Interest rates

Will historic sanctions against Russia have an impact on global interest rates?

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– The world witnessed the brutal reality of Russia’s invasion of Ukraine. Western countries have responded by imposing some of the toughest sanctions in modern history, including targeting specific Russian banks, sanctions against people in Vladimir Putin’s inner circle, as well as Vladimir Putin himself. And evicting financial institutions, Russian financial institutions, from something called Swift, which is a financial messaging system.

With more insight into the impact she sees in trading and what it could mean for central banks, we’re joined by Priya Misra, she’s global head of rates strategy at TD Securities. Priya, I just want to start with how are the markets working this morning? What do you see? What do you mean?

– So it’s an extremely volatile situation. I mean, we saw the news this weekend. I think we don’t have a lot of details yet. For example, you talked about banning Swift banks, but are they specific banks? Is the energy cut off? Are all commodities excluded from these transactions?

So I think it’s still evolving. And so you asked about the market. I would say the market is always pricing in the risk of different outcomes. And we have a very wide range of outcomes here, from the conflict itself escalating, more sanctions, what are the economic fallouts? So I think it’s extremely volatile.

We are witnessing classic movements, I would say, of flight towards quality movements. So the dollar is bad. Treasury rates are down, or I would say general government bond yields are down. Risky assets are in trouble. I think people are looking for liquidity, but I would disentangle all of these impacts into either a liquidity event or a credit event.

And I think right now more concerns are on the credit side. What losses on Russian assets will investors face? Liquidity, I think, is actually not as bad as one might imagine if you compare it to other episodes, the Lehman crisis, or 2020, the COVID crisis. So I think so far the liquidity seems to be good, but the market is preparing, I think, for high volatility, big moves on either side. But it’s still quite scalable.

– Mm-hmm, really. I mean, both in the physical context, in terms of what we see, and also in the financial markets. I want to talk about the maybe broader impacts as we look to the future.

When you think about where we’re going to see more of these credit events versus liquidity events, let’s say credit events, obviously I mean Europe is going to feel that more likely than North America, but the matters commodities, inflation, we’re seeing, hard and soft commodity inflation this morning. And I want to speak with the Fed and the Bank of Canada in a few minutes, but how do you see this playing out in the short to medium term?

– Of course, so I think the most obvious is Russia. In fact, the sanctions specifically target Russia, sort of freezing the liquidity there. So you see this, what we call the liquidity bubble, around Russian assets. So I think that’s number one.

Second, the spillovers from Russia to other emerging markets. I mean, there’s a wide range within emerging markets. But if investors turn to developing markets because of higher risk premia, it hurts the rest of emerging markets. I would say that emerging markets in Asia seem to be less affected than, say, emerging markets in Eastern Europe for obvious reasons, but that would be the next place.

Then you look at the exhibitions between Russia and the rest of the world. And I would say Europe stands out here. European banks have much more exposure to Russia than to the United States, which is why I would say that Europe could have more credit risk as well as liquidity risk, because a lot of these payments there are more payments between Europe and Russia.

And then you mentioned raw materials. And that’s how this thing can spread out into the rest of the world, and into the macro fundamentals, that’s what we’re seeing. Any war is a stagflationary shock. And that’s, I think, made worse – COVID itself has been a stagflation shock. And now we are dealing with a war, with already high prices skyrocketing. It’s not just energy, it’s energy, the rest of the raw materials, it’s food. And so I think that’s why central banks are going to have this very difficult time trying to fight inflation while supporting growth, and preventing that, the negative impact on growth that comes from inflation high.

– Alright, so let’s talk about central banks, because they have a puzzle now, I’m sure, as they figure out what to do. I mean, most – if you look at the markets, the markets are pricing in rate hikes from the Bank of Canada and the Fed. A few of them, quite a few of them, in fact, over the next few years. Does any of this change what you expect from the Fed and the Bank of Canada? And you start with whatever you want, but that’s the thing, is that going to change the next meeting, the next outcome?

– So let me start with the Bank of Canada, because it’s this week. We are looking for a 25 basis point hike. And then in two weeks we have the Fed meeting, we’re looking for 25 basis points there too. So it doesn’t change what we were looking for, what it does change is the initial loading of the bulls, or how aggressive central banks can be.

Because apart from the risk of inflation, there is a severe tightening of financial conditions. And part of what hikes, or quantitative tightening, do is tighten financial conditions. Well, if the war is tightening financial conditions, then overall, it looks like central banks need to do less.

So I think some of the hawkish rhetoric can be recalled, and you can hear more of a reactive tone from the central bank. They can still initiate bulls, but they can absolutely state that “listen, if the economy starts to slow down, we can also slow down our rate of tightening”. I think I reject the story of a political error.

And it’s piling up in the US, Canada and the UK, that central banks could be over-tightening. I think that’s where central bank rhetoric is important because it can say, “No, we don’t have to, we’re not going to overdo it. We’re going to watch the economy, watch financial conditions and recalibrate policy.” So I see that more as a medium-term impact on central bank policy rather than, at the moment, I don’t think it has an impact on the very short-term move. I think they need to start, given that the fundamentals are still strong and inflation is very high.

– Does it change – I mean, the rates, obviously, are a tool. They also have quantitative easing and tightening. Could something change on that front in terms of – could we hear the message that they are reconsidering this?

– I think they still want to exit using both tools, so both quantitative tightening and hikes. But I think there is an urgent need to do QT because it’s relatively less well understood – well, the Bank of Canada has never undertaken QT. The Fed has only undertaken it once. So I think there is less familiarity with this tool.

And so I think their aggressiveness in terms of how quickly they start, how quickly QT ramps up, I think it might stop a bit, or it might slow down in terms of how quickly they would do QT. But I think the intention is absolutely to start QT, because I think they need to tighten up using both the rates tool and the balance sheet tool to get those longer end rates up. That’s one of the reasons we think long rates have been so entrenched is that central banks hold a lot of government bonds. So I think they want to start QT, but they can be a bit measured and gradual in how they implement it.

– Priya, last question for you, to say it’s a fluid situation that – a lot of people are suffering, obviously, in Ukraine, and we’re all watching – what are you watching in terms of what’s going to happen next?

– Of course, so apart from what is happening on the ground, on which it is very difficult to have a good reading, but what is the extent of the conflict. But also what is the response of the West? And I am thinking of the details on the sanctions. So we got details of the central bank sanctions. And I think that’s why the ruble did what it did, because I think the Russian central bank’s ability to intervene was severely reduced.

But what are the Swift sanctions on the banking system? Because if they reduce all payments back and forth between the Russian banking system and the rest of the world, then I think that has very significant implications. If it’s more targeted, then I think it could be less. So I would be watching for more details on the sanctions. What is Putin’s playbook after this?

So I think it’s really the West back and forth against Russia. And then we have a lot of economic data this week in the United States, we have the payroll, as well as the ISM and President Powell testifying. So if it wasn’t a busy enough week, we also have the Fed Chairman testifying before the House and Senate, so we’ll be waiting for any comments as well. Something to keep us busy this week, that’s for sure.

– Priya, thank you, it’s always a pleasure.

– Thank you.

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