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Three Market Questions: Week of January 31

CalendarJanuary 31, 2022

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead. Here are some of the things we're watching:

1. Will tensions with Russia spill over into currency markets?

Bill Clinton’s political adviser James Carville once said, "I used to think that if there was reincarnation, I wanted to come back as the president or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

In recent weeks, he has been proven right once again. Even as Russia has massed troops and equipment on the Ukrainian border and Western authorities warned of an impending invasion, it was ructions in the bond markets that struck fear into the hearts of traders - not Vladimir Putin’s threats.

The ruble has come under selling pressure, and skewness in options markets suggests traders are seeking to insure against a potential downside shock. But implied volatility levels in most major pairs remain well below historical averages. Safe haven currencies like the Japanese yen and Swiss franc are seeing outflows. And the dollar has exhibited deeper correlations with Jerome Powell’s words than with scary headlines from a region that some think could become ground zero for a third world war.

This sense of calm likely reflects the Russian economy’s relative isolation from the Western financial system, but also a belief that the cold logic of mutually assured destruction will limit the extent to which global energy supplies are disrupted. According to this line of thinking, Western governments are unlikely to impose sanctions on Russian oil and gas exports, and Mr. Putin will follow his forebears in ensuring that shipments continue uninterrupted, even during times of geopolitical conflict.

But this Doctor Strangelovian plot line has some holes.

Russian currency reserves amount to more than 27 percent of gross domestic product - higher than in any other top-20 economy, and more than enough to offset a prolonged drop in energy revenues. The country has spent almost a decade becoming more self-sufficient, and is working to reduce its reliance on the dollar.

In Washington and many European capitals, the motivation to reduce dependence on Russian energy is strong. Plans are reportedly being drawn up to perform a sort of seaborne Berlin Airlift, with the US offering to ship petroleum products and liquified natural gas to the Continent in the event of a pipeline shutdown.

This isn’t to suggest that a conflict would be economically costless. Global natural gas supplies cannot be rerouted without major price implications, and long-term costs would almost certainly rise if the Nord Stream 2 project were imperiled. Russia is the third largest oil supplier to the US, and a major player in global markets - sanctions would cut both ways, impacting Putin’s biggest source of cash, while lifting politically-sensitive global inflation levels.

But students of history know that leaders who think they have leverage are often emboldened to take more aggressive rhetorical postures. The risk of a military and economic miscalculation is rising.

Bottom line: We think currency market volatility expectations have room to rise this week. Oil-correlated units like the Canadian dollar could outperform if the war of words over Ukraine heats up, while the euro - negatively exposed to a terms of trade shock - could experience sharp moves in both directions as the crisis evolves.

- K A R L S C H A M O T T A , C H I E F M A R K E T S T R A T E G I S T

2. Will the ECB raise rates on Thursday?

No. And it will not sound anywhere near as hawkish as the Fed. Despite a sympathetic movement higher in bund yields as Treasury yields have risen, the two economies are in very different situations. European inflation dynamics are more muted and clearly attributable to supply shocks than the combination of supply and demand pressures seen in the US. And while it may jawbone about potential second-round inflationary effects, the ECB is less perturbed by the inflation outlook than the Fed.

ECB Chief Economist Philip Lane said in an interview last week that the bank “expect[s] inflation − in overall terms for this year − to be around 3.2 per cent in the euro area, and then to be below 2 per cent in 2023 and 2024.”

Higher energy prices are making an outsize contribution (2.46 percent of 5 percent) to European inflation dynamics. But Lane noted that higher oil prices were “reducing living standards, increasing the import bill” and served as “a negative channel to lower incomes, lower consumption.” This stands in stark contrast with the focus on the impact of higher oil prices on headline inflation that led to ill-timed ECB rate hikes in in 2008 and 2011. Finally, Lane said that “a scenario where inflation is persistently, significantly above 2 per cent, which would require a serious tightening…. would…. in the context of the euro area, be less likely than the other two scenarios [inflation staying below or settling at 2 percent].”

Why then, are German 10-year yields moving higher in tandem with Treasuries? One answer is that just as foreign inflows into US markets may result in lower yields than warranted by economic conditions, those outbound European investment flows are likely pulling German yields higher than they otherwise would be. Even without ECB action on rates, net issuance, ongoing tapering, and global factors could pull bund yields even higher in 2022.

In addition, German yields are linked to the structure of the Eurozone itself. As the premier euro-denominated safe-haven asset, bunds reflect not just the global reflation cycle but also internal Eurozone stresses. And these stresses have diminished as the pandemic provided an impetus to partial fiscal mutualization.

The contrast between a hawkish Fed and a dovish ECB may not necessarily lead to a much weaker euro. Between 2017 and 2018, the Fed hiked by 100 basis points while ECB rates remained neutral. Still, the euro appreciated strongly over the period, helped in part by the victory of Emmanuel Macron in the French presidential election. Perceptions of relative political stability and the prospect of structural economic improvements can move cross-border capital and currency valuations beyond the brute power of interest rate differentials.

- K A R T H I K S A N K A R A N , S E N I O R M A R K E T S T R A T E G I S T

3. How will markets react to Friday's non-farm payrolls number?

For decades, non-farm payrolls numbers have dominated the economic calendar, with relatively small month-over-month changes in employment levels carrying the power to shake global financial markets.

This week’s report could be different.

After a slew of disappointing releases, investors are prepared for a weak headline number, with consensus forecasts currently set around the 155,000-position mark.

The Omicron coronavirus wave, which chilled activity in December and early January, has moved past its peak, making this glance into the rear-view mirror less relevant for forward-looking markets.

A string of Federal Reserve officials have already congratulated themselves for bringing the economy back to full employment - meaning incremental shifts in new data are unlikely to move the policy expectations needle.

And Jerome Powell appears to be following President Nixon’s “madman doctrine”, abandoning forward guidance-based diplomacy and doing his best to convince markets that the central bank could raise rates without warning at any meeting this year.

This approach is likely designed to trigger a tightening in financial conditions by lifting the dollar and knocking interest rates out of negative real territory, but the trading implications are clear: the dynamic that has persisted in various forms since the global financial crisis - in which bad economic news raises the likelihood of policy intervention and drives markets higher - has now broken down.

Bottom Line: If Friday’s number comes in below consensus, policy expectations might remain unchanged, but a positive surprise could lift odds on a 50-basis point hike at the March Fed meeting - and deliver a lasting shock to currency markets.

- K A R L S C H A M O T T A , C H I E F M A R K E T S T R A T E G I S T



AUD Reserve Bank of Australia Rate Decision


EUR Markit Manufacturing Purchasing Manager Index, January

EUR Unemployment Rate, December

CAD Gross Domestic Product, November

USD Markit Manufacturing Purchasing Manager Index, January

USD ISM Prices Paid

USD ISM Employment

USD Job Openings and Labor Turnover Survey, December


EUR Consumer Prices, January

USD ADP Private Employment, January

USD Weekly Energy Inventories

BRL Central Bank of Brazil Rate Decision


GBP Bank of England Rate Decision

EUR European Central Bank Rate Decision

USD Weekly Jobless Claims


USD Non-Farm Payrolls

CAD Unemployment Rate

USD Baker Hughes U.S. Rig Count


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