RUSSIA-UKRAINE - NOT A MAJOR CREDIT RISK EVENT

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The Russian invasion of Ukraine is a serious geopolitical crisis with far reaching consequences. It will hurt near-term economic performance, especially in Europe, and provide an additional impetus for global investors to lower their risk exposure.

So far, the situation in markets seems to be mostly orderly. Sales of equities as market participants rush into safe havens such as US Treasuries and gold is a standard reaction to a crisis with elevated uncertainty. Despite the losses involved, this should not cause any lasting economic damage. But after the painful experiences of the Global Financial Crisis and Eurozone Debt Crisis, we need to ponder whether credit markets are at risk whenever major adverse shocks happen.

In our view, the risks to global credit and money markets (excluding in Russia which will duly suffer under western sanctions) are minimal. With their ample means, major central banks including the Fed, the ECB and the BoE can and would take any measures necessary to ensure that these crucial parts of the global financial infrastructure continue to function smoothly.

Recent trends in credit markets show a normal reaction to upcoming monetary policy normalisation

In Charts 1-6 we show some key measures of credit market conditions in the US and Europe.

Charts 1 and 2 show that spreads in US and Eurozone overnight markets remain at ultra-low levels despite edging a little higher in recent weeks in response to growing expectations that western central banks will start to reverse some of their monetary accommodation.

While spreads in Eurozone bond markets have widened recently – Chart 3, this is part of a return to a more normal economic environment as bond yields rise across the bloc. Crucially, the widening is not a panic response to rising expectations that the ECB end its net asset purchases (likely in Q3). It does not pose an imminent threat to fiscal sustainability in the periphery.

Similarly, the gradually rising cost of insuring against corporate default in US high yield (Chart 4), US investment grade (Chart 5) and European investment grade (Chart 6) corporate bond markets reflects the return of market discipline in pricing such paper as central banks take a step back.

The lesson of the pandemic

March 2020 almost turned into a real credit event. As the charts below show, credit markets started to freeze fast once investors surmised that shutting down major economies would trigger a cash flow crunch on an unparalleled scale. Questions such as whether businesses and workers would get paid briefly seemed to turn into legitimate fears. However, central banks - with the help of governments - ended the initial bout of panic fast. Within days things started to return to normal.

In case of any credit stresses in coming days, central banks could and almost certainly would take care of dislocations. With their vast array of tools, central banks in advanced markets have a virtually limitless capacity to intervene in money markets at a moments notice. High rates of capitalisation and huge excess reserves in the US and European commercial banking systems should prevent any temporary credit market volatility from turning into an impediment to credit supply to the real economy.

Consequences of high inflation – risk to equities, not credit

Could the surge in inflation on both sides of the Atlantic stop or limit central banks from intervening in money and credit markets? Not in our view. While inflation constrains monetary policy, it does not constrain central banks actions to maintain financial stability.

Instead of the Fed or ECB buying more bonds following the Russian invasion – which one might have expected up until recently – central banks this time around will likely continue to normalise their policies, albeit with some additional caution around near-term moves especially in the case of the ECB and the BoE. In times of heightened uncertainty, the ECB will likely want to keep its options open even more than before. This poses a potential challenge for equities, which may need to find a bottom on their own (unless things were to get so bad that the spill-over of paper losses for corporates were to become a serious risk to economic performance on its own). But a reluctance to buy more bonds amid elevated inflation is a very different issue from the ability and readiness of central banks to act to alleviate potential money and credit market stresses that could otherwise unsettle economies. Hypothetical examples would be for central banks to act as an emergency counterpart in currency swaps or to meet any short-term increase in demand for reserves until stresses ease

Chart 1: EURIBOR-OIS three-month spread