Mike Dolan

LONDON, (Reuters) – Global investors are more worried about a monetary policy mistake than usual.

They are inextricably intertwined at the moment.

Over the past week, world markets were agitated by fears that Russia would invade Ukraine. Along with these concerns came the risk of a confrontation between NATO nuclear powers and Moscow.

The price of oil rose to $100 per barrel, and market tensions over the U.S. Federal Reserve’s (and other central banks’) ability to rein in inflation at 40-year highs went up.

There was confusion as the talk of emergency interest rates rising and surging crude oil prices led to bond yields going higher as many sought safety there because of the risk of conflict.

Surging volatility was the result in U.S. Treasury market markets where MOVE index implied volatility reached its highest level since March 2020’s COVID shock.

However, where should you focus your efforts? Bank of America (NYSE) surveyed more global fund managers this month and identified “monetary risk” as the greatest threat to financial markets stability. This is in contrast to geopolitical credit, trade, or business cycle risks.

Even though the survey was done before Ukraine tensions escalated, net 64% of respondents considered inflation and hawkish central banks to be the greatest “tail risks.” Only 7% chose to support the Russia-Ukraine war.

This angst resulted in the largest net cash readings for portfolios since the first pandemic, increased recession fears and the largest net percentage of funds betting against a flat yield curve since 2005.

Investors are concerned about central bank policy mistakes, partly due to geopolitical and pandemic distortions. Inflation surge misinterprets and central banks tighten too quickly or too soon – or underestimate it – allowing high inflation to grow and forcing them to work harder to control the situation.

Both are not great options for holding bonds and equities.

(Graphic: Crude base effects and inflation expectations,https://fingfx.thomsonreuters.com/gfx/mkt/jnvweldayvw/Three.PNG)

(Graphic: Treasury bond volatility and the Yield Curve, https://fingfx.thomsonreuters.com/gfx/mkt/zgpomjxnrpd/Four.PNG)

SELF-FULFILLING

These fears were only reinforced by the remarks made over the week by James Bullard (St Louis Fed Chief and Voting Fed Policymaker) – who sparked frantic market talk about the first inter-meeting Fed increase in nearly 30 years.

Bullard indicated that he supports a full percentage-point increase in Fed’s main Interest Rate by Midyear. It is because Fed’s credibility “is on the line”.

Although some investors are skeptical about the Fed being aggressive enough, it is unnerving for central bankers to act in order to appear to markets, governments, and the general public as “doing something”. Even though their analysis suggests that there’s very little they can do, or to reduce an energy shortage, or to address geopolitical shocks.

Spooking markets can also have their own dynamic if authorities decide to follow suit.

Tiffany Wilding, PIMCO’s director of marketing and communications, said that she doesn’t see any chance for an intermeeting Fed increase. She also doubts the Fed will choose to give a substantial 50 basis point hike in March.

She said that even though the ride on U.S. bonds was extreme, it could be dangerous for investors. “Market pricing may become an self-fulfilling prophecy.”

Salman Baig, Unigestion Multi-asset Manager, believes that the Fed will be more patient than the markets and have more patience.

However, he said: “Tightening into slowing growth risks further slowdown. There is a concern that a policy misstep could result in a significant reduction to 2022 earnings.”

All the movement and furtiveness of eastern European troops and tanks can play an important role in the seeding of such an error.

However, there have been concerns about price rises. Market and policymakers believed that even a flatlining crude oil price would cause annual base effects to be crushed in the first quarter of this year. This would reduce inflation pressure in all areas in 2022.

The 35% rise in Brent crude oil over the last month was largely due to Ukraine tensions. They have ended that hope. Together with Omicron’s wave of COVID this likely played a key role in Fed’s hawkish turn around New Year.

An increase in year-on–year oil price growth has not subsided – closely linked to inflation expectations from bond markets. They have been hovering around 45% since November. These gains would be lost if they had been maintained at November’s late prices.

Brent’s 5% decline on Tuesday in spite of a tentative de-escalation from the Ukraine standoff is a glimpse at how significant the current oil spike was due to these tensions. Indeed, many fund managers raised oil exposure as a hedge against geopolitical tensions.

This is due to Europe’s quadrupling in prices in the last year. Tuesday’s Ukraine relief saw an almost 10% decline in these.

These monetary and geopolitical risk are interconnected and difficult to separate. The risk of hawkish error could be increased by war and an energy crisis. To confirm the year’s end, it may be worth avoiding them.

(Graphic: BofA chart on funds’ fear of monetary policy risks, https://fingfx.thomsonreuters.com/gfx/mkt/gkvlgjydopb/One.PNG)

(Graphic: BofA chart on funds’ yield curve expectations, https://fingfx.thomsonreuters.com/gfx/mkt/znpnejaxdvl/Two.PNG)

The editor-at-large of finance and markets for Reuters News is the author. All views and opinions expressed in this article are the author’s.

(By Mike Dolan. Twitter (NYSE): @reutersMikeD. Editing by David Holmes