FX Dashboard: In the Line of Fire – Impact on Central European Currencies from Russia’s Invasion

Earlier this week, the US dollar index (DXY) touched 99.4, the strongest level since March 2020. Even though it’s off the peak now, since the start of the Russian invasion of Ukraine on Feb 24, the dollar has strengthened by 1.8%. This is consistent with my view that in the near term the dollar should remain strong, with a risk of further appreciation – see The US Dollar View and Its Implications for EM Currencies. Overall, my view is the current environment is not supportive of EM currencies broadly.

As expressed in Contagion Risks from Russia to Other EM Currencies, the headwinds to EM currencies increased following Russia’s attack. Indeed, since Feb 24, EM currencies have depreciated by 1.8% on average for 21 currencies, which is in line with the historical beta of slightly below -1 to the US dollar. If the dollar revisits its peak, the risk is the pace of depreciation for EM currencies increases beyond its historical beta.

Of the EM currencies, the worst hit are from Central European (CE) countries. As the chart below shows, these currencies have considerably outpaced the sell-off in broad EM, even when looking at the cross against the euro.

Data Source: Refinitiv; Note: EM FX is equally weighted indices of spot returns of 21 currencies; EURCE4 is an index of CE4 currencies against the euro

Parsing the performance by currency since the start of the invasion, the CE currencies stand out as the worst performers along with the Turkish lira (TRY) – see the charts below. The drivers behind this underperformance are:

• Euro under pressure: CE currencies tend to follow the euro as they are closely interlinked with the eurozone via trade. The euro, meanwhile, has weakened as should be expected with the US dollar strengthening. However, there are other reasons to expect that the euro may remain under pressure:
  • Global economic growth to suffer, led by Europe: After softening towards the end of 2021, the European economy showed signs of a strong bounce this year, as evidenced from the Euro area February economic sentiment and Germany’s January industrial production data. Looking ahead though, both activity and confidence readings are likely to drop due to the uncertainty about the duration and impact of the war, with the European countries the most vulnerable due to their proximity. It’s too early to estimate the magnitude of the impact, but the direction is clear.
  • Inflationary risk, again led by Europe: A direct result of the war has been a sharp increase in commodity prices, particularly oil following the ban of imports from Russia by the US. Prices of other commodities, including wheat and nickel, have also risen sharply as either Russia or Ukraine or both are important exporters. Some of the price increases are the result of sanctions while others are due to supply issues. The price increases are large enough to result in demand destruction, hurting economic activity further, especially in Europe which is a major commodity importer.
• Risk of direct conflict: NATO has been careful to not get directly involved in the war, even though they have actively supplied weapons to Ukraine and are accepting refugees from there. However, President Putin’s exact motives behind the invasion are unclear, which makes it difficult to rule out his intentions of a deliberate escalation by attacking one of the NATO countries, especially since the war is faring badly for Russia and its economy is getting crushed by the sanctions. Even if there is no deliberate attack, the risk of an accidental or unintentional escalation cannot be ruled out.

The European and CE authorities have taken a few steps to try and mitigate the impact on their economies and currencies:

• EU joint bond sale: According to Bloomberg, the EU is debating issuing a joint bond to finance the increased energy and defense needs of the region as a direct result of Russia’s invasion. Issuing a mutual bond would help alleviate the impact on the regional economy from the increase in commodity prices.
• Rate hikes: Poland’s central bank delivered an upside surprise with a 75 bp rate hike at its meeting this week. The move led to an increase in rate hikes priced in the curve. Hungary’s central bank followed a 50 bp base rate hike at a meeting just before Russia’s attack with a greater-than-expected 75 bp increase in the one-week deposit rate, which is the de facto policy rate and allows for quick adjustments in interest rates.
• FX interventions: Central banks have also stepped up currency interventions with Poland, Hungary, and Czechia intervening multiple times in recent days. With sufficient international reserves, the interventions can continue as necessary.
• Swap lines: Poland’s central bank is seeking foreign currency swap lines with the ECB, Fed, and SNB as a precautionary measure.
• Exports ban: Hungary has banned grain exports effective immediately to compensate for the loss of wheat imports from Russia and Ukraine.

These steps will deliver what is intended – mitigating the impact on their currencies. Ultimately, the magnitude of the impact will be a function of the duration and intensity of the war, which is difficult to predict. Nevertheless, a risk premium needs to be in place in the euro and the CE currencies for the time being.

I have currently two outstanding trade recommendations in the region: Long Hungarian forint (HUF)/Short Czech koruna (CZK) and Receive Poland 10y (PLN 10y) vs Pay Eurozone 10y (EUR 10y) local rate (see here and here). Both trades have been affected by recent developments. Nonetheless, keeping regional hedges has reduced the impact. For now, I continue to recommend holding both trades.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 21 currencies

Best Longs / Best Shorts

• To the list of underperformers based purely on my models in the attached FX Dashboard pdf, I added Polish zloty against the euro (EURPLN) and Korean won (KRW) as their z-scores crossed 1.
• The list already had Israeli shekel (ILS), Hungarian forint against the euro (EURHUF), the Philippine peso (PHP), and the Taiwan dollar (TWD) on it.
• On the list of outperformers, I replaced Thai baht (THB) with Chilean peso (CLP).
• The list already had Peruvian sol (PEN) and Brazilian real (BRL) on it.

Best Crosses

• The list of the preferred relative-value trades based purely on my models changed to Short BRL vs Long ILS or Hungarian forint (HUF) or Polish zloty (PLN) and Short PEN vs Long ILS.
• The 3m expected returns for these pairs are in the range of 14-16% (not annualized), assuming mean reversion.