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Three Questions: Week of February 14

CalendarFebruary 14, 2022

Good morning, happy Valentine's Day, 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. How might war in Ukraine impact currency markets?

Financial markets were rocked on Friday after Western intelligence reports, leaked on Twitter, suggested that Russian President Vladimir Putin had decided to invade Ukraine. Equities and bond yields dropped, oil prices jumped toward $100 a barrel, and implied volatility in the euro-yen pair - a proxy for Europe’s exposure to the conflict, and Japan’s role as a safe haven - soared as the story spread.

No one knows whether an invasion will take place - perhaps not even Putin himself. But open-source intelligence suggests that Russia now has more than 130,000 troops encamped on Ukraine’s borders, with key assets like amphibious landing ships, missile batteries, air support, and field hospitals positioned for an invasion. Although Western allies are pouring in arms and materiel, the Ukrainian military remains decisively outmanned and outgunned.

After taking a series of steps to shield the economy against Western sanctions over the last decade, Russia is also somewhat economically fortified. Self-sufficiency has grown. Trade has shifted out of dollars, and toward non-aligned countries. External debt has shrunk, and the country has amassed foreign exchange reserves amounting to more than a third of GDP - the most significant stockpile among the 20 biggest economies in the world.

And negotiations are at an impasse. According to a statement issued by the Kremlin on Saturday, US President Biden has provided no “substantial answer” on Putin’s security demands.

The scales have clearly tilted in a dangerous direction.

If an assault begins this week, it will likely involve air strikes, marking a clear and unambiguous discontinuity with the hybrid warfare that has long characterized Russian activities in Crimea and the Donbas.

This will almost certainly trigger a bigger and more violent repeat of Friday’s trading dynamics, with equity indexes dropping and yields coming down as investors reprice central bank tightening trajectories. In currency markets, the dollar, Japanese yen and Swiss franc might gain as traders seek safety, while the euro comes under renewed selling pressure as concerns about energy security deepen. A global rush to secure access to industrial metals and stable energy supplies might deliver an upside shock to commodity prices, but risk-sensitive currencies like the Australian and Canadian dollars are unlikely to benefit.

However, once the initial knee-jerk reaction has faded, more complex second-round effects might unfold and drive exchange rate reversals. Russian control of Ukrainian gas infrastructure might - counter-intuitively - stabilize European energy supplies. If the US is unable to get other countries on board, sanctions-driven weaponization of the dollar might backfire, sending emerging market central banks, sovereign wealth funds, and oil exporters fleeing from US markets. The risk of cyberattack-driven supply chain disruptions - like last year’s Colonial Pipeline hack - might rise. And surging prices could remind central bankers of mistakes made in the seventies - when over-accommodative fiscal and monetary policy settings intersected with a series of geopolitical shocks to send inflation soaring.

De-escalation remains possible - German Chancellor Olaf Scholz is headed to Kyiv and Moscow in a last-ditch effort to defuse the situation. The entire crisis may yet prove to be part of an elaborate Russian disinformation campaign. But markets are notoriously ineffective at pricing geopolitical risk, meaning that volatility across currency, commodity and fixed income markets could rise even further in the coming days.


2. Will Fed messaging calm market fears of hyperactive rate moves?

The minutes of the Fed’s January 25 meeting will be released this Wednesday, but it seems likely that other forms of official communication will offer more useful perspective. Markets are abuzz with talk of 50-basis point hikes and surprise intermeeting rate moves, but in our view, it is very unlikely that Fed speakers will lead the market to price an even more hawkish path than is currently priced for the remainder of 2022.

The minutes will almost certainly be more hawkish than the anodyne statement released after the meeting. This should not be a surprise, given the tenor of Chair Jay Powell’s press conference, in which he refused to rule out executing larger-than-normal 50-basis point hikes or making back-to-back moves at successive meetings. And they have been superseded by a very sharp tightening in financial markets, triggered by Thursday’s inflation release and exacerbated by the St. Louis Fed president - James Bullard - calling for a 100 basis point move before the July meeting. Markets now expect benchmark rates to climb by 165 basis points by year end, with moves heavily front-loaded.

We think officials are likely to emphasize not just a heightened attention to inflation, and the data-dependent nature of the Fed’s reaction function, but also - critically for markets - skepticism on the need to move before the March 16 meeting.

Unscheduled intra-meeting rate moves in recent decades have taken the form of rate cuts aimed at easing financial conditions amid fears of imminent systemic stress. This is different from wage and price setting across the economy - a process that operates on a very different schedule.

It’s unclear what an intra-meeting move would achieve - other than a hypothetical restoration of Fed “credibility”. But there are few signs of such a threat in 10-year yields, the shape of the Treasury yield curve or the value of the dollar.

And it’s important to note that the Fed is a consensus-based institution. Although there are occasional dissents, it is not the Bank of England, with its history of narrow votes and the Governor occasionally ending up in the minority.

If regional Fed presidents succeed in talking market-implied yield expectations down, global risk appetite could rebound, putting pressure on the dollar - although events in Ukraine will continue to loom large.


3. Will inflation data lift the British pound against the euro?

After last week’s strong 2021 growth data, inflation numbers due on Wednesday will give the Bank of England comfort in continuing a hiking cycle well ahead of its European counterpart. This could allow the British pound to renew gains against the single currency - even if its performance against the dollar depends on Fed messaging and geopolitical risks.

Markets expect headline inflation to come in at 5.4 percent, well above the central bank’s 2 percent target, and a hike on March 17 is essentially baked in - with the only question being the increment. The market is currently placing coin-toss odds on a 50-basis point move, with a stronger-than-forecast print likely to drive probabilities higher.

At the last meeting on February 4, policymakers voted for a 25-basis point hike by a 5-4 margin, with a hawkish minority favoring a bigger 50-basis point boost. In a speech last week, Chief Economist Huw Pill emphasized the central bank’s commitment to fighting inflation in the face of negative supply shocks, while calling his vote for a 25-basis point move an “investment in containing market expectations of aggressive activism.” He warned of “the prospect of more to come in the coming months” - implying that a downside miss in the inflation data was highly unlikely to eliminate the prospect of a hike in March, while another upside surprise could solidify the case for a large move.

In contrast, even hawks such as Klaas Knot of the Dutch central bank don’t see the European Central Bank moving on rates before the fourth quarter.

This, as Boris Johnson’s continuing troubles have had little impact in currency markets, and as hopes have grown around Foreign Secretary Liz Truss (a potential successor should Johnson fall) achieving a breakthrough with the EU in talks on Northern Ireland, removing another near-term shadow over the pound.

Of course, over the longer term, the loss of free goods and services access to the EU will continue to weigh on the UK’s trend growth and inflation outlook - an outcome reflected in the pound’s performance after the June 2016 referendum. This in turn will limit more sustained gains in the pound, - even if the cycle and trading dynamics favour it for now.




EUR European Central Bank Speech, Lagarde

JPY Gross Domestic Product, Q4

AUD Reserve Bank of Australia Meeting Minutes


GBP Claimant Count Rate, January

EUR Gross Domestic Product, Q4

CAD Housing Starts, January


GBP Consumer Price Index, January

USD Retail Sales, January

CAD Consumer Price Index, January

USD Department of Energy Weekly Inventories

USD Federal Reserve Meeting Minutes, January


EUR European Central Bank Speech, Lane

USD Weekly Jobless Claims

USD Federal Reserve Speech, Bullard

USD Federal Reserve Speech, Mester


USD Baker Hughes Weekly Rig Count

EUR European Central Bank Speech, Panetta

CAD Retail Sales, December


“It is notable that in almost every case in history when a country’s rapid growth has been associated with even more rapid growth in its debt burden, the subsequent adjustment has always turned out to (be) far more difficult than even pessimists had predicted.” Carnegie Endowment: How Does Excessive Debt Hurt an Economy?

“As much as some commentators might wish that the Fed could influence the economy independently of the labor market, the facts suggest that most of the Fed's ability to affect inflation outcomes derives from its ability to slow the growth of employment or wages.” Employ America: What Are You Expecting? How The Fed Slows Down Inflation Through The Labor Market

“By and large, members of the public were far more concerned about how inflation would affect their cost of living, real personal income and the value of the dollar than economists were.” NY Times: Inflation Is Not a Simple Story About Greedy Corporations

“In the end, China bought only 57 percent of the US exports it had committed to purchase under the agreement, not even enough to reach its import levels from before the trade war.[1] Put differently, China bought none of the additional $200 billion of exports Trump's deal had promised.” Peterson Institute: China Bought None of the Extra $200 billion of US Exports in Trump's Trade Deal

“Russia’s annexation of Crimea in 2014 was an inflection point for globalization. The economic integration between east and west that began with the fall of the Berlin Wall in 1989 started to unravel.” Wall Street Journal: Russia Thrived as It Integrated With the West—a New Cold War Is Unraveling That

“As the Federal Reserve prepares to start hiking rates as soon as next month, leading emerging economies such as Brazil and Russia are so far ahead of the US central bank, they could be nearing the end of rate-hiking cycles they embarked on last year.” Financial Times: Emerging Markets Signal End to Aggressive Rate Hiking Cycles

“Ordinary citizens may not think it matters much if a bunch of day-traders and fund managers get burned. But such a fire could damage the rest of the economy.” The Economist: What Would Happen If Financial Markets Crashed?