Introduction

The Russian invasion of Ukraine has reverberated through financial markets. Russian ambitions indicate a replacement of Ukraine's government and its demilitarisation. Relations between the two countries have been antagonistic since Ukraine's pro-Russian president Victor Yanukovych's toppling during the "Revolution of Dignity" in February 2014. Yanukovych had refused to sign a political association and free trade agreement with the EU, which enjoyed the support of the Ukrainian parliament. Russia viewed the ousting as a threat to its national security as Ukraine moved closer to a future with the EU and NATO. This "westernisation" culminated in 2019 with amendments to the Ukrainian constitution, leading to an irreversible strategic course towards EU and NATO Membership (wikipedia.org).

Earlier today, President Putin announced on television that he decided to "carry out a special military operation" in Ukraine. As a result, there are explosions in Kyiv, Kharkiv, Odesa, Mariupol, and Kramatorsk. According to the Russian defense ministry, Ukrainian military infrastructure and its air defenses were damaged.

The question of potential retaliation introduces several scenarios. Latvia, Poland, Lithuania, and Estonia have invoked Article 4 of the NATO treaty. This states that "[t]he Parties will consult together whenever, in the opinion of any of them, the territorial integrity, political independence or security of any of the Parties is threatened." Ukraine is not a member of NATO but has sought membership as per its amended constitution. The consultation focuses on reinforcement and deterrence, suggesting concern that Russia's invasion will continue beyond Ukraine's borders. This scenario seems remote as it would trigger Article 5 – an attack against any alliance member is an attack against them all. As Ukraine is not a member of NATO, it is not protected by Article 5 (cnbc.com).

Oil Prices & The Stagflation Scenario

At this point, sanctions seem to be the primary response by the west. However, these may be limited due to the current level of global inflation. Brent is trading at $103/barrel, and WTI is at $97/barrel, with telling risk premiums discounting into price over the last 24 hours. Meaningful sanctions that disrupt crude supply will see these risk premiums necessarily increase as an already tight energy market becomes tighter. This type of supply shock introduces the possibility of stagflation into the economic equation. Policymakers tend to operate on the demand side of the economy. Since sanctions will impact the supply side, this essentially leaves monetary and fiscal policy largely impotent.

Germany, Europe's largest economy, receives 35% of its oil, 50% of its coal, and 55% of its natural gas from Russia. To offset any disruption due to sanctions will require stockpiling of these resources, which will take time. The US may coordinate the release of oil reserves. Still, on a macro level, these are unlikely to provide a price ceiling for long (estimates are for 50 days if all US reserves are deployed) and will replenish these at higher prices (www.forexlive.com).

Soft Commodities (Daily)

The chart below shows the price of wheat on the left and the price of corn on the right. Both traded limit up on the news of the invasion, the expansion in their respective Bollinger bands indicative of the increase in volatility. Given that Ukraine makes up 29% of global wheat exports and supplies 19% of the world's corn (www.forexlive.com), the attack triggered a significant increase in their respective risk premiums.

Stock Markets (Weekly)

The left chart shows FXCM's CFD for the S&P 500 (SPX500), and the right is its CFD for the DAX (GER30). Both indexes have a lower peak followed by a lower trough (the DAX has a series of lower peaks followed by lower troughs). This is the classical technical definition of a downtrend and is a bear market until proven otherwise. The danger lies in their stochastics. If these move into their respective lower quintiles and hold (green rectangles), bearish momentum will be building in both the S&P 500 and the DAX. This bearishness will apply pressure to both indexes downwards. In addition, the Russian invasion of Ukraine has likely increased the risk premiums of risk valuation models, which in turn has lowered the present values of risk assets and their indexes, such as SPX and DAX. If the risk premiums continue to build, this will further reduce the present value, and the respective stochastics will likely maintain in their lower quintiles.

Safe Havens (Weekly)

The chart on the left is FXCM's dollar basket, USDOLLAR, and the chart on the right is its gold CFD, XAUUSD. These two instruments show strength; however, we believe that one will outperform the other. The USDOLLAR has charted a series of higher trough followed by higher peaks on the weekly. This is a defined uptrend on a longer timeframe. XAUUSD (gold) has charted a higher trough followed by a higher peak, indicating that the precious metal is trending up on a longer timeframe. Their respective stochastics will be an essential indicator to follow. These two instruments typically have an inverse relationship. The fact that they are trending up together is uncommon. Typically, one should outperform the other. If the demand for the greenback outstrips, this will reflect in the USDOLLAR's stochastic, as it moves above 80 and holds (left green rectangle). If the demand for gold is in excess, XAUUSD's stochastic will maintain its upper quintile. If stagflation manifests, monetary policy will limit due to sanctions, and gold may be more desirable. However, if supply-side inflationary pressures ease, central banks are likely to continue tightening demand, which will likely benefit the greenback.

Conclusion

This escalation between Russia and Ukraine to military conflict has led to a risk-off sentiment in the financial markets. How the West reacts will be of interest. The reliance on Russian exports, especially given the inflationary environment, implies limited sanctions. One may be forgiven for surmising that President Putin knew this in timing his invasion.

Featured Image by FelixMittermeier from Pixabay