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Weekend Edition 26-27 February 2022 (10-Minute Read)

Hello there,

A wonderful weekend to you as war clouds continue to hang like a pall over Eastern Europe and the Ukrainian capital of Kyiv remains under siege, perhaps just days before falling to invading Russian forces.

In brief (TL:DR)

  • U.S. stocks surged on Friday in a surprisingly strong comeback with the Dow Jones Industrial Average (+2.51%), S&P 500 (+2.24%) and the Nasdaq Composite (+1.64%) all ending the week higher to erase earlier losses from the initial shock of the Russian invasion of Ukraine.

  • Asian stocks closed mostly higher, on bets that the war would spur a pullback on U.S. Federal Reserve rate hike expectations.

  • Benchmark U.S. 10-year Treasury yields held steady at 1.969% (yields rise when bond prices fall).

  • The dollar pared gains as risk appetite returned.

  • Oil was lower with April 2022 contracts for WTI Crude Oil (Nymex) (-1.31%) dropping to US$91.59.

  • Gold fell with April 2022 contracts for Gold (Comex) (-2.01%) at US$1,889.34.

  • Bitcoin (+1.86%) rose headed into weekend to US$39,240 in line with other risk assets as markets shrug off the initial shock of the Russian invasion of Ukraine.

In today's issue...

  1. Could Investors Yet Find a Friend in the Fed?

  2. Is it time to panic about Ukraine yet?

  3. Regulated Crypto Derivatives Push Last Piece of Puzzle

Market Overview

Risk assets continued to rise in the U.S. for a second day as economic data and uncertainty due to Russia's invasion of Ukraine caused traders to pull back bearish bets on more aggressive rate hikes by the U.S. Federal Reserve next month.

Ukraine's capital Kyiv remains under siege and while Russia has indicated that it was willing to hold talks, there was no indication of Ukraine's leaders acceding to demands or any indication that the fighting has let up.

Western powers have upped sanctions against Russian leaders, including the foreign minister and President Vladimir Putin.

If Russian forces get bogged down in a prolonged urban conflict in Ukraine, it could deliver a major blow to global markets and slow the normalization of central bank policy that had largely been expected this year.

High food and raw material prices because of supply disruption could also put a damper on already waning sentiment.

Asian markets were mostly higher Friday, in line with the rest of the world, with Tokyo's Nikkei 225 (+1.95%), Seoul's Kospi Index (+1.06%) and Sydney’s ASX 200 (+0.10%)up, while Hong Kong's Hang Seng Index (-0.59%) was down at the close.

1. Could Investors Yet Find a Friend in the Fed?

  • Russian invasion of Ukraine could see a more dovish European Central Bank despite inflationary pressures

  • U.S. Federal Reserve policymakers are keeping their cards close to their chest, robust growth, tight labor markets and price pressures could see them hike rates, but the Russian invasion of Ukraine could temper the aggressiveness of such monetary policy moves

As Russian troops encircle the Ukrainian capital of Kyiv and despite a spirited resistance, it’s now really only a matter of “when” rather than “if” the city will fall.

Although Russian troops have not made the swift progress that their commanders may have been betting on, a badly outgunned Ukrainian resistance holds on desperately.

After a call with Chinese President Xi Jinping, Russian President Vladimir Putin has claimed that he is now opened to dialogue with Ukrainian President Volodymyr Zelenskyy, but given the urgency of the situation in Kyiv, may be a little too late.

The breadth and scope of the Russian invasion of Ukraine caught many money managers by surprise, as evidenced from the 47% drop for Russian stocks on the day of the invasion and will necessarily complicate an already tricky global economic outlook by jacking up inflation.

But other major markets are already starting to shrug off the initial shock of the invasion, with the benchmark S&P 500 dropping on Thursday but managing to end the day in the green.

Europe came under more pressure, given its proximity to the epicenter of the conflict, but looked to be recovering losses by the end of the week.

While it’s very hard, especially at the onset, to understand the impact of Europe’s largest land battle since the Second World War, some investors are already taking the opportunity to buy the dip.

There appear to be no shortage of managers who judge that that there is insufficient reason to believe this war will throw the global economy off course, especially since sanctions haven’t really bitten too substantially into Russia’s commodities trade.

And there are two ways to view this current crisis – a further prop to already heady inflation numbers, or as a potential shock to growth – and if it’s the latter, could yet see a more restrained U.S. Federal Reserve as it considers its policy path ahead.

A string of Fed officials this week already confirmed that they are monitoring the Ukraine situation closely and continue to remain nimble on policy.

Last week, President of the Federal Reserve Bank of Richmond Tom Barkin said in reference to policy direction,

“I don’t think you are going to see much change to the underlying logic (on interest rates). But this is uncharted territory so we will have to see where the world goes."

Fed governor Christopher Waller echoed such sentiments, speaking at the Economic Forecast Project, at the University of California, Santa Barbara, he noted,

“It is too soon to know how Russia’s attack on Ukraine will affect the US economy, and it may not be much easier by the time of our March meeting.”

In which case the Fed could well raise rates as planned, but perhaps not as aggressively as some market participants may have factored in at the earlier part of this year.

2. Is it time to panic about Ukraine yet?

  • Most major markets have mostly shrugged off the Russian invasion of Ukraine despite initial pullback on the news

  • Unwinding short positions may have helped to feed into the swift turnaround, as well as expectations that central banks may take a slightly more gradual approach to normalizing monetary policy

Scrolling through your social media feeds, especially those which are more professionally inclined would lead one to wonder why the global markets aren’t more rattled by the Russian invasion of Ukraine.

Because surely putting a country which is responsible for as much as 13% of corn and 12% of wheat globally at risk should have a far larger impact on markets?

Yet the benchmark S&P 500 ended the week up after a hard selloff earlier.

One possibility of course is that investors have no idea how the Russian invasion of Ukraine will pan out and so are reverting to their almost mechanical moves to buy the dip, the other of course is hedge funds closing out short positions.

Because many hedge funds were closing out short trades, reducing exposure overall given the market volatility, to cover those short positions (square off), they bought the underlying stocks and ETFs that they had bet against, buoying the entire market.

The other possibility of course is that investors just don’t think the impact of the invasion is likely to be limited and while markets are priced for a medium-term disruption, they haven’t factored in a broader disaster, like a Europe-wide continental war.

Even the flight to safety has seemed somewhat restrained – the dollar and yen have expectedly appreciated, but not to an extent that would suggest fear and panic have gripped investors.

Benchmark U.S. Treasury yields fell and gold rose, but not to an extent that would suggest the end is near.

Because it’s perhaps worth remembering that all the economic fundamentals in place before the invasion, are still very much in place today.

U.S. growth is still robust, labor remains tight, and prices remain high.

A rate rising cycle by the major central banks looms on the horizon, although the Europeans may have less stomach for hiking borrowing costs for now.

And while there is no shortage of analysts and strategists predicting that central banks will tighten on schedule, perhaps even more aggressively than markets have priced in, that assumes that the policymakers seem to operate in some sort of vacuum.

U.S. Federal Reserve officials this past week have more or less sung from the same song sheet, that they expect no material change but are keeping a keen eye on events unfolding in Ukraine.

Inflation also cuts both ways, it stymies growth and that Russia supplies 40% of Europe’s gas and 20% of its oil mean that sanctions would be akin to Europe shooting itself in the foot and taking that mauled foot off the gas of its economy at a time of elevated prices.

Because policymakers can’t control the things beyond their means, for instance an ill-advised all-out invasion of a sovereign country, they can really only focus on the things they can control – borrowing costs.

The European Central Bank has always been far more dovish than its U.S. counterpart, despite posturing prior to the invasion suggestive of a possible hawkish pivot.

But because recession risk is increasing in Europe as energy prices surge, it will hamstring the ECB’s possible policy choices, almost inevitably defaulting the central bank to maintain the current policy stance.

Markets have currently priced in a medium-term contained disruption, bad, but not the end of the world, but tail risks have increased significantly.

If the war spreads to other countries, starting with the former Soviet-bloc Baltic nations, which unlike Ukraine, are NATO members, then what started off as an invasion of Ukraine could rapidly escalate into a continental conflict akin to the Second World War.

In a year’s time, either the Russian invasion of Ukraine would have changed little about markets, or it could have been the first domino to fall in a battle that embroils an entire continent.

So while it may not yet be time to panic, it is definitely the time to start thinking about the time to panic.

3. Regulated Crypto Derivatives Push Last Piece of Puzzle

  • More cryptocurrency industry participants looking to get a piece of the regulated crypto derivative pie to cater to demand in the retail sector

  • Possibility that retail investors could have the same sophisticated derivative tools used by pros in the cryptocurrency sector soon, akin to what was seen in the FX markets

Cryptocurrency derivatives are often the tail that wags the dog, with speculation being able at times to represent (albeit notionally) more than the amount of the underlying asset that could ever exist at that point in time.

Given that the liquidity for cryptocurrencies like Bitcoin is more perceived than actual (by one measure 60% of Bitcoin wallet address over the past year have seen no transfers), derivatives can have an outsized impact on prices, sometimes even shaping prices more so than trade in the underlying asset.

But much of that trading activity exists outside the realm of the highly regulated U.S. derivatives market, with traders taking on the counterparty risk of offshore entities in exchange for the prospect of massive windfalls.

According to data provider CryptoCompare, volumes in crypto derivatives reached almost US$3 trillion last month, almost double the entire market cap of the cryptocurrency universe and taking place almost exclusively on unregulated forums.

As the cryptocurrency industry switches its T-shirts for suits, some companies are leaning into regulated markets, to build a bigger use base and to challenge existing financial institutions that offer trading in equities and other financial assets.

Coinbase Global (-1.52%), a U.S.-listed cryptocurrency exchange last month agreed to buy FairX, a small Chicago futures exchange, to make the derivatives market for crypto “more approachable.”

The Coinbase Global move comes after rival cryptocurrency exchange struck a deal last year to buy IG Index, while CBoE bought ErisX, a digital assets trading business and FTX US scooped up derivatives platform LedgerX.

Derivatives allow traders to borrow to magnify bets on financial assets, and while available for almost all manner of traditional financial products, have remained elusive for cryptocurrencies on regulated forums and out of reach for retail investors.

In the United States, cryptocurrency exchanges can’t offer leverage without first being regulated with the Commodities and Futures Trading Commission as a regulated futures commission merchant, which explains why many are buying licensed entities to overcome those gaps.

But retail traders have long been a major source of demand for crypto derivatives.

Last year, amidst soaring cryptocurrency prices, demand for derivatives to goose up bets pushed higher on exchanges like Binance, FTX and OKEx.



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