Head of Fixed Income Strategy
Summary: The bond market is signaling that the recent invasion of Ukraine will bring higher inflation and slower growth, increasing stagflation probabilities. Meanwhile, the cost to insure Russian bonds has risen to the highest since the 2008 global financial crisis, weighing on emerging markets' cost of funding, particularly in hard currency. Escalation of tensions in Eastern Europe challenges the corporate bond space on both sides of the Atlantic as credit spreads widen to the highest level since the 2020 pandemic.
The Russian invasion of Ukraine is a game-changer for central banks' monetary policies worldwide; that's what the bond market says. Inflation pressure will soar and remain sticker, and central banks will not be able to be as hawkish as initially expected due to a considerable slowdown in growth.
Short-term breakeven rates rose to their highest on record, with the 2-year German breakeven rate rising to 3.5%, the 2-year US breakeven approaching 4% and the 5-year UK breakeven rate hitting 4.8%.
The breakeven rate is the difference between nominal bond yields and the yield of an inflation-protected bond. It tells the market's inflation expectations at a specific time in the future. Interestingly, a fast drop in real yields has led to today's sudden rise in breakeven rates. The bond market tells us that central banks will not be able to fight inflation with an aggressive rate hiking cycle without hindering risk assets' discount margins and growth. The risk of stagflation has risen sharply.
Although nominal yields have dropped across the whole yield curve on the safe-haven demand, their fall has been contained as markets believe that sticky inflation will force central banks to implement tightening policies regardless of growth.
Therefore, the bias for flatter yield curves remains intact, significantly if the situation worsens. As Steen Jakobsen, Chief Investment Officer at Saxo Bank, highlighted in a recent piece: “Western powers will have to hurt themselves if they are to hurt Russia as new sanctions are likely to affect the flow of commodities itself and possibly Russia’s financial system and its access to the world”. Basically, there is a high probability that inflationary pressures might worsen.
Markets are also pricing the risk of a Ukrainian invasion and more sanctions on Russia. The Russian CDS spread has risen to 880bps, the highest since the 2008 global financial crisis. At the same time, eurodollar Russian bonds with 2027 maturity dropped to 60 cents on the dollar. To suffer the most, however, is Ukraine's 2033 eurodollar bonds dropping in distress territory at 38 cents on the dollar.
Although it's quite natural to see the above happening, it's important to keep in mind that these developments increase emerging markets' cost of funding, causing problems within this space.
A problem that many are overlooking is that the current situation is adding pressure on an already difficult credit market. Junk bonds haven’t priced in the primary US bond market since February the 10th. After a two-week lull, Twitter was the first corporate to sell $1 billion junk bonds. Yet it cannot be taken as a bellwether, as Twitter is a well-known name in the junk bond space. Today's issuance of BellRing Brands will be more noteworthy, as it will show whether appetite for junk remains sustained despite widening credit spreads and volatility.
The same can be said about Europe despite a junk bond sale deal priced last week. Choppy primary bond markets are a huge red flag for the corporate bond space and central banks, which aim to maintain the smooth functioning of markets.
We believe that the evolving macroeconomic backdrop will deteriorate demand for junk bonds. A tantrum is almost inevitable as stagflation risks become more evident.
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