The Federal Reserve is predicted to increase interest rates in the upcoming week due to the added uncertainty caused by the Ukraine crisis.

• The Federal Reserve is expected to increase interest rates by a quarter-point on Wednesday, which may not cause a significant reaction in markets as it is the first increase since before the pandemic.
• Despite the market volatility caused by Ukraine's ongoing turmoil, investor focus remains on the country.
• The central bank is expected to raise interest rates, and investors will monitor its comments on inflation, the economy, and future rate increases.

While uncertainty over the Ukraine crisis persists, investors may view the Federal Reserve's first post-pandemic interest rate hike as manageable.

The Fed is expected to announce a 0.25% increase in its target fed funds rate at the end of its two-day meeting on Wednesday, along with new forecasts for interest rates, inflation, and the economy.

In the upcoming week, several significant economic reports will be released, including the producer price index on Tuesday, retail sales on Wednesday, and existing home sales on Friday.

Next week, the Fed will likely raise interest rates by a quarter point and then take a backseat to monitor events in Europe, according to Steve Massocca, managing director at Wedbush Securities.

The Russell 2000, which outperformed the three major indexes, lost 1% for the week, while the worst performer was the stock market with a 3.5% decline.

The sudden increase in oil prices caused concern among investors, as crude reached $130 early in the week but dropped below $110 by Friday.

Energy stocks were the top performers, up nearly 1.9%, while the broader market was down about 2.9% for the week.

Fed ahead

The uncertainty surrounding the effects of Russian sanctions on commodities markets and the unclear resolution of the conflict in Ukraine may contribute to continued market volatility.

The guidance on the Ukraine crisis and its impact on interest rates will be closely monitored through the central bank's statement and Fed Chair Jerome Powell's comments on Wednesday.

Mark Cabana, head of U.S. short rates strategy at Bank of America, stated that his guidance is likely to be similar to what he said in his congressional testimony. He pointed out that the downside risks to the growth outlook have increased, while the upside risks to inflation have risen.

The conflict between Russia and Ukraine has caused a surge in commodity prices, exacerbating inflation, with February's consumer price index rising by 7.9%. Economists predict that the increase in gasoline prices could push it above 9% in March.

The price of unleaded gasoline at the pump increased by nearly 50 cents in the past week, reaching $4.33 per gallon, as reported by AAA.

While market experts view rising inflation as a driving force behind the Fed's decision to increase interest rates, uncertainty about the economic future may prevent the central bank from raising rates as much as some economists predict, with seven rate hikes forecast for this year.

The Fed is predicted to increase interest rates five times in 2022 and four more times in 2023, according to Cabana. Previously, the Fed had forecast three hikes in both years. Cabana stated that the Fed may reduce its forecast for 2024 to only one hike from the two it had previously predicted.

The Fed plans to reduce its nearly $9 trillion balance sheet by replacing maturing Treasury bonds and mortgages as they roll off, a process known as "quantitative tightening," or QT. Officials have said they would like to begin this process this year after they start hiking interest rates.

Our base case is that QT will be ready to be flipped in May, but we acknowledge that there is a possibility that this may be delayed later. If the Fed determines that it is unable to raise interest rates as much as it had hoped, it may choose to postpone shrinking the balance sheet immediately, which would result in a looser policy.

Bond market liquidity

Bond yields reached their highest level of 2% on Friday, after earlier falling below 1.7% this month as investors sought safety in bonds. Yields move inversely with bond prices.

Treasurys behave differently in an inflationary environment than in a flight to quality asset, according to Cabana. This is a different dynamic than what has been observed, and while there may be a flight to quality into Treasurys, they are reflecting higher inflation expectations.

The uncertainty in Ukraine is causing concern in the markets, as evidenced by the less liquid Treasury market.

The Treasury market has become more volatile, with bid-ask spreads widening and some traditionally less liquid parts of the market becoming less liquid, such as TIPS and the 10-year note. Market depth is also thinning out, which is attributed to elevated uncertainty and a lack of risk-taking willingness by market participants. This should be a concern for the Fed.

But Cabana said markets are not showing major stress.

"Although there are no indications of impending financial collapse or increased counterparty credit risks, it is clear that things are not going smoothly," he stated.

"Funding markets are showing a premium for dollars, with people paying a lot to obtain them, just as they have since Covid," he stated.

The Fed is being sought for reassurance by the market regarding its monitoring of the conflict in Ukraine, according to Cabana.

It is unlikely that the market would be upset if the Fed reflected a high degree of confidence in one direction or another, he said.

Dollar strength

The dollar index increased by 0.6% during the week and has been rising since Russia's invasion of Ukraine. The index measures the value of the dollar relative to a basket of currencies, with a significant portion of its weight being the euro.

Bannockburn Global Forex's chief market strategist, Marc Chandler, notes that while the dollar funding market is experiencing some pressure, it is not yet strained.

The dollar's strength is evident as it reaches five-year highs against the yen, despite the risk-off environment.

If the dollar follows its typical pattern of weakening after an interest rate hike, it may do so in the upcoming week, as stated by Chandler.

He remarked that it's typical for the dollar to increase before the rate hike and then decline afterward, which may be due to the buy the rumor, sell the fact on the Fed.

Oil on the boil

This week, oil prices surged to their highest point since 2008 due to concerns about a potential oil shortage resulting from sanctions on Russia. Fear of violating financial sanctions has caused buyers to avoid purchasing Russian oil, and the U.S. has announced plans to ban such purchases.

At the start of the week, the price of oil per barrel was $130.50, but by Friday it had decreased to $109.33.

Helima Croft, head of global commodities strategy at RBC, stated that the market's bid up to $130 was premature, as the U.S. ban on Russian oil only affected a portion of the market. She noted that the run-up in prices on Monday was due to market players speculating about a broader embargo on Russian oil, including Europe, its main customer.

She stated that the market is currently too extreme, either way, and she believes it is justified at $110. Additionally, she thinks it is justified to go over $100, and she doesn't see an off-ramp in the near future. Furthermore, she believes there is room for the market to continue rising.

Week ahead calendar

Monday

Earnings:

Tuesday

FOMC meeting begins

Earnings: Volkswagen

8:30 a.m. PPI

8:30 a.m. Empire State manufacturing

4:00 p.m. TIC data

Wednesday

Earnings: DouYu, PagerDuty

8:30 a.m. Retail sales

8:30 a.m. Import prices

8:30 a.m. Business leaders survey

10:00 a.m. Business inventories

10:00 a.m. NAHB survey

2:00 p.m. Federal Reserve interest rate decision and economic projections

2:30 p.m. Briefing by Federal Reserve Chair Jerome Powell

Thursday

Earnings: Accenture, Commercial Metals, , Dollar General. ,

8:30 a.m. Initial jobless claims

8:30 a.m. Housing starts

8:30 a.m. Philadelphia Fed manufacturing

9:15 a.m. Industrial production

Friday

10:00 a.m. Existing home sales

2:00 p.m. Chicago Fed President Charles Evans