GLOBAL CREDIT BULLETS | Monday, 21st March 2022

Ukraine – Early for negotiation hopes.
Last week, markets rallied on hopes on the ongoing negotiations between Russia and Ukraine. Early in the week, the Ukrainian delegation has opened on a few sticking points, particularly the commitment to drop NATO membership aspirations. The increased frequency of meetings between negotiators and softer comments from Russian high ranks have corroborated hopes. In fact, we think some ground is still to be made before we reach a proper deal. There is no clear convergence on any territorial split, and Russia will arguably try to sit at the table in the strongest possible position, to maximize chances of persuading Western leaders to curb back sanctions. Both factors point to a few weeks of tension ahead before we can talk about a deal. News on the ground is in line with this view. Military action around the main cities (especially in the East) has intensified over the past days, with tensions on the rise in the Western part of the country too. Top-down politics does not suggest a brighter outlook: the tone of contacts between the Kremlin and European leaders is not improving, and the Biden-Xi meeting last Friday failed to provide a clear breakthrough. Overall, we see another few weeks of conflict as likely. However, the cost for Russia of a protracted conflict is high, militarily and economically, suggesting some form of deal is likely in the near-to-medium term.

Russia – Postponing default.
The well anticipated sovereign default of the Russian Federation has not taken place, for the time being. The Federation was finally able to pay $117mn in coupons to bondholders last Wednesday. The payment was in doubt due to a combination of reduced willingness of the Minister of Finance to keep the country currency, and objective payment difficulties due to the newly installed sanction regime. We believe uncertainty over future repayments remain high, despite the paid coupon last week. In April, Russia will need to repay a relatively large maturity, with $2bn coming due. The appetite for this payment may not be too high in a context where tensions with the West remains high. Moreover, external debt coming due over the next 12 months amounts to $80bn, equivalent to c.60% of the current account. If Bank of Russia reserves remain frozen, payments may become increasingly more difficult, especially as the economy gradually enters a recession and the ruble stays weak. In other words, the current situation is not sustainable for the sovereign, both in terms of politics (willingness) and economics (ability) of repayments. We remain cautious on Russian assets and see strength in CDS or the currency as opportunities to add protection.

Fed – Let hikes start.
Last Wednesday, the Federal Reserve has started its hiking cycle after two years of extraordinarily easy monetary policy. The hike brought rates from 0% to 0.25%, as expected. Overall, the decision brought hawkish surprises. Fed’s own forecasts shows now seven hikes this year, two above consensus and basically one per meeting. Also, some forecaster predicts a higher amount, suggesting space for hawkish surprises. Finally, quantitative tightening may come as early as May, instead of in summer or later, as previously thought. The Fed’s communication thus remains consistent with previous guidance, despite the war in Ukraine. The ECB meeting two weeks ago set an outlook along similar lines, suggesting inflation concerns now firmly trump growth scares in the mindset of global central bankers. Rates markets are now pricing a good number of hikes. Still, the long bonds lagged the front-end, with global curve at historical flats. This may suggest either a market concern for global growth or an incorrect pricing of forward inflation. We believe the second is right. Consensus forecasts for 2023 inflation remain well below spot, and inflation swap curves are inverted. In other words, markets are still pricing a rapid fall in inflation once commodity markets normalize, and hence a partial reversal to the 2010-2020 regime. We fundamentally disagree with this market perception, as core inflation pressures are building up too, and supply-driven commodity booms are not as quick to revert as demand-driven ones, historically. We thus think inflation expectations will need to adjust higher, adding to the case of higher long-end nominal rates. We continue to remain cautious on rates plays, including developed markets government debt, low yielding / IG credit and long duration bonds. We see value in spreads of limited areas of credit markets and maintain portfolio duration as low as possible.

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Algebris Investments’ Global Credit Team