One Bank’s View Of What Happens Over The Next Few Hours, For The Rest Of The Week, And Beyond

With markets scrambling to peer beyond the fog of war, Deutsche Bank FX strategist George Saravellos breaks it down, and writes that It is perhaps most useful to think about the market impact of the dramatic developments in Ukraine over the last twenty four hours by time horizon. His thoughts are below:

Over the next few hours, the direct impact is likely to be dominated by the likely severity and scope of sanctions to be potentially placed on Russia and the impact this has on various aspects of financial plumbing. The jurisdictions that are most likely to impose freezes on Russian assets are likely to be seen at most risk of capital diversion towards those that are not. For example, with Russia still holding 200bn of EUR reserves, there is a question of what happens to this allocation. We highlighted overnight how GBP has potentially also benefitted from significant Russia capital inflow in the past and is therefore at risk from capital diversion. With Switzerland so far not confirming sanctions, in addition to all its broader safe-haven characteristics, the CHF should be the biggest outperformer in Europe, though the SNB is likely to be more active in smoothing moves. This notwithstanding, with most of the G10 more likely to impose sanctions, CNH (and other EMs) seems to be the most likely alternative destination for immediate capital flight.

For the rest of the week, the most important question for the market is what is the impact of the crisis on energy prices. Put simply, is the supply of natural gas to Europe going to be restricted and how much does the price spike? European natural gas futures have moved sharply higher today. We wrote about the transmission channels of geopolitical risks in Ukraine to the euro here, and with developments being at the very low end of expectations that EURUSD has depreciated significantly makes sense. Where natural gas prices settle a week from today will matter a lot.

Beyond the week, the most important question for the market is what the monetary and fiscal response is going to be to what are clearly stagflationary developments? The mere presence of massive uncertainty should soften central bank hawkishness across the board in coming weeks. But beyond that, the response is likely to be dependent on two things. First, the relative impact of higher energy prices on growth versus inflation. Second, the likely fiscal response to offset the negative hit to growth.

The US stands out as the economy with the least direct negative growth impact of the crisis versus Europe, so beyond the near-term uncertainty, the ultimate Fed conclusion may well lean hawkish. However, another negative supply shock accompanied by a further rise in inflation will merely serve to reinforce the same dynamics we have been writing about in recent weeks – front-loaded hikes but rising recession risks and an inability to reprice neutral rates significantly higher.

For European central banks, the conclusion is far more ambivalent and very much dependent on the fiscal response. The greater the fiscal response to offset negative growth (eg via energy price subsidies), the more this will lead central banks to focus on the hawkish inflation interpretation and vice versa. This will be a critical variable to watch going forward but given the nature of the shock our prior is that supportive fiscal policy is very likely.

Recent developments have clearly been a big setback to our positive euro view. We would, however, argue that GBP is even more at risk given BoE pricing, equally significant exposure to energy and other risks. We are not changing any forecasts until we have greater clarity on the ultimate energy impact in coming days and the combined monetary and fiscal outlook discussed above.