine completely overshadowed the US nonfarm payrolls report.  Job growth was much stronger than expected in February, at 678k, and the unemployment rate fell to a new post-Covid low of 3.8%, despite a higher labour force participation rate.   But perhaps the most notable feature of the report was the sharp fall in wage growth, with average hourly earnings coming in much weaker than expected at 5.1% y/y.  It’s hard to know how much signal to take from the average hourly earnings data.  Some might argue that workers are starting to return to the labour force, in turn dampening wage growth, now that enhanced unemployment benefits have ended, schools and childcare facilities are open, and the Omicron wave is well past its peak.  Alternatively, it could just be month-to-month volatility.  Alternative wage measures are still very strong, with the Atlanta Fed’s Wage Growth Tracker hitting a 20-year high in January.

Either way, a 25bps March hike looks like a done deal after Fed Chair Powell said last week that he would recommend such a move.  The market is pricing around a 90% chance of a 25bps Fed hike next week and just less than six hikes by the end of the year.

Commodity prices continue to surge higher on supply fears.  Despite Russian energy exports having not been the subject of direct sanctions, consumers are reportedly avoiding Russian commodities.  This at a time when inventories in many commodity markets are already very tight.  The Bloomberg commodity index hit a fresh 7½-year high on Friday, bringing its gain on the week to 13%, its biggest weekly increase since the inception of the index in 1960.  Commodity price increases have been broad based.   On the week, Brent crude oil was 21% higher, nickel 19%, aluminium 15%, zinc 12%, and copper 8%, while in terms of soft commodities, wheat futures were 60% higher on the week and corn 15%.  European natural gas futures more than doubled in price last week, closing at a record €193.  There’s unlikely to be any let up for oil prices to start the week with US Secretary of State Blinken saying over the weekend that the US was speaking with European countries about banning Russian oil imports.

The main story in currency markets is the ongoing weakness in the EUR on the back of concerns about the impact of Russian sanctions and surging energy prices on the Euro area economy.  The EUR broke below 1.10 for the first time since mid-2020, falling 1.3% on Friday to 1.0930.  The GBP was caught in the downdraft, falling 0.9%.  The USD was stronger by default, with the BBDXY index hitting an 18-month high on Friday.

It has been a completely different story for the NZD and AUD, which have been benefiting from the tailwind from fast rising commodity prices.  The NZD and AUD appreciated 1.7% and 2% respectively last week, performance you wouldn’t ordinarily expect to see on a week when the EUR was 3% lower.  The NZD ended the week around 0.6860, nearing its highs for the year, while the AUD reached a three-month high of 0.7370.  For now, firmer commodity prices appear to be overriding the headwind from weaker risk appetite for both antipodean currencies.

There have been large moves in some of the NZD crosses.  The NZD/EUR cross has blasted higher to 0.6280, its highest level since mid-2017 and up over 7% since the of January.  The NZD/GBP cross was 1.8% higher on Friday and is approaching 0.52 for the first time in almost three months.  The NZD/AUD cross has been an oasis of stability in comparison, still tracking a relatively narrow range between around 0.9250 and 0.9400.

Funding markets are starting to show some signs of stress.  FRA-OIS spreads in USD continue to push wider while cross-currency basis swaps have again turned more negative, signalling that liquidity is becoming tighter and USD funding harder to come by.  The implied Libor-OIS spread for the front (March) futures date has increased to around 35bps, its highest level since the Covid panic in early 2020 and up from 5bps at the start of February.  Analysts are divided on the reasons for the uptick in funding pressures with some arguing that sanctions had effectively ‘locked up’ Russian funds which were being used as short-term funding by Western banks while others see the pressures arising from precautionary funding activity by banks.  The Fed’s FX swap line was tapped for $292m in the week to Wednesday, still much lower than the levels seen during the pandemic when funding markets were extremely dislocated.

In news over the weekend, Putin signed a decree temporarily allowing the Russian government and companies to pay owners of foreign bonds in rubles rather than hard currency.  Russia’s sovereign debt in USD and EUR is already trading at deeply distressed levels, around 20 to 40 cents in the dollar, consistent with default.  
In a report published last week, credit rating agency Fitch said it expected the direct impact of the Russian crisis should be manageable for European banks, with the main risk being that a severe economic downturn could hit profitability and cause a broader deterioration in loan books.   Fitch noted that for Societe Generale and UniCredit, the two European banks with the largest exposure to Russia, even a full write-off of their Russian subsidiaries would only reduce their capital ratios by 40bps and 15bps respectively and leave both well above regulatory minimums.

Turning to local news, the ANZ consumer confidence index slumped to a record low in February, below even the levels reached during the GFC and the initial Covid lockdown.  There are a number of headwinds for consumer confidence at present including the current Omicron wave, rising mortgage rates, and falling real incomes (due to high inflation).  The prospect of further falls in house prices is likely to be another factor which might weigh on consumer confidence later this year.  At face value, consumer and business confidence are at recessionary levels although one would hope that confidence will rebound once the Omicron wave passes.  But with inflation still extremely elevated (indeed, likely to rise further given what is happening to oil prices) and growth headwinds mounting, it may make for some difficult RBNZ decisions ahead.

Given the hawkish tone of the recent MPS, the market figures that the RBNZ will put more weight on the inflationary impulse rather than the growth challenges.  There is still 67bps priced into the next two meetings, implying a high chance of a 50bps move at one of them (with May seen as the more likely option by the market).  The 2-year swap rate hit a fresh cycle high of 2.85% on Friday in illiquid conditions, before settling 4bps higher on the day, at 2.81%.  The yield curve flattened sharply, with the spread between 5-year and 10-year swap rates hitting 0bps for the first time since December.  With the RBNZ seemingly set on pressing ahead with aggressive rate hikes to keep a lid on inflationary expectations, the curve is likely to invert as the market factors in growing recession risk and, eventually, the next rate cut cycle.

The week ahead is likely to be again dominated by developments in Ukraine and the international response to Russia.  The ECB meeting takes place on Thursday night, with the market on watch for when its bond buying might end and how the situation in Ukraine might affect the policy outlook.  US CPI is the main data release, expected to show headline inflation hitting a fresh 40-year high of 7.9% y/y.  It’s a relatively quiet week domestically with GDP partial indicators released.