FX Daily: Overpricing A Quick Diplomatic Solution?

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Markets have turned more optimistic on Ukraine's situation today after Biden and Putin agreed to meet. Still, the situation in the Donbas region remains volatile and we suspect markets may be overpricing a "smooth" diplomatic solution too early. Downside risks for risk assets remain sizeable and we expect some support to USD and safe havens this week.

USD: Safe havens still attractive

The geopolitical situation in Ukraine has remained quite volatile over the weekend, as the US government insists Russia has already decided to start an invasion (Moscow has repeatedly denied this) and a new ceasefire hasn’t been fully re-established in the Donbas area after it was violated last week. However, markets have started the week on an optimistic note as Presidents Joe Biden and Vladimir Putin agreed in principle to meet, with Thursday’s summit between US Secretary of State Antony Blinken and his Russian counterpart Sergey Lavrov set to lay the groundwork.

Still, given the very unstable situation in the Donbas area and no guarantee that diplomatic efforts will be able to de-escalate tensions just yet, we continue to see a good deal of downside risk to risk assets in the short term. There is indeed a risk that the situation will morph into a longer diplomatic game that could prevent markets from fully pricing out geopolitical risk for a while.

We discussed what all this means for the FX market this week in: “G10 FX Week Ahead: Crosswind landing”. Given lingering geopolitical tensions and the lack of other very strong market drivers in the coming days (the US data calendar is very light), we think safe-haven currencies (USD, Japanese yen, and Swiss franc) may find some support this week. Incidentally, the dollar may receive some extra help from markets re-asserting bets on a 50bp Federal Reserve rate hike in March as some hawkish FOMC members speak this week. DXY could therefore continue to hold above 95.50.

In the rest of G10, pro-cyclical currencies remain completely tied to geopolitical tensions and we do see room for more corrections. One key event to follow in this segment is the Reserve Bank of New Zealand rate announcement on Wednesday: we expect another 25bp hike and signals that more back-to-back rate increases are on their way, which should give some help to the New Zealand dollar. We still expect European currencies to emerge as underperformers if tensions in Ukraine escalate further: the high-beta Norwegian krone and Swedish krona, in particular, remain highly vulnerable.

EUR: Not much geopolitical risk in the price

EUR/USD is not currently embedding a great deal of geopolitical risk and the market’s reluctance to price out some tightening by the European Central Bank by the end of the summer has also provided some support to the pair. Unless the Ukrainian situation takes a decisive turn for the better, we see mostly downside risks for EUR/USD this week as the dollar could find some support, and the EUR may start to embed more geopolitical risk.

Domestically, we expect the eurozone data flow to be quite encouraging this week, starting with today’s PMIs which should see a rebound from the Omicron-induced slump in January. That should mostly be priced in by now, and we doubt that data will be able to give any material lift to the euro in the coming days. A move back to 1.1300 would be warranted by fundamentals and the current market environment.

GBP: More good data, but external factors count too

After a set of supportive data releases for the pound last week (inflation, unemployment, and retail sales), we expect to see some quite solid UK PMIs today, bolstered by falling sickness rates and a return to the workplace. While potentially giving some extra support to the pound at the start of this week, geopolitical/risk sentiment will likely drive most of the GBP moves this week.

As for the EUR, sterling is not currently pricing in a great deal of geopolitical risk at the moment, which means that downside risks may prevail this week. We think the cable could slip back below the 1.3600 level soon.

SEK: Riksbank minutes in focus amid geopolitical turmoil

Sweden's krona has been an accurate benchmark for geopolitical tensions in Ukraine, due to its geographical vicinity and high-beta to global risk appetite, and we expect more volatility and downside risk for the krona this week. USD/SEK may edge back above 9.40 and EUR/SEK could approach 10.70 in the coming days.

Today, domestic factors may also come into play today for SEK as markets will be watching the minutes of the Riksbank’s 9 February meeting, where policymakers surprised on the dovish side by sticking to their projections for no rate hikes before 2024 and announcing that the size of the Bank’s balance sheet will remain unchanged in 2022. The Riksbank is largely seen as well behind the curve with its projections, so it will be key to see whether there was some opposition among members against the ultra-dovish stance. Any signals in this direction could give some help to the krona today, although external factors should overshadow any Riksbank-related moves. A speech by Riksbank’s Martin Floden later today will also be in focus.