Potential stagflation in the eurozone has spurred fear in global markets, with the Euro having lost serious ground to its peers such as the dollar, while the Russian rouble nose-dived to all-time lows amid the ongoing Russian invasion of the Ukraine. The present-day invasion of Ukraine has captured the attention of the world, including economists and analysts who try to gauge the direction of future interest rates. The inevitable fallout of the war will be a rise in inflation that will tighten the belts of corporates and, most notably, the end consumers. This article aims to address the consequences of the Russia-Ukraine crisis; as a follow-up to the latest waumonthly that discussed the particulars of the conflict unfolding in the Ukraine with the main implications being on the already inflated price level in months to come – which has already begun to unfold in the Eurozone.

We have seen volatility prevail in financial markets as indicated by the Chicago Board Options Exchange’s Volatility Index (also referred to as the VIX Index) while emerging market (EM) currencies proved to trade somewhat on the back foot relative to safe-haven currencies. This is most notable in the recent collapse of Russia’s rouble. Russia’s violent attacks on the Ukraine have sent shock waves pulsing throughout global capital markets since its initiation on 24 February, where the Russian military has since continued to gain control of regions near the Russian border, Black Sea, and Northern Ukraine. At present it is evident that Russia’s economy bears a tremendous cost as a result of various imposed sanctions and other corporates halting operations in the region. Despite the market correcting slightly since the start of the invasion, investors remain risk averse under current market conditions which thereby boosts demands for safe-haven assets – namely the US dollar, Swiss franc, Japanese Yen, various commodities, and government bonds to name a few.

It is evident that EM currencies from mineral-rich nations have been able to bypass the current bearish trend in forex markets by some degree. For example, the South African rand has appreciated by approximately 1.0% against the dollar since the start of the invasion, albeit weakening just shy of 3.0% at the peak of the invasion. The Russian rouble sank by a dismal 31% against the greenback since initiation. Recently, most consumers of crude oil products (mainly petrol and diesel) have felt the brunt as the price of Brent Crude Oil peaked to an almost 10-year high of $137 per barrel. In addition to climbing oil prices, the price of major commodities grouped under energy, base metals, industrial and agricultural products surged since the start of the invasion – with UK natural gas prices more than doubling since Germany halted the use of the Nord Stream 2 pipeline (a subsea natural gas pipeline leading from St Petersburg in Russia to Germany).

With the Federal Reserve already combatting high inflation levels in the US, BCA Research expects the Federal Reserve to proceed with tighter monetary policy in two-stages. Firstly, investors expect the Fed to raise rates as much as seven times by early 2023. Goods and services inflation will decline over the next 12 months, facilitated by the easing of supply-chain bottlenecks, this may allow the Fed to break from raising rates for most of 2023. Secondly, after raising rates modestly into 2023, to allow for a comfortable adjustment period post the Russian invasion, the Fed may resume hiking rates towards the end of 2023 or into 2024. This recommencement of interest rate hikes may take place after it is clear that the neutral rate of interest in nominal terms is closer to 3%-to-4% rather than 2% – the interest rate currently used within US markets.

Surging commodity prices, especially energy prices, will have a negative medium-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes as they try to reel in inflation from running rampant. This is illustrated in Chart 1 below. For investors to gauge the direction of inflation expectations, a key indicator used is the price of oil – a commodity which is pivotal within the global logistical network, and reflects the price hike that will ultimately be placed on the end consumer. It takes time for the global economy to adjust to such a surge in commodities, and the prices of final goods and services may only reflect the increase in months to come, regardless of whether the underlying oil price settles over the next few months. In general, inflation expectations (which can be derived from the prevailing interest rates) and oil prices appear to be significantly correlated as noted Chart 2 below.

Chart 1

Chart 2

Chart 3

In addition, the shift to a more polarised world has increased the risk of undoing the progress made towards globalization. Globalization has been the essential force restricting inflation over the past few decades. Lastly, war could encourage households to reduce their savings, as inflation slowly erodes their purchasing power. Lower savings will in turn lead to a higher equilibrium rate of interest. As we look forward, central banks around the world have the tremendous task of trying to reel in inflation without stalling economic growth. With all the uncertainty that lies ahead it is more important than ever that the world unites to relieve the undue pressure of rising prices on households around the world.