Morgan Stanley Flips on Rates as Ruble Hits Bonds: Russia Credit

The plunging ruble is prompting Morgan Stanley to switch its interest-rate forecast to an increase from a cut as inflation risks mount, punishing holders of Russian bonds already roiled by rising tensions with Ukraine.

The ruble, set for the biggest drop against the dollar this month among 31 major currencies tracked by Bloomberg, tumbled to record lows this week as Russia conducted military exercises near its border with Ukraine, where gunmen occupied a regional parliament building and airport in the Crimean peninsula. The slide is stoking inflation concern, jeopardizing the central bank’s 5 percent target for consumer-price growth this year. Policy makers suggested they may need to lift borrowing costs.

“Recent ruble weakness is sparking the risk that inflation will accelerate over the next few months,” Dmitry Dorofeev, a money manager at BCS Financial Group in Moscow, said in e-mailed comments on Feb. 25. “This may force the central bank to temporarily raise rates. The biggest losers are the medium-dated notes, where local players dominate.”

The currency depreciated 0.5 percent to 42.2585 against Bank Rossii’s target basket of dollars and euros at 2:23 p.m. in Moscow, heading for another record-low close. It has weakened 2.6 percent against the greenback this month, while Russia’s local-currency bonds lost 2.7 percent in dollars, the worst performance in the Bloomberg Emerging Market Local Sovereign EMEA index. The gauge is up 2.6 percent in February.

‘Game Changer’

This year’s depreciation is a “game changer” that will lead to higher inflation and a 50 basis point, or 0.5 percentage point, interest-rate increase by the end of June, Morgan Stanley analysts led by Jacob Nell and James Lord said in an e-mailed note on Feb. 24. They revised an earlier call for a half-percentage-point rate cut in the second half of 2014.

Such calls are weakening Russia’s shorted-dated government notes most, compressing the spread with longer-dated securities.

The extra yield investors demand to hold 15-year government bonds over five-year debt declined to 55 basis points today, the lowest in 13 months, data compiled by Bloomberg show.

“A weaker ruble with pass-through effect into inflation and more hawkish comments from the central bank have pushed up the short end of the curve,” Jetro Siekkinen, an emerging-market bond manager in Helsinki at Aktia Asset Management, which has about $10.5 billion in assets, said by e-mail on Feb. 25.

Armed Gunmen

Ukraine’s acting president Oleksandr Turchynov said Russian soldiers were “directly involved” in a conflict in Crimea as armed troops wearing uniforms without insignia guarded the region’s main airport in Simferopol.

This week gunmen occupied the Crimean parliament in the same city after the ouster of Ukraine’s pro-Moscow President Viktor Yanukovych following months of anti-government protests.

Russia, whose Black Sea fleet is based in Crimea, put fighter jets on combat alert yesterday as part of its military drills, Interfax news service said, citing the Defense Ministry.

“The market is really afraid because it doesn’t understand what’s going on,” Vadim Bit-Avragim, who helps oversee about $4.2 billion at Kapital Asset Management in Moscow, said by phone yesterday. “All investors are pricing in the possibility of Russia’s military intervention in Ukraine.”

‘Credibility’ Issue

Russia’s benchmark Micex stock index snapped four days of declines, rising 0.1 percent today. The additional yield on Russian dollar bonds over Treasuries declined three basis points to 244, according to an index compiled by JPMorgan Chase & Co.

The yield on bonds due February 2027 rose two basis points to 8.46 percent today, equal to a 19-month-high set last week. The share of non-residents in the 3.7 trillion local ruble bond market fell to 23.9 percent on Jan. 1 from 28.1 percent on May 1, according to central bank data.

Russia’s inflation rate may rise above 6.5 percent in March and April, from 6.1 percent in January, pushing Bank Rossii “to hike to maintain its credibility,” according to Morgan Stanley’s note. Rates will stay on hold in the second half of 2014 before a gradual, 100 basis-point easing cycle “once inflation is in line with the target,” the analysts wrote.

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