More room for USD to gain on safe haven flows

USD:  With dollar longs now substantially pared back and positioning better balanced, USD is benefiting from 3 sources – (1) safe haven demand from the Russian – Ukraine conflict; (2) confidence that the Fed will commence rates lift-off despite geopolitical tensions; and (3) from a USD liquidity squeeze precipitated by Western sanctions imposed on the Russian financial system – though gains in USD from this source are limited in scale and likely to be temporary. There seems to be little to change this trend of dollar strength until the Russia – Ukraine conflict ends with limited scope for retracement.  

EUR: Selling EUR has been the dominant theme in FX this month as the Russia – Ukraine crisis unfolds and energy prices spike. A period of considerably higher energy prices is likely to further raise euro area inflation but also weigh on growth via weaker household spending. The ECB seems more concerned about the latter for now, which suggests it may delay tightening euro area financial conditions until well into year-end or even later. This is in contrast to the US that seems more insulated from the stagflation narrative and where the FED looks to stick to its tightening timeline commencing March. As a result, risks continue to point to further EUR weakness against USD but also against the Commodity FX complex (AUD, NZD and CAD) that seems to be enjoying a lift from the rise in energy and base metal prices.  

GBP: Russia – Ukraine tensions are weighing on cable but to a lesser extent than EUR. UK’s inflation outlook looks more elevated than the euro area and BoE seems to have less margin for policy error. The BoE itself is concerned enough about inflation risks to see 4 dissenters voting for a 50bp hike at the BoE’s February meeting, though the majority ended up voting for a 25bp hike instead. Meanwhile, key UK jobs and retail spending data continue to outperform expectations while markets now discount a BoE cash rate close to 2.0% by early next year. This supports a range bound  cable with a firmer UK rates outlook supporting the downside while upside looks capped by USD resilience and the Russia – Ukraine crisis.  

AUD: Is currently enjoying the support of higher commodity prices resulting from heightened geopolitical tensions. And with RBA Governor Lowe signaling potential rates lift-off is more likely in 2023 than 2022, markets seem to be tightening Australian monetary conditions via the currency to reflect the strengthening economic recovery from Covid. But with market rates discounting 4 25bp RBA rate hikes for 2022, the RBA’s recently expressed desire for an even structurally lower Australian unemployment rate before commencing rates lift-off, leaves it more at odds with market pricing and will need to be reckoned with. For now, the clearer path towards AUD bullishness lies more vs a weaker EUR than USD.   

RMB: Fundamentals that should weaken RMB (narrowing rate differentials with USD and slowing in China’s export momentum) have been replaced by RMB’s emerging status as an alternative settlement and reserve currency following the Russia – Ukraine conflict. This has strengthened RMB. The imposition of Western sanctions including on Russia’s central bank (CBR) might encourage Moscow to ramp up its use of RMB.  CBR has already increased its RMB holdings over the past few years, to ~13% of its total reserves (equivalent of USD130bn) and is likely to raise them further. This might enhance RMB’s safe haven currency status in the short term but RMB’s fundamentals should re-emerge to limit such gains vs USD and eventually weaken the currency as China’s trade and portfolio inflows slow later in 2022.