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The prospect of a diplomatic solution in Ukraine seems to become more tangible, and while some geopolitical risk may continue to be priced out today (helping pro-cyclical against safe-havens), some caution should persist. The dollar may keep losing ground on improved sentiment, but bets on front-loaded Fed tightening should help to limit any losses.

USD: Eyes on Ukraine and Fed minutes

Risk assets have benefitted from signs of de-escalation in Russia-Ukraine tensions, as Moscow announced that some of its troops have returned to base after completing a drill. Markets will continue to monitor the situation closely and are reasonably not rushing to fully price out some degree of military intervention in Ukraine: after all, NATO said they still haven’t seen clear evidence of a pullback of Russian troops.  

A diplomatic solution remains our base case (albeit arguably still a close call), and we expect the geopolitical risk premium to fade with time. The timing for that is however highly uncertain, and pro-cyclical FX gains could remain moderate in the near term.

More optimism around a diplomatic solution in Ukraine may keep applying some pressure on the dollar and the other low-yielders today, and possibly help in further reverting recent oil gains. Given the magnified impact on crude, CAD and NOK should keep struggling to fully cash in on improved geopolitical sentiment.

At the same time, the dollar has received some support from rising speculation around front-loading of Fed tightening: markets will scan the minutes of the January FOMC meeting today to see how much support there was around a fast start in the tightening cycle. On the data side, the US calendar includes January retail sales (which should be encouraging) and industrial production (expected at 0.5% MoM).

DXY could slip further on improved risk sentiment, but the 95.10 early-February lows are unlikely to be heavily tested given the support offered by Fed tightening prospects.

EUR: Room for a move to 1.1400

EUR/USD climbed as markets turned more optimistic on a diplomatic resolution in Ukraine yesterday, and may remain bid today should geopolitical sentiment continue to improve. Quite interestingly, the EUR had no reaction to the quite hawkish comments by the ECB’s Villeroy (generally not a hawk), who claimed that while some transition between the end of PEPP in March and the end of net APP purchases was warranted, such transition could take only a couple of months, which means that QE could end in 3Q. The negligible market reaction is a testament to the fairly high conviction call by the market around ECB tightening by the end of the year: a narrative that is set to keep providing a floor to EUR/USD into the 10 March ECB meeting.

There are no scheduled ECB speakers today and no market-moving data releases in the eurozone, which means EUR/USD will remain mostly driven by swings in risk/geopolitical sentiment. Further de-escalation in Ukraine could aid a continuation of the rebound to 1.1400.

Elsewhere in Europe, SEK had a big run yesterday, jumping more than 1% against the dollar. This is not surprising considering that the Krona was fully exposed to the Russia-Ukraine tensions without having any of the “protection” offered to other European currencies (e.g. oil for NOK, hawkish ECB bets for EUR), making it a quite accurate benchmark of geopolitical risk. Expect more SEK volatility in the next few days, but should we see more optimism around a diplomatic solution USD/SEK could slip into the 9.10-9.20 area and EUR/SEK into the 10.40-10.45 area.

GBP: Inflation figures endorse aggressive bets on tightening

The improved global risk environment is keeping the pound bid, and this morning’s inflation figures for January in the UK are helping to consolidate gains in GBP/USD. A mild acceleration in both the headline rate (5.5%) and the core rate (4.4%) means that there is no apparent reason for markets to re-evaluate their aggressive bets on BoE tightening at the moment (six hikes by year-end are fully in the price). This should continue to put a floor below GBP in the near term.

CAD: Steady high inflation confirms the need for BoC tightening

The January CPI report in Canada today should see headline inflation stabilize marginally below 5.0%, while core measures may see a mild acceleration. All this should continue to underpin the need for the Bank of Canada to tighten policy quite aggressively in 2022. Still, markets are pricing in six hikes in 2022 (also our call), which means that the upside room for front-end rates and CAD after the CPI release may be quite limited today.

CAD is in a peculiar spot at the moment, as the spill-over of geopolitical tensions in Ukraine into the oil market means that the loonie is shielded from adverse global risk moves as tensions escalate, but cannot fully benefit from risk sentiment improvements if a diplomatic solution becomes tangible as that would weigh on crude prices. We expect USD/CAD to hover around 1.2700 this week, but we continue to see downside risks prevailing in the long run as the BoC tightening cycle should offer support to the loonie.