The energy crisis has sent shockwaves through the FX markets, prompting a widespread deleveraging of risk. This shift in market dynamics is a cause for concern, especially for investors.
A Shifting Landscape in FX Markets
Yesterday, we witnessed a subtle yet significant change in the drivers of FX markets. While Monday's focus was on the impact of soaring energy prices on currency movements, Tuesday brought a different story. It was a day of broad deleveraging, as cross-market volatility spiked and investors rushed to unwind their open positions.
Equities took a hit, with financials leading the sell-off due to their large overweight positioning. The spike in volatility and rising Value-at-Risk metrics prompted a widespread reduction in position sizes, particularly in FX markets, which further strengthened the dollar's position.
But here's where it gets controversial... Some argue that the story of redemptions in the private credit space is merely a side note to the overall market sell-off, with headlines like those of Blackstone and Blue Owl being just a small part of the bigger picture.
Navigating the Energy Crisis
The near-term market drivers of risk are twofold. Firstly, the ability of energy prices to reverse and decrease if the Straits of Hormuz can be reopened is crucial. Secondly, the actions of central banks in either cutting rates to support economic activity or avoiding policy tightening will significantly impact market sentiment.
Last night, risk assets received a brief boost when President Trump suggested that shipping in the Straits may receive naval convoy support and that US federal institutions would back the insurance of shipping fleets. However, the market is waiting for concrete evidence of these actions before fully committing.
As for central banks, the inflationary risk posed by the energy shock has caused a re-pricing of the short-end of the curve. This trend briefly reversed yesterday as equity losses intensified, but unless we see another major sell-off today, the hawkish re-pricing of the short-end looks set to continue, favoring the dollar.
The Dollar's Dominance
The dollar has had an impressive week so far, with the DXY index reaching as high as 99.68 yesterday. Investors may be hesitant to chase the dollar beyond the 100.00/100.35 highs seen over the last eight months. However, a clear improvement in the energy situation is needed before investors feel comfortable taking short dollar positions again.
EUR/USD: Finding Support
Long euro positioning, particularly in the asset management community, left EUR/USD vulnerable yesterday, with the pair dropping to 1.1530. The currency pair is being impacted by both the terms-of-trade story and the broad-based deleveraging narrative.
The terms-of-trade story will likely be the dominant theme, and the duration of the energy shock will determine whether EUR/USD needs to trade down to 1.10/12 or can find support near 1.15. Our base case scenario suggests that operational intensity will decrease over the next week, and the Straits of Hormuz will slowly reopen.
Unless there are major new headlines from the Gulf today, we may see conditions calm down a bit, and EUR/USD could find support in the 1.1550/1575 area.
CEE: A Chance for Relief
The Central and Eastern European region experienced a second wave of sell-offs yesterday, but we believe this was the main part of the shock since the US-Iran conflict began. Despite seeing multi-week highs earlier in the day, there were signs of relief at the end of yesterday's trading session, with oil prices stabilizing and gas prices falling from their highs.
This provides an opportunity for CEE currencies to recover today. The National Bank of Poland will decide on interest rates today, and while a 25bp rate cut to 3.75% seemed likely before the conflict, the decision is now a close call. Our economists still believe a rate cut is the most likely outcome (https://think.ing.com/articles/national-bank-of-poland-preview-geopolitical-tension-makes-a-march-cut-a-close-call/).
In the Czech Republic, February inflation data will be released this morning, and our economists expect a decrease to 1.4% YoY, which should help calm the sell-off in rates.
Central Banks' Resilience Tested
The managed currencies of the region, the Turkish lira and Romanian leu, have faced a significant test of their central banks' ability to maintain control. In Turkey, February inflation confirmed a year-on-year increase for the first time since September, putting the Central Bank of Turkey in a challenging position.
Despite this, the CBT has successfully kept USD/TRY stable by reducing carry positions, although FX implied yields have spiked, effectively tightening monetary conditions. We expect USD/TRY to remain stable as the CBT aims to limit inflationary pressures.
In Romania, a similar situation is unfolding, with long positioning in FX and Romanian government bonds unwinding after a strong rally. EUR/RON saw a short-term spike but quickly returned below 5.100. The central bank is likely to maintain a balanced approach, given the unwinding of long positions and the decrease in excess liquidity seen in January data.
Final Thoughts and a Question for You
The energy shock has caused a ripple effect across FX markets, prompting a broad deleveraging of risk. As investors navigate this complex landscape, the actions of central banks and the evolution of the energy crisis will be crucial.
What are your thoughts on the current market dynamics? Do you think the energy shock will have a lasting impact on FX markets, or will we see a quick recovery? We'd love to hear your insights in the comments below!
