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War trades lose steam amid hopes for a ceasefire


Signs of progress in peace talks spread some cheer in markets

Safe havens and crude oil cool down, stocks and euro bounce back

Fed and Bank of England set to raise interest rates this week

War trades power down

Financial markets have turned into one gigantic ‘war trade’ in recent weeks. Politics has overshadowed economics, with most assets driven entirely by the conflict in Ukraine. This phenomenon is on full display today after negotiators on both sides signaled progress in the latest peace talks and kept the door open for a ceasefire soon.

With the pendulum swinging towards peace, traders are cautiously taking on risk again, increasing their exposure to European assets. The euro and stock markets in the region are flashing green today, although the gains are minor as nobody wants to bet the house on a diplomatic breakthrough while the war continues to rage.

In contrast, safe havens and war-sensitive commodities are on the retreat. Gold prices, the Japanese yen, sovereign bonds, and crude oil have taken a hit as investors take some profits off the table. The yen has been hit particularly hard, sinking to a fresh five-year low against the dollar thanks to the growing divergence between American and Japanese monetary policy.

Inflation and peace talks

There are several reasons this war is so important for markets but the primary one is inflation. The crippling sanctions on Moscow will translate into higher prices for metals, food, and energy products, which in turn are expected to keep the inflationary fire burning for a long time.

Metrics of inflation expectations have gone through the roof lately, leaving central banks little choice but to raise interest rates, even if that means accepting a higher risk of recession. With major cities in China descending back into lockdowns over the weekend, the supply chain could also remain under strain.

Higher interest rates cannot fix supply shocks and will only slow down global demand, but that’s unfortunately the only hammer central banks have at their disposal. Therefore, the war and its impact on commodity prices have a direct link to the speed of monetary policy tightening, making it the single most important variable for markets. The peace talks are expected to resume today and any more signs of de-escalation could add fuel to the latest reversals in war trades.

Huge week ahead

The Federal Reserve and the Bank of England are both set to raise interest rates this week to combat spiraling prices. This would be the first time the Fed raises rates this cycle, and with the rate hike itself already baked in, the market reaction will depend on the updated ‘dot plot’ and what Chairman Powell says.

The latest dot plot pointed to three rate increases for this year but market pricing currently implies seven, so it’s almost certain the dots will be revised higher. The question is exactly how much higher.

Overall, keep in mind that in an inflationary environment like this one, every central bank wants a stronger currency. A stronger US dollar can help cool inflationary forces faster, without the need for the Fed to tighten policy so much. This provides Chairman Powell an incentive to strike a hawkish tone this week. However, the Bank of England may be a different story.

Markets are already pricing in four rate increases over the next three meetings, which is a tall bar for the BoE to overcome. This doesn’t leave much scope for sterling to benefit from monetary policy this week. Instead, a truce in Ukraine is probably needed for a relief rally.

Source: https://www.xm.com/research/analysis/marketComment/xm/daily-market-comment-war-trades-lose-steam-amid-hopes-for-a-ceasefire-156669
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