The global financial landscape is in flux, and the energy crisis is the catalyst. Yesterday, the foreign exchange (FX) markets experienced a subtle yet significant shift, as the energy shock triggered a broad deleveraging of risk across various sectors.
The Energy Shock's Impact on FX Markets:
The energy crisis has sent shockwaves through FX markets, causing a rapid unwinding of risk positions. This deleveraging is a direct response to the surge in cross-market volatility, which has investors on edge. While these risk unwinds are typically short-lived, investors are now in a holding pattern, awaiting positive news on the energy front or a change in central bank policies.
US Dollar's Focus on Energy and the Fed:
The US dollar's trajectory is closely tied to energy prices and the Federal Reserve's actions. Monday's market movements were dominated by the impact of high energy costs on energy-dependent currencies. However, Tuesday brought a broader deleveraging as cross-market volatility intensified, particularly in the equity markets, with financials taking a hit. The sell-off in private credit (as seen with Blacktsone and Blue Owl) adds to the narrative, but it's the spike in volatility and Value-at-Risk metrics that has investors reducing their positions. This reduction benefits the dollar, especially as investors had been short on the currency.
But here's where it gets controversial: some dramatic overnight headlines, such as South Korea's Kospi index plummeting 12%, may be misleading without context. This index had surged 50% year-to-date until February, so the recent drop could be a correction rather than a crisis.
The Energy-Central Bank Conundrum:
The near-term fate of risk assets hinges on two critical factors: energy prices and central bank policies. If the Straits of Hormuz can reopen, energy prices may ease, providing a much-needed boost to risk assets. Additionally, central banks' ability to cut rates to support economic activity, or at least maintain current policies, will be crucial. President Trump's comments about naval convoy support in the Straits and federal backing for shipping insurance provided a temporary lift to risk assets, but the market craves tangible action.
Inflation, the Fed, and the Dollar:
The energy shock's inflationary impact is reshaping the yield curve, particularly the short end. This trend briefly reversed yesterday as equity losses mounted, but unless there's another significant equity sell-off, the hawkish re-pricing of the short-end is likely to persist, strengthening the dollar. Today's ADP release and the ISM services index's prices paid component could further bolster the dollar if they show positive signs. The Fed's Beige Book, due tonight, will be closely watched for any indications of persistent price pressures, which could lead to a reduction in expectations for Fed rate cuts this year. Currently, 45 basis points of easing are priced in for 2020.
The dollar has performed exceptionally well this week due to these factors, with the DXY index reaching 99.68 yesterday. Investors are cautious about pushing it beyond the 100.00/100.35 highs seen in recent months, but they also need reassurance about the energy crisis before considering short dollar positions.
Euro's Vulnerability and Potential Support:
Long euro positions, particularly among asset managers, left EUR/USD susceptible to the recent market movements. The currency pair hit a low of 1.1530, affected by both the terms-of-trade story and the broader deleveraging trend. The terms of trade will be the more influential factor, and the duration of the energy shock will dictate whether EUR/USD falls to 1.10/12 or finds support near 1.15. We anticipate operational intensity to ease over the next week and the Straits of Hormuz to gradually reopen, supporting the latter scenario.
CEE Currencies: A Glimmer of Hope:
Central and Eastern European (CEE) currencies experienced a second wave of sell-off yesterday, but there are signs of relief. Despite multi-week highs in EUR/HUF and EUR/CZK, and EUR/PLN reaching its highest since April 2019, oil prices stabilized, and gas prices retreated from their peaks. This provides a potential recovery opportunity for CEE currencies.
Central Bank Decisions in CEE:
The National Bank of Poland's rate decision today is highly anticipated. Initially, a 25 basis point rate cut to 3.75% seemed likely, but recent geopolitical tensions have made it a closer call. Our economists still expect a rate cut, but the accompanying statement will be scrutinized for clues about future policy direction. In the Czech Republic, February inflation data, expected to show a decrease to 1.4% YoY, could help stabilize the market, although the reaction may be muted given current conditions. Our forecast no longer includes a CNB rate cut this summer, indicating a shift in expectations for the region's monetary policies.
Turkish Lira and Romanian Leu: Central Banks in Focus:
The Turkish lira and Romanian leu, managed currencies in the region, have tested the central banks' resolve. In Turkey, February's inflation data confirmed a year-on-year increase, the first since September, putting pressure on the Central Bank of Turkey amid the US-Iran conflict and rising oil prices. Meanwhile, the Turkish lira has been a significant carry trade in emerging markets. Despite the conflict, the CBT has kept USD/TRY stable by reducing carry positions, but this has led to a spike in FX implied yields, effectively tightening monetary conditions. In Romania, EUR/RON is witnessing a similar situation, with long positions in FX and government bonds unwinding after recent rallies. The central bank's ability to manage these currencies and control inflation will be a key focus in the coming days.
Controversy and Comment:
The energy crisis has thrown the FX markets into a state of flux, with investors navigating a complex web of geopolitical tensions, central bank policies, and inflationary pressures. As the situation evolves, will the energy shock continue to drive deleveraging, or will investors find reasons to re-enter risk positions? What role will central banks play in shaping the market's trajectory? Share your thoughts and insights in the comments below. Are there any alternative interpretations of these events that could challenge the prevailing narrative?
