Head of FX Strategy
Summary: The Russian invasion of Ukraine took the euro down just after the currency had begun mounting a significant recovery attempt in anticipation of a shift toward tightening from the ECB at its March 10 meeting. The ECB did make a reasonably hawkish shift given the uncertain backdrop, but more important still has been Germany - within days of the Ukraine invasion - promising massive fiscal outlays to address its energy and defence vulnerabilities. The EU has joined the call and will fund large new fiscal initiatives with joint debt issuance. All of these fiscal moves will profoundly deepen EU capital markets and could provide a long-term boost for the euro. If the terrible fog of war hopefully lifts soon, the conditions are promising for the euro to reprice significantly higher.
It is important when studying markets to always consider what is “in the price”, or what the market is expecting to happen in the coming six to twelve months rather than the current lie of the land. This is particularly important as we are on the cusp of an expected significant monetary policy tightening in the US and elsewhere. The outlook for the ECB is directionally similar, but less certain. That is largely because the eurozone and its periphery are the economic areas most beset with uncertainty and direct exposures from any further fallout from the war in Ukraine. The situation can change dramatically from the time this is being written, either for the better (détente/peace) or for the worse (a complete severance of energy deliveries from Russia). That should mean that the potential range of euro outcomes is extremely wide over the next one or two quarters. But already baked into the cake is a profound support for the euro: a massive new fiscal programme led by Germany, which is promising approximately 5 percent of GDP in new spending to address energy, defence and other vulnerabilities made painfully evident by Russia’s invasion of Ukraine.
The most supportive combination for a currency is tighter monetary policy and looser fiscal policy, and the eurozone is set to move the most in the fiscal direction over the coming year at least. The ECB monetary policy can play some reasonable catch-up once the war in Ukraine hopefully disappears as a factor, even if difficult relations with Russia—and a cloud over its energy exports into Europe—could remain. The ECB signalled a far more rapid quantitative tightening schedule at its March meeting than was expected and is clearly ready to hike as soon as it has stopped expanding its balance sheet by Q3. We could be headed to a positive ECB policy rate by year-end if the war in Ukraine has ended by then. And to emphasise the fiscal policy differentials with elsewhere, let’s compare the new EU fiscal largess with an outright fiscal cliff in the US. Fiscal outlays are likely frozen because of political gridlock within the Democratic party and are unlikely to improve after the mid-term elections, which is likely to put one or both parties of Congress under Republican control. So, while a major further downdraft in the euro is certainly possible in the coming quarter if the impact we saw in the first two weeks of the war in Ukraine returns and deepens, the fundamentals for the euro have shifted profoundly to the positive. EU existential risks have receded decisively as Russia’s aggression has sparked deepening fiscal integration. The new EU and especially German fiscal outlays will deepen EU capital markets, keeping more capital at home rather than recycled abroad. The euro is primed for a strong comeback if the fog of war lifts soon.
Chart: looking up for the euro? The euro has been weaker than it was shortly after the Russian invasion of Ukraine this year on only two occasions since the early 2000s—and the EU sovereign debt crisis of 2010-12 was surprisingly not one of those times! Rather, the first time was the episode starting in 2015 when there was remarkable policy divergence between a tightening Fed and the Draghi ECB finally rolling out its tardy QE policy. Then there was the brief new low at the pandemic outbreak. From here, we are far more constructive on the euro’s potential, especially from the angle of fiscal policy divergence. The EU is moving aggressively on the fiscal front with new spending priorities on energy and defence sparked by Russia’s invasion of Ukraine, while a considerable fiscal drag is set to deepen for the US and the UK, for example. The chart is of the JP Morgan real effective, CPI-adjusted Euro.
Many suggest that the coordinated sanctions against Russia’s central bank assets in the wake of its invasion of Ukraine are a once-in-a-generation historic development, perhaps on a par with Nixon’s closing of the “gold window” that effectively ended the Bretton Woods system in 1971. Certainly, any nation that accumulates significant reserves and thinks that it could risk falling foul of Western alliances will find it unacceptable that its financial system and economy could prove as vulnerable as Russia’s.
China in particular, as the world’s largest holder of foreign reserves and in increasing rivalry with the US, will likely see the actions against Russia’s central bank as a massive wake-up call that will make it want to move as quickly as possible away from reliance on the US dollar. On top of that, with the explosion of commodity prices and the lack of US fiscal discipline, any major holders of USD and other fiat FX reserves may want to diversify out of holding negative-yielding fiat assets and invest in commodities and other hard assets and productive capacity instead, even if there is no immediate sanctions threat.
These processes take time, and the US dollar will retain a premium as the world’s most liquid currency as we navigate the rocky road ahead. Markets will need to get accustomed to higher inflation and far tighter monetary policy, but the US dollar is set for a major reset lower in the years ahead as major exporting countries will not find it a store of value. They will look to recycle their surpluses elsewhere, making it increasingly difficult for the US to fund its yawning twin deficits.
Q1 saw the five small G10 currencies—the three commodity dollars (AUD, CAD and NZD) and the Scandies (NOK and SEK)—trading with perhaps an historic degree of performance divergence. The Swedish krona, for example, was doubly weak on the combination of its traditional sensitivity to risk sentiment, along with its economy being seen as leveraged to the outlook for the wider EU economy, which received an ugly blow from the war in Ukraine. The more commodity-leveraged AUD soared as Australia’s commodity export portfolio is almost a perfect offset for the war in Ukraine, given that it’s a major wheat exporter and the world’s largest exporter of LNG. NOK got a boost from oil prices, CAD less so, and somehow NZD enjoyed a tailwind as a major food-secure exporter and after the RBNZ refreshed its hawkish stance from last year. SEK has since rebounded sharply and should do well on the positive backdrop for the euro, although it is sensitive to risky asset volatility. The oil currencies may be in for a rough ride later this year if recession looms on the damage that high energy prices have meted out. AUD is still one to watch for longer-term upside potential if China makes good on stimulus.
The Bank of England has moved to normalise policy before the Fed and certainly before the ECB, but is unlikely to match the pace of Fed hikes. The UK is more likely than some of its peers to be headed toward a recession this year on the combination of the impact of significant supply constraints in the economy, the energy spike, and a major fiscal drag, especially relative to the EU, which is set to move aggressively in the direction of expansion. EURGBP is worth watching as an important barometer for sterling. One offset on the positive side for sterling is that the EU’s security vulnerabilities made clear by Russia’s invasion of Ukraine will likely keep Brexit-related trade tensions at a minimum as the UK has the most potent military force in Western Europe and is needed as an ally.
Last quarter I was far too early in calling for mean reversion for the Japanese yen. It only got a minor bump from cratering risk sentiment in the outbreak phase of the war in Ukraine before it weakened to new historic lows, partly on soaring commodity prices due to the scale of Japan’s reliance on food and energy imports, and later more on the backdrop of rising rates. During Q1, the Bank of Japan doubled down on its yield curve control (YCC) policy, defending the 0.25 percent cap on 10-year Japanese government bonds. Rising long safe haven yields theoretically mean that if global yields continue to rise, the yen will have to absorb the pressure if JGB’s can’t. However, the JPY is at historically cheap levels, and as we head toward a recession, the rise in long yields and commodities may moderate. The end of the financial year in Japan on March 31 is often also a critical pivot point—as it was in 2021, when the JPY bottomed and US yields peaked for the cycle on that very date.
As for the Swiss franc, its run-up on Russia’s invasion of Ukraine was quickly reversed when Switzerland joined the international community in its sanctions against Russia, a further erosion of Switzerland’s traditional special status as a safe harbour for money of possibly questionable origin. Rising yields are also a relative CHF-negative as the SNB will always pursue last-mover status, even if the country is still rock solid from a current account and stability angle.
EM currencies and CNH. As noted above, China will likely seek to move away from its reliance on the US dollar and other foreign FX with all possible haste. That is a difficult task to accomplish when the country operates with a capital controls regime domestically (the CNY is not tradeable off shore). There are technical workarounds—the offshore CNH with promises of perhaps physical settlement in something else such as gold or a digital currency—but it takes time to build trust in new arrangements, so how it achieves this goal bears close watching from here. Since early last year, China has already maintained a strong yuan policy as it has moved to deleverage the property sector and reduce the influence of the tech sector, and as a bulwark against rising commodity prices. These priorities are unlikely to change as long as commodity prices remain high, but the pace of CNH strengthening has become very steep this year and will threaten China’s export competitiveness. China has also indicated easing priorities to support its flagging domestic economy, which continues to be disrupted by Covid-related lockdowns, a non-factor in most countries now. Elsewhere, there has been a clear commodity and current account angle to the development in EM exchange rates, which is likely to persist as long as commodity volatility remains high. Turkey and India are vulnerable on commodity exposure, while South Africa and Brazil have benefitted from their commodity exposure.
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