The world has changed drastically since my last blog post with the harrowing events unfolding in Ukraine. I try hard not to comment on geopolitics in my thought pieces, but safe to say, as someone fortunate enough to not live close to the danger zone, it is difficult to watch the impact on innocent people living through these horrible events. So forgive me for skirting around the politics of the situation and focusing on the financial market impacts instead.
An obvious one first: commodity prices are much, much higher. Europe is a major consumer of Russian oil and gas, while Ukraine and Russia are major exporters of soft commodities like wheat. So higher commodity prices that form a significant part of input prices mean the currently decades-high inflation numbers look likely to get even higher. This will have a real impact on businesses and consumers alike, depending on how much of the impact is absorbed or passed through. With higher commodity prices, commodity exporters such as Australia, Canada, and South Africa have seen a relatively strong currency in recent weeks – despite the risk of waning demand in the medium term.
Another obvious one with the current risk-averse sentiment is lower equity markets, as investors are nervous of a more global escalation hitting global demand. In FX, this has led to a stronger US dollar as a haven and some initial strength to the safe-haven Swiss franc (although the Swiss National Bank is on high alert of this getting out of control). Another traditional haven, the Japanese yen, has fared worse as the complexity of their reliance on external energy has caused some weakness that normally we wouldn’t see. The pound and the euro are both lower against the greenback, both for geopolitical spillover risk and for the impacts that higher commodity prices will have. It follows that an escalation of the situation would lead to further market movements along these paths. In contrast, a swift resolution in the warzone (one way or another) without further escalation is likely to see a reversal of the above trends.
"The classic tug of war between demand and inflation will surely become the focus for central bankers in the coming months, and will ultimately become a key driver for FX pairs for the rest of this year."
So, where does this leave central banks? Before Russian troops moved into Ukraine, markets had priced in multiple interest rate hikes in the UK and the US, with inflation moving from transitional to… well, not transitional. One would think the inflation outlook is even worse now with this additional commodity price shock, which could continue for some time, leading to even sharper rate rise expectations. At the time of writing, around 1% of interest rate rises are priced in over the next three meetings in both the UK and the US, confirming this theory.
The difficulty, though, is the risk that demand falls just as drastically with a cost of living squeeze that seems unlikely to ease in the short term – and for me, this leads to some important questions. Would interest rate rises materially reduce inflation when uncontrollable external input factors drive price rises? Will demand naturally fall in a higher price, risk-averse environment, doing some of the heavy lifting that the central banks may aim to do later this year? Do central bankers feel cornered into acting either way as inflation is so far above their mandated target levels that they feel they have no choice but to tighten policy?
The classic tug of war between demand and inflation will surely become the focus for central bankers in the coming months, and will ultimately become a key driver for FX pairs for the rest of this year. It seems nailed on that rate increases and updates on quantitative tightening will be coming in the next few weeks on both sides of the pond. The critical question will be how tight will monetary policy need to become? The world continues to watch as the situation unfolds in Ukraine.