FX Daily: Bordering On The Disorderly

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As can be said for many other financial instruments, developments in FX are bordering on the disorderly. With commodity markets now taking another leg higher on speculation over embargoes on Russian exports, fears of stagflation in Europe will continue to build. Expect European FX and most emerging market currencies to remain under pressure.

USD: Flight to safety continues

The dollar continues to perform strongly as the flight to safety and liquidity continues. Trading conditions on Friday afternoon and probably this European morning too are moving towards the disorderly - e.g. an indiscriminate purchase of implied volatility and continued heavy pressure in global equity markets as global growth forecasts are cut further.  In addition, US comments regarding a possible embargo on Russian exports have seen Brent trade to $139/bl (Russia exports around 5m barrels per day of crude) and USD/RUB in the offshore market being quoted as high as 138.

In other signs of stress in the market, the USD FRA-OIS spread (a measure of interbank credit stress) continues to widen, and on Friday afternoon the 3m EUR cross-currency basis swap again moved out to the wides. One could argue that dollar funding should not prove a problem given lots of excess dollars in the US banking system and a variety of new Fed tools to provide dollar liquidity. Yet presumably there is enough uncertainty out there that financial institutions will be reluctant to let go of dollar balances. We will be interested to see whether any of the Fed's 7-day USD swap lines get used a lot more this Wednesday. Last week's ECB 7-day dollar auction saw European banks drawing $272.5m dollars via this swap line.

There will also be much uncertainty here as March 12th sees seven Russian banks removed from SWIFT. European fixed income markets have already seen some stress here - the German MinFin last week had to issue extra 2024 bonds, allegedly because the freeze of Russian assets had tied up holdings in these particular bonds.

Disorderly markets have also triggered Fx intervention from central banks in Poland and the Czech Republic. Our team believes that this is the supply of FX liquidity to improve market functioning, rather than attempts to protect any particular level - though 5.00 in EUR/PLN must be a big psychological level for the local community.

One shoe in the process of dropping may be the broad-based selling of emerging market currencies. Here, fund managers, no doubt are facing heavy redemption requests from funds exposed to the region. Russian assets remain frozen and, unless funds are frozen, redemptions will have to be met from other holdings. For example, in EM local currency bond benchmarks, the big 10% weights are given to China, South Korea, and Indonesia, while other large weightings are given to Malaysia, Thailand, Brazil, Mexico, and Poland. Most of these currencies look vulnerable, barring China and perhaps Indonesia, which look very managed.

Expect the dollar to remain in demand today and DXY to continue heading towards 100.      

EUR: FX options market moves to extremes

EUR/USD has decisively broken below 1.10 as this most liquid FX pair is used as the proxy hedge for European FX in general. In addition, the EUR/USD FX options market probably remains one of the few more liquid venues in the derivative space. Here we can see the demand for Euro downside protection running to and in some cases exceeding the spike levels at the start of Covid.

How low could EUR/USD go? Support levels seem to be around the 1.0760/70 area and then the March 2020 lows of 1.0640 - but probably at times like these, big figures of e.g. 1.0500 become more relevant.

Will the ECB intervene? Certainly, there is a cycle developing of 'sell Europe' - which the ECB might be keen to break. Yet there is a continental war on and the ECB would not want to get involved in an ineffective intervention campaign. Were things to get out of hand, we would think coordinated G5 intervention to support EUR/USD would be more likely than ECB's own account intervention. But that may not occur until closer to parity.  

In terms of scheduled events, the ECB meeting is this week's highlight. But events to the east of Frankfurt will dominate. 

GBP: Hanging in there

Presumably, it's FTSE 100's heavier exposure to the extracting industries means it is only down 5% year to date versus -17% for major Eurozone benchmarks. The greater conviction behind the BoE response to the commodity price shock is no doubt helping GBP too.

EUR/GBP has now broken below major lows seen in 2019 and 2020 and is trying to reclaim the losses of Brexit in summer 2016. A further grind higher in GBP looks likely. 

NOK: Buoyed by the re-pricing of European natural gas.

Until Europe builds more LNG infrastructure or the Netherlands chooses to pump more gas, it seems that Norway will offer the only alternative to Russian gas. Norway's terms of trade have spiked 50% over the last month. The October low of 9.65 beckons for EUR/NOK.