Among G10 Currencies, EUR Hardest Hit

Markets Hit Hardest by Ukraine Crisis

Currencies, equities and Treasuries were all affected by the escalating tensions between Russia and Ukraine. Some markets were hit harder than others and the magnitude of the impact reflects each country’s vulnerability to the crisis. European equities for example are down between 1.5 to 3.5% while U.S. equities are down less than 1%. Among the G10 currencies, euro was hit the hardest while the Canadian dollar barely lost value. The reason is because Europe is more economically reliant on Russia than the U.S. Commodities were hit hard with wheat prices rising 4.8% to its highest level in more than 2 months, corn prices rose 1.5% to its highest level since September. As Ukraine is one of the world’s largest exporters of corn and wheat, these increases should not be surprising. If supplies are halted for any reason, prices will rise even further. We have also seen a significant rally in the price of crude oil, which climbed to its strongest level in 5 months and gold, which is at a 4-month high. Yet Russian and Ukrainian markets were hit the hardest, having been punished for being ground zero of the world’s troubles. Russian stocks dropped more than 10% Monday and are down almost 15% in the past 2 weeks. Since the beginning of the year, the Russian Ruble has lost 12% of its value and is now at a record low. Investors are punishing Russia for their incursion into Crimea and the longer the crisis drags out, the greater the risk that political actions will plunge the economy back into recession. While leaders around the world are focused on finding a diplomatic solution through non-military pressure, the markets are also pressuring Putin to back down. Stiff sanctions seem to be the most likely consequence of Russia’s actions but military intervention remains a possibility. Lets not forget that under the Budapest Memorandum signed in 1994, the Ukraine agreed to give up its arsenal of nuclear weapons in exchange for “security assurances” from the U.S. and U.K. if their territorial integrity becomes threatened. Any sign of potential military action by Western Nations would cause more risk aversion in the forex market because investors rarely view the prospect of war as positive especially when it involves major world powers like the U.S. and Russia.
Commodity prices have a direct impact on inflation and while it is temporary, the recent increase reduces the chance of easing by some central banks and increases the chance of tightening by others.

Vladimir Putin is never one to back down easily so until he shows signs of relenting, we expect currencies and equities to remain under pressure. If there are signs of progress, expect a nice relief rally in the FX market. While Monday's better-than-=expected U.S. economic reports helped to stem the slide in USD/JPY, with no market moving data scheduled for release tomorrow and a possible ultimatum from Russia, geopolitical risks will remain the key driver of currency flows. Personal income, spending and the ISM manufacturing report surprised to the upside. Incomes grew 0.3%, spending increased 0.4% and the ISM index rose to 53.2 from 51.3. As some of the first signs of improvement in the U.S. economy, these reports will ease concerns that the U.S. recovery lost momentum at the start of the year.

EUR: At the Mercy of Ukraine

Of all the major currencies, the euro has been hit the hardest by the escalating crisis in the Ukraine. It is no secret that the Ukraine is just as important to Europe as it is to Russia and Russia is an important energy partner for the region. Therefore Europe has a lot more at stake than the U.S. Russia supplies a quarter of Europe’s oil, half of which is pumped via pipelines running through the Ukraine and if the conflict leads to an energy supply shock, oil prices would rise significantly. Thankfully a mild winter has reduced demand for heating fuel and stocks are high, allowing European nations to handle a 1 to 2 month disruption in supply. Nonetheless the prospect of higher commodity prices will deter the European Central Bank from easing monetary policy. Improvements in activity reports will also make this week’s ECB decision easier – the Eurozone’s PMI manufacturing numbers were revised higher for the month of February. The composite index was notched up to 53.2 from 53.0, due in large part to stronger activity in France. This revision is important because France had the largest underperformance in the initial report and now some concerns about the country’s underperformance will ease. Eurozone producer prices are scheduled for release tomorrow and while price pressures are expected to decline, developments in the Ukraine will continue to drive EUR/USD flows. If Russia’s ultimatum to the Ukraine is real and they make good on their threat of a military storm if Ukraine military is not withdrawn from Crimea by 10pm ET, EUR/USD will fall further. However the Russians denied that there is an ultimatum so if the deadline passes and there is no increased military activity, EUR/USD should rally in relief.

GBP: Risk Aversion Overshadows Data Improvements

Stronger than expected U.K. data failed to lend support to the British pound. According to the latest PMI report, manufacturing activity increased slightly in the month of February. The index rose from a downwardly revised 56.6 to 56.9 which doesn’t seem to be very impressive but if you consider that the employment component of the report rose to a 33 month high, the overall release is positive for the British pound. The same is true of mortgage approvals, which rose to its highest level since November 2007. These reports suggest that the recovery in housing and manufacturing activity is regaining momentum after the slowdown at the end of last year. Unfortunately neither one of these reports had much impact on the British pound. Like the euro, sterling was hit hard by the ongoing crisis in Ukraine. While the focus is on how the U.S. will respond to Russia’s incursion into Crimea, the U.K. also signed the Budapest Memorandum to protect the Ukraine’s territorial integrity. Cameron shares Obama’s view that Russia must face significant consequences if they refuse to back down. Tomorrow’s PMI Construction report will take a back seat to geopolitical risks.

AUD: What to Expect from the RBA

Despite the high level of risk aversion in the financial markets, the Australian dollar was surprisingly resilient, ending the day unchanged against the U.S. dollar. The better-than-expected economic reports released overnight led many investors to believe that the Reserve Bank will maintain a neutral monetary policy stance Monday evening. Having just shifted from an easing to a neutral bias last month, few expected the RBA to alter its views on monetary policy. However last week’s decline in capital spending and construction raised concerns that the central bank could acknowledge the signs of slower growth. Last night’s rise in the manufacturing PMI index, TD securities inflation report, job ads and new home sales should ease some of the central bank’s concerns and give them enough confidence to leave their outlook and policy stance completely unchanged, which would be mildly positive for AUD. The New Zealand and Canadian dollars on the other hand weakened against the greenback despite a sharp improvement in New Zealand’s terms of trade and Canadian industrial product and raw material prices. Aside form the RBA rate decision, the country’s current account balance, building approvals and PMI services report was due out Monday evening.

USD/JPY: Hit From All Sides

The Japanese Yen traded higher against all of the major currencies Monday. While the biggest loss was in GBP/JPY and EUR/JPY, USD/JPY fell to its lowest level in more than 3 weeks. The currency pair was hit from all sides with risk aversion, a decline in Treasury yields along with weakness in U.S. and Japanese equities weighing on the currency. As this is a quiet week in Japan, the market’s aversion to risk and U.S. data will be the primary driver of USD/JPY flows. The Japanese Yen is a quintessential safe haven currency so if the situation in the Ukraine continues to deteriorate, the Yen will be a big beneficiary. Of course this has absolutely nothing to do with the health or outlook for Japan’s economy and instead has everything to do with unwinding trades funded by the low yielding Yen. For the Bank of Japan, the sell-off in the Nikkei and rally in Yen is occurring at a risky time for Japan. Based on recent economic reports including last night’s capital spending and vehicle sales, the pace of recovery is slowing. The rise in the Yen will only make life more difficult for exporters while the slide in Japanese stocks could erode consumer confidence. If economic activity does not improve soon, the BoJ may feel the need preempt a deeper contraction by increasing stimulus before the consumption tax increase.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.