Financial markets have been hit by the war between Russia and Ukraine, but rising inflation dynamics and consequent central bank policy tightening will drive currency markets, Chris Turner, Global Head of Markets at ING, wrote in a note titled, ” of trade war against trade monetary restraint.”
“Yesterday’s trading session was a prime example of the futility of trying to pick a top in the interest rate markets. It seems too early in the cycle, especially with so many central bankers ready to step on the brakes to avoid that inflation is spiraling out of control Aggressive tightening and perhaps a more difficult risk environment will now dominate FX,” he said.
Since Russia invaded Ukraine at the end of February, commodity prices have risen sharply due to supply disruptions due to sanctions against Moscow by Western countries. That, in turn, has pushed up inflation worldwide.
With inflation running rampant, major central banks were expected to turn to aggressive monetary tightening policies to contain mounting price pressures. The US Federal Reserve is forecast to lead the way, and expectations for more significant and faster rate hikes are mounting.
The dollar index (DXY), which measures the dollar’s performance against six of its peers, rose this week to its two-year high above the 100 mark.
“In a week of IMF meetings, we have heard from quite a few central bank speakers, and the message from the Federal Reserve and the Bank of Canada, among others, is that key rates must be brought to neutral as soon as possible. Even Catherine Mann of the Bank of England hinted at the need for a faster pace of tightening,” said Mr Turned.
“Central bankers’ expectations stepping in increments of 50 basis points or even 75 basis points are now contributing to volatility in interest rates markets. This theme looks set to stay with us in the coming months and may well become the dominant market engine rather than the war in Ukraine, which, aside from human tragedy, has largely been treated as a raw material shock,” he added.
While commodities heavily consuming currencies have risen since the conflict in Ukraine, the US dollar has risen following Fed policymakers’ calls for extremely aggressive rate hikes.
“Don’t try to fight the strong dollar bull trend, and the DXY could probably stay above 100,” Mr. Turner said.
“What does this potential shift in focus mean for foreign exchange markets? The war in Ukraine and the impact on commodity prices had turned currency trading through the terms of trade lens – or winners and losers in the commodity war,” said ING’s global head.
“If we want to shift into a more difficult risk environment due to what we call involuntary tightening – where real returns go deeper into positive territory – we could begin to see some of the risky commodity pairs share some of the war-inspired gains” , he added.