FX Talking: Same shock, new drill

A new military conflict has broken out. Energy and natural gas prices are surging and so is the dollar. The 2022 playbook saw the dollar soar by 15%+. While very few, if any, know when this conflict will end and when energy prices reverse, what seems highly unlikely is that the Federal Reserve is about to embark on a 500bp tightening cycle as it did in 2022. Barring a prolonged period of high energy prices which causes a global recession, we think the dollar’s upside is relatively limited.

Europe also looks better placed to cope with an energy crisis than it did in 2022, being less dependent on gas and having more access to renewables and nuclear. At the same time, we expect the European Central Bank to be much closer to tightening than the Fed, where the latter is governed by both a stable inflation and maximum employment mandate. Modelling some of the most severe energy outcomes, we struggle to see EUR/USD sustainably below the 1.10/12 area this year. We have cut our EUR/USD profile, however.

Within the G10, it has been the energy exporting commodity currencies that have best kept pace with the dollar rally. The Australian dollar’s rally looks more sustainable than that of the Canadian dollar, but both would be hit were global equity markets to take a major turn lower. Sterling also looks to be on borrowed time, where recently priced Bank of England tightening expectations can quickly dissipate. Elsewhere, expect Japanese and Swiss authorities look set to intervene against yen weakness and Swiss franc strength respectively.

In emerging markets, Hungary dominates the CEE story ahead of major elections in April. In Asia, Indonesian and Philippine FX appear more vulnerable to the energy shock. And if conditions calm, USD/CNY could easily move into a new 6.70-7.00 trading range.