Market Pricing of the Ukraine War

What current pricing suggests about market expectations

Geopolitical risk is largely ignored by markets. The only sign of it, usually, is to be found in oil futures; such as when there is a war scare in the gulf. No more. There has been a dramatic repricing underway since Russia invaded Ukraine. The purpose of this note is to document this repricing so that we are better informed about market expectations.

We begin with rates. We obtain data on rate expectations embedded in futures prices from CME. A hike at the March meeting was priced in by January. By February, markets were pricing in a large probability of a 50 basis points (bp) hike—which seemed a bit far-fetched to your analyst. Anyway, that’s been completely priced out. Markets are now virtually certain that the FOMC will lift-off with a 25bp hike.

Repricing of rate expectations for December has been even more dramatic. By Feb, markets were pricing in 5-7 quarter point hikes; with smaller probabilities assigned to as much as 8-9 hikes, which would’ve pushed up rates above 2% by year’s end.

The next graph zooms into the action ytd. Again, the upper end of these expectations has been completely priced out since the invasion. Futures markets now expect just 5-6 hikes by year’s end. Anything above has been fully priced out. So, markets expect a much shallower hiking cycle from the Fed.

In the market’s reckoning, the Fed will have be extra cautious in light of the supply side shock. That is reasonable. The global macro environment has deteriorated markedly. At the heart of the shock is commodities, to which we turn after a brief look at equities futures.

Blue-chip equities are the principal risk assets for US investors — their bread and butter. Expectations about returns on major stock market indices have deteriorated markedly. The sell-off began in November with small cap stocks. By January, the pain had spread to large-cap US equities. Note that these futures prices have been rebased to April 2021 in order to facilitate comparison across assets.

Let’s move on to the heart of the repricing that is taking place in commodities markets. We construct sub-indices for European natural gas, European crude oil (brent), as well as five metals and fourteen major agricultural commodities in Chicago. We them combine the four sub-indices by adding them up to yield an aggregate commodities index. A graph of this index over the past decade reveals a supermassive commodities price shock that began last year, some time before the famous note on the new commodities supercycle was published by strategists on the 38th floor of 200 West.

Oil above $100 per barrel has gathered a lot of attention. But the oil price shock pales in comparison to the repricing we have seen in metals, agricultural commodities, and above all, in natural gas.

Putin’s gas weapon is at the heart of the West’s economic war conundrum. Germany and Italy are very exposed. Dutch futures, the major European natural gas futures, are pricing in a massive price shock. But more is still to come. Although German policymakers have verbally signaled the willingness to bear the cost, energy exemptions carved out in the Swift sanctions on Russian banks suggest that they’re still hoping the situation deescalates so that Putin may yet refrain from using the gas weapon. That seems quite unlikely without much progress on the diplomatic front.

Brent, the main Eurasian oil futures market, has risen in lock-step with spot prices.

I uncovered a glaring anomaly in commodities futures. Russia is the world’s largest supplier of palladium, a key industrial metal used in autos. The price of palladium futures have jumped. But the spike is minor compared to what we see in other commodities. Why is that?

Ukraine is a major exporter of wheat, the world’s principal staple. So it is not surprising that we would see a spike in wheat futures prices. Most at risk from this shock is none other than the granary of the Roman Empire, Egypt, which is now extremely reliant on wheat imports on account of massive subsidies that place bread prices well below cost. But others are not far behind. This is a world-wide shock.

Ukraine is also a major producer-exporter of soybean oil. The removal of Ukrainian supply from world markets seems to have been priced in only partially.

More worrying than soybeans, however, is the concurrent price shock in all major staples. We saw wheat futures above. Here’s corn and rice.

The price shock in the world’s staples is not solely due to the Ukraine war. Most of the repricing reflects the embedding of inflation expectations, which are rising across the world. The shock is global and particularly painful for poor countries, although the advanced economies are hardly immune.

Nor is the price shock in agricultural commodities confined to staples. Cotton, coffee, cattle, etc, have also risen sharply, again reflecting the entrenchment of expectations that inflation will persist globally for some time.

The global price shock is broad-based and affects all the key commodities. The sum of it amounts to a global adverse shock of considerable magnitude. The risk of an extended period of stagflation is now very high. It makes life extremely difficult for all inflation-fighting central banks; above all, the Fed. It has no choice but to hike in order to contain inflation, even though there is now a significant risk that doing so will push the US economy into recession. So the conjuncture has the makings of a full-blown, 1970s-style stagflation crisis. Roubini lays out the Fed’s conundrum on the pages of Project Syndicate:

A deep stagflationary shock is also a nightmare scenario for central banks, which will be damned if they react, and damned if they don’t. On one hand, if they care primarily about growth, they should delay interest-rate hikes or implement them more slowly. But in today’s environment – where inflation is rising and central banks are already behind the curve – slower policy tightening could accelerate the de-anchoring of inflation expectations, further exacerbating stagflation.

On the other hand, if central banks bite the bullet and remain hawkish (or become more hawkish), the looming recession will become more severe. Inflation will be fought with higher nominal and real policy rates, increasing the price of money, and thereby dampening the overall economy. We have seen this movie twice before, with the oil-price shocks of 1973 and 1979. Today’s re-run will be almost as ugly.

Although central banks should confront the return of inflation aggressively, they most likely will try to fudge it, as they did in the 1970s. They will argue that the problem is temporary, and that monetary policy cannot affect or undo an exogenous negative supply shock. When the moment of truth comes, they will probably blink, opting for a slower pace of monetary tightening to avoid triggering an even more severe recession. But this will de-anchor further inflation expectations.

Nouriel Roubini

Financial conditions have already deteriorated and will continue to deteriorate for some time. Risk assets will continue to move sideways, if indeed, we can avoid an across-the-board repricing of risk. Most likely, sell-off of risk assets will intensify as markets price in the full magnitude of the global price shock and the extremely difficult position that the technocrats now find themselves in.