MARKETS

US equities fell Thursday, S&P down 0.6%, heading into the close. Europe’s Stoxx600 down 1.7%. US10yr yields up another 3bps to 1.968%. Bunds up 6bps after ECB went ahead with the accelerated taper of APP. Oil fell again, down 1.2%. But press reports suggest Russia and Ukraine talks failed to yield progress.

Despite the yo-yo in equity markets, participation remains low. Since the Ukraine war began, the biggest fear has been systemic stability and watching for signs of cross-asset contagion or funding problems. But other than a spike in commodity prices, the overall tone has not turned as unfavourable as one would have expected on the heels of one of the world’s largest energy producers getting “cancelled.”

Still, the sheer speed and quantum at which markets reacted to the Ukraine war suggest systematic programs are dominating while active investors hunker down, still braced for a lot of very negative fallout.

When confidence is low, risk managers are in the drivers’ seat, keeping bank and market maker liquidity to a minimum which could be exacerbating interday moves. And no wonder as predicting day-to-day market actions is about as consistent as flipping a coin.

OIL

It’s been a rollercoaster ride for oil this week, and for some, the weekend can not come quick enough.

Russian exports have already fallen by about 1.6-2 mb/d via buyer’s self-sanction, so the recent price spike due to US and UK sanctions was an overshoot as the embargo was formalizing a portion of exports already lost.

With systematic strategies and news reading algos compounding the volatility and bullish sentiment, we have likely experienced several interday price overshoots via headline risk.

There is still an abundance of chatter under the surface that diplomatic efforts will prove successful in unlocking supply alternatives, with Saudi Arabia, UAE, Iran seemingly the most likely candidates.

Still, Russia remains the most significant risk for oil, and the prospect of lost production will keep a relatively high floor on oil prices. Still, an extension through this week’s highs will depend on evidence of disruption beyond what has already been factored into the equation.

GOLD

The geopolitical risk premium in gold fades reasonably quickly; however, the great unknown this time is the longer-term impact of higher commodity prices as sanctions on Russia could further disrupt supply chains which spell out non-transitory inflation any why slice and dice.

The lack of escalation on the war front and the FOMC looming where consensus is building for the Fed to adjust the dot plot higher could cause gold traders to fall back into higher yield lower gold mode.

The CPI coming in on consensus was initially interpreted as a miss( 10y yields lower), but they subsequently bounced higher as there was no attempt to sell the front end, with breakevens never really showing any signs of steepening. Suggesting there is a growing awareness of a more hawkish Fed on the dot plot front

I think bond shorts will hold through the FOMC, and this could weigh on gold provided there is no escalation on the war front. A big if, but gold could slide to $1950 into next week’s FOMC.

Into the weekend, however, I suspect the market could remain in headline defensive mode; hence gold could remain supported above $1970, which I now think is a psychological tipping point.

FOREX

On the back of a hawkish Chair Powell testimony, fewer negative headlines on the Russia/Ukraine front, a hawkish ECB (despite a confusing press conference), US CPI and a European recovery fund 2.0. US yields have fully recovered the drawdown since the Russia-Ukraine war. The next leg of yield direction will be dictated by next week’s FOMC meeting – especially the dot plot and press conference.

The OIS market thinks this cycle will only last for eight hikes, just pulling forward seven hikes to 2022 and one hike in 2023 before a cut in 2024. However, even Chicago Fed’s Charles Evans, one of the doves, said the Fed should raise rates to near 2% by the end of this year, which suggests we are likely to see a higher terminal rate in the dot plot.

Meanwhile, Chair Powell is expected to repeat his speech during the testimony by saying a 50bp hike is possible during the cycle if inflation continues to spike.

I expect the FED to remain in full-on inflation-fighting mode and expect the US dollar to remain firm next week.

EURO

The ECB was interpreted hawkishly in that APP is expected to end in Q3, which implies that a first interest rate hike is possible in the same quarter. It was highly hawkish, given the markets weren’t expecting much on the surface.

However FX market cares more about rate hikes. On that note, President Legarde’s press conference communication was an absolute shambles. It seems to me that while the ECB President expressed inflation risks, she simultaneously downplayed the statement’s hawkishness. The communication was likely perceived as confusing, which meant European risk fell under more pressure.

Traders have priced in a European recession because of the energy price shock. While oil has traded a long way off recent highs, + $90 per barrel still poses a significant economic risk.

Price action is very likely to remain driven by EU risk sentiment, particularly with the short-term pain training a squeeze through EURUSD 1.1125.

I’m turning less bearish on the Euro as EU fiscal will dominate the landscape this year, which should support growth and EU equity markets.

From Stephen Innes Managing Partner at SPI Asset Management