FX Daily: Approaching Tail-Risk Territory

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Markets may start to materially price in a fully-fledged invasion of Ukraine after Russia officially recognized Eastern-Ukraine separatists and moved troops to the region. The US is expected to announce sanctions against Moscow today. The downside risk for European and high-beta currencies remains elevated, and safe-havens should stay supported.

USD: Ukraine's situation looks increasingly alarming

Some optimism at the start of yesterday’s session around a diplomatic solution in Ukraine was very short-lived, as the Kremlin first poured cold water on the prospect of a Biden-Putin summit (which had only been agreed in principle) and then officially recognized the Russia-backed separatists of the Donetsk and Luhansk People’s Republic in Eastern Ukraine, deploying troops to the region. Meanwhile, there have been reports of military confrontation between the separatists and Ukrainian forces, the US is reportedly discussing moving its embassy out of Ukraine and is expected to announce sanctions against Russia today.

It is clear that the equilibrium in the region is looking increasingly fragile and given indications that the diplomatic efforts are at a stalemate, downside risks for high-beta assets remain elevated. We had flagged in our Week Ahead preview how this week could have marked a shift to a longer geopolitical/diplomatic game that would have caused some degree of political risk to be entrenched into risk assets for some time. After the recent developments, the situation appears more alarming, and markets may start to price in a material risk of a fully-fledged invasion of Ukraine, as well as its consequences for the global geopolitical and economic equilibrium.

With this in mind – and acknowledging the high volatility and unpredictability of the situation – we think upside risks should prevail for safe-haven currencies (US dollar, Japanese yen, and Swiss franc) while European high-beta currencies (like Norway's krone and Sweden's krona) should remain the most vulnerable in a generally fragile pro-cyclical FX segment.

When it comes to the dollar, a still fairly quiet US calendar (Markit’s PMIs and Richmond Fed Manufacturing Index are the two main releases) will likely be overlooked given geopolitical concerns. However, some remarks by FOMC hawk Raphael Bostic might ignite further speculation about a 50bp Fed hike in March, which could offer a little more help to the dollar today.

EUR: Encouraging Ifo to be offset by geopolitics

Yesterday’s eurozone PMIs showed a very strong rebound in the service sector, although the impact on the euro was negligible given the already quite hawkish expectations on European Central Bank tightening and the worsening external environment. Today, the German Ifo should also have a contained market impact despite likely sending some encouraging signs on the recovery.

Market jitters caused by geopolitical tensions may well persist in the next few days and trigger an extension of the EUR/USD drop to the 1.1200-1.1250 area.

GBP: A historic break lower in EUR/GBP?

Despite the pound is generally a more sensitive currency to swings in risk sentiment compared to the euro, EUR/GBP has been depreciating quite steadily as tensions in Ukraine have flared up. While good UK data and hawkish bets on the Bank of England have likely contributed to GBP strength, markets are likely estimating a greater fallout from a collapse in diplomatic relationships with Russia for the eurozone than for the UK. Accordingly, we would not be surprised to see EUR/GBP test the 0.8300 support as early as today: a break below this key level would bring the pair back to a range last seen in the aftermath of the June 2016 Brexit vote.

There are no major events on the UK calendar today, except for a speech by the BoE’s Dave Ramsden (Governor Andrew Bailey and other members will testify before parliament tomorrow). We think that GBP/USD remains quite exposed to the downside due to geopolitical tensions, and we expect a pull-back to 1.3500-1.3550 in the coming days unless we see a clear de-escalation.

NZD: RBNZ to hike by 25bp and signal more tightening

The Reserve Bank of New Zealand announces monetary policy tomorrow at 0100 AM GMT and – as discussed in our meeting preview – we expect a 25bp hike, which is fully priced in. There is no real speculation around a 50bp move, and given that the key economic data are broadly in line with the RBNZ November projections, we think the Bank will stick to its plans to raise interest rates gradually. That said, the risks that rate hikes could be front-loaded and a consequent 50bp rate increase tomorrow are probably higher than what the market is currently pricing in (approximately 30% implied probability).

Assuming our call for a 25bp increase proves correct, the focus will mostly be on the updated economic and rate projections, which are currently implying five more (25bp) hikes in 2022 after the one in February. We think the RBNZ may endorse the market’s pricing and signal another rate hike in 2022 (or six in total after the one in February).

This could be enough to offer some moderate support to NZD, which however remains heavily tied to geopolitical sentiment. Any post-RBNZ reaction in the FX market may be quickly offset by external drivers and NZD/USD may struggle to stay above 0.6700.