Risk appetite remains cautious with Russia-Ukraine tensions heightened. Lower equities and bond yields and a stronger USD. Market lowers likelihood of a 50bps Fed hike after comments from NY Fed Pres. Williams

Risk appetite remains cautious as Russia-Ukraine tensions continue to mount.  Equities and bond yields fell further on Friday while the USD appreciated on safe haven demand.  The market pared back the likelihood of a 50bps Fed hike next month after NY Fed President Williams pushed back against the idea.  The NZD performed well against what was a risk-off backdrop, ending the week around 0.67.  Importantly, we believe that New Zealand government bonds have qualified for the World Government Bond Index (WGBI), with entry likely to take place later this year.

The Russia-Ukraine standoff remains in the spotlight and continues to drive day-to-day market movements.  Tensions remain heightened with Russian separatists in eastern Ukraine ordering civilians to evacuate to Russia based on what they allege is Ukrainian preparation for an attack.  Ukraine strenuously denied the allegations amidst suspicions that Russia is setting the stage a “false flag” incident that could be used to justify an invasion. Biden said on Friday (after the market close) that he was convinced Putin had decided to invade Ukraine, with an estimated 170,000 to 190,000 Russian military personnel now stationed in the region.  The WSJ quoted White House officials as saying they expect an attack “in the coming days”.

Equities remain under pressure amidst the risk of an imminent Russian invasion, with indices in Europe and the US down across the board on Friday.  The S&P500 was off by 0.7%, bringing its loss on the week to 1.6%, while the NASDAQ was 1.2% lower.  European benchmarks were down between 0.3% and 1.5%.  Meanwhile, bonds continued to benefit from a flight to safety, with the US 10-year dropping to 1.93% (from almost 2% on Friday afternoon).   The UK 10-year rate fell 9bps to 1.38%.  Intraday volatility in both equities and bonds is high and likely to remain so while there is the threat of near-term military conflict.

The market continues to pare back the probability of a 50bps hike from the Fed in March, with NY Fed President Williams appearing to steer the market towards expecting a 25bps move next month.  Williams, whose views are often seen as being closely aligned with Chair Powell, said “there’s really no kind of compelling argument that you have to be faster right in the beginning” with rate hikes, adding that the Fed should “steadily ” raise rates from March.   The market-implied probability of a 50bps Fed rate hike next month is down to around 25%, having been almost fully priced in the wake of the US CPI report just over a week ago.  This doesn’t close the door on the debate however and upside surprises to upcoming CPI and nonfarm payrolls data could yet see the market ramp up pricing for a 50bps move.

There was a flurry of other Fed speakers on Friday, all consistent with the Fed embarking on a long series of hikes starting next month.  Vice Chair-elect Brainard appeared to endorse market pricing of almost seven rate hikes this year, saying it would be appropriate to start a “series of increases” next month, which markets are “clearly aligned with”.  Brainard added that balance sheet reduction (so-called quantitative tightening, or ’QT’) could kick off “in the next few meetings”.  Chicago Fed President Evans, seen as one of the most dovish voices on the committee, said “the current stance of monetary policy is wrong-footed and needs substantial adjustment ”, noting that inflation pressures had broadened beyond just those items most affected by supply-chain issues.

Meanwhile Bloomberg reported that consensus is emerging on the ECB to end QE bond purchases in September, earlier than previously announced.  The ECB has previously pledged to buy bonds until “shortly before” rate hikes, so were the ECB to make such an announcement at its meeting next month, it might point to a rate hike in October or December (the ECB sources quoted by Bloomberg saw December as the more likely outcome).  This might still come as a disappointment to the market which is almost fully pricing a 25bps rate hike by the September meeting and almost two hikes by the end of the year.

Currency markets were more influenced by the evolving situation in Ukraine rather than central bank talk on Friday.  The USD was generally stronger on safe haven demand, gaining 0.2% on a BBDXY basis.  Over the course of the week, the USD was down marginally, by 0.2%.  For the second day running, the NZD outperformed despite the risk-off backdrop, appreciating 0.1%, with the JPY (+0.05%) the only other G10 currency to gain ground against the USD on Friday.  The NZD closed out the week at around 0.67.

In an important development for the local market, we believe that New Zealand government bonds have qualified for the FTSE-Russell World Government Bond Index (WGBI), the primary government bond benchmark used by global investors.  The semi-annual snapshot of market size was taken at the 4pm London fix on Friday and we estimate that there was US$50.078b of eligible NZGBs outstanding, just creeping above the US$50b minimum threshold for inclusion in the index.  We will need to wait until late March for formal confirmation that New Zealand government bonds will join the index although we may receive provisional confirmation sometime this week.  If we’re right that New Zealand government bonds have qualified, then they should officially join the index later this year, probably at the start of November.

Industry estimates suggest around US$2.5 trillion in assets under management track the WGBI, including a higher proportion of ‘passive’ funds that seek to match the benchmark, Japan’s GPIF among them.  So, even with a small index weight (we estimate around 0.2%), New Zealand government bonds’ inclusion in the WGBI is likely to generate substantial offshore inflows.  This should benefit both the bond market (implying lower yields than otherwise) and the NZD.  Of course, its likely to be very much a second-order factor compared to other drivers  such as the OCR outlook, broader economic developments and trends in key global markets.

The domestic focus for the week ahead is firmly on the RBNZ’s February MPS.  We’re expecting a 25bps hike, hawkish messaging, and an upward revision to the RBNZ’s OCR forecast track.  We see a 50bps hike as a significant risk, although it’s not our central scenario.  We slightly amended our OCR forecast on Friday and now see consecutive 25bps rate increases between now and next February, taking the cash rate to a peak of 2.75%.  The market is already well priced for such a scenario, with a peak in cash rate of just under 3% seen in mid-2023.   There is a 25% chance of a 50bps rate hike priced in for Wednesday.

The other focus at the MPS will be what the RBNZ has to say about its plans for ‘managing down’ its almost $54b in LSAP bond holdings.  We think the RBNZ is likely to signal its intention to start gradually selling back its LSAP holdings to Treasury, probably starting around the middle of this year.  With New Zealand government bonds likely to join the WGBI later this year, we would suggest the argument for LSAP sales is even more persuasive now.  Additional bond supply might be useful in counterbalancing what is likely to be substantial foreign demand for NZGBs associated with entry to the WGBI.

Offshore focus this week is likely to be on developments in Ukraine.  In terms of economic data, the European PMIs are released tonight and key Australian wage data comes out on Wednesday (important because the RBA is looking for higher wage growth as evidence that inflation will remain sustainably at target).  There are mostly second-tier data released in the US. The US bond and equity markets will be closed tonight for Presidents’ Day.