As predicted, the UK, Europe, and the US have maintained their position of using financial sanctions as the primary tool to push back against Russian aggression, including:

• Sanctions (such as asset freezes and travel bans) against more than 100 individuals close to the Russian government, as well as President Vladimir Putin and Foreign Affairs Minister Sergey Lavrov
• Expanding the list of sanctioned financial institutions to additional large state-owned banks
• Restrictions on the ability to do business with Russia’s ministry of finance, state-owned investment funds, and Russia’s Central Bank
• Additional restrictions on Russian (mostly state owned) enterprises’ ability to access financing in US dollars, euros, or sterling
• Preventing Russian banks from accessing the SWIFT financial messaging system

We think that recent events introduce a different set of factors that have been largely off the markets’ radar for a long time – most notably the return of geopolitical risk.

Just a few months ago, when the pandemic and its aftermath still dominated the economic narrative, geopolitical risks were seen as largely marginal – something that spiked occasionally but would fade over time. Now, the world order appears very different. That western countries were not capable of containing Russia raises the prospect of further de-stabilisation, especially over the long-term.

But in the near term, central banks – already so keen to keep a lid on inflation – could face greater challenges as sanctions start to bite in FX and energy markets.

While the situation is clearly very fluid, we see the crisis influencing global FX markets in a number of important ways.

1. The European Central Bank (ECB) may not be so quick to tighten monetary policy, hiking rates only late in 2022 or in 2023, meaning a weaker euro against sterling and the US dollar

Markets reacted quickly in the early aftermath of the invasion, most notably its expectations around when and how quickly central banks will hike interest rates in a bid to cool the economy. We feel this is most appropriate in Europe given the relatively strong links with both Russia and Ukraine. These risks are compounded by potential indirect impacts on consumer spending, growth expectations, inflation due to higher global energy prices, and tighter global financial conditions.

2. The US Federal Reserve and the Bank of England don’t seem to be knocked off the tightening path – so expect more monetary policy divergence across major central banks

Compared with Europe, lower direct exposure of the US and UK to Ukrainian and Russian economies skews risks toward a wider gap in monetary policy between major currencies. A (relatively) weaker labour market in the Euro-area, compared to the US and the UK, gives the ECB slightly more flexibility to turn dovish in the face of the crisis. We think the same cannot be said for the US and the UK, where stronger underlying labour markets can keep pressure on central bankers to remove accommodation and nudge interest rates higher.

3. With the exception of the Russian ruble, emerging market (EM) FX will remain driven by economic fundamentals

Needless to say, we expect the Russian rouble to perform poorly after having already weakened some 30% year-to-date. More broadly, EM currencies have remained fairly resilient since the beginning of the year, but they suffered in the wake of the crisis as portfolio managers sought to reduce risk exposure. We expect some recovery in the coming weeks as negative headlines exhaust their influence. Higher energy prices will put some pressure on EM trade balances, but we would also expect central banks to retain or even increase hawkishness on the back of higher expectations. All in all, ruble aside, we think our longer-term EM FX views remain intact – we’re positive on the Chilean peso, Brazilian real, and renminbi, but expect underperformance for the Mexican peso, the South African rand, and the Korean won.

The escalation of tensions is occurring against a backdrop that already saw rising crude oil prices. Put bluntly, oil supplies are struggling to keep pace with surging demand fuelled by global reopening. Organization of the Petroleum Exporting Countries (OPEC) has remained quite conservative in its supply increases, and global production has also been slow to recoup pandemic-era declines.

Notably, the western response appears to have been designed to put relatively little direct pressure on Russian energy markets and exports. That said, western countries have a few options to try and manage higher prices and disruption, though we aren’t particularly confident they’re workable or effective – none of them fundamentally alter the core supply / demand outlook outlined above.

Coordinated Strategic Petroleum Reserve (SPR) Release

Western nations have already announced their intention to use their first option – an SPR release. The 31 member countries of the International Energy Agency (IEA) agreed this week to release 60 million barrels of oil from their emergency reserves,  equivalent to 2 million barrels a day for 30 days. However, strategic reserve releases are one-offs, stopgap supply fixes, and as such they are unlikely to have as lasting an impact on the supply/demand balance in the way a more permanent increase in production would.

Put pressure on OPEC to accelerate supply increases

In addition to SPR releases, we think the pressure from the US and other major energy consumers on OPEC to increase near-term oil supplies is likely to be immense. OPEC’s next formal meeting in March 2nd, but we are not convinced that OPEC will respond quickly. The conflict in Ukraine has not (yet) created a significant disruption in actual oil supplies, even though market prices have adjusted to an increased risk of future supply disruptions. Complicating matters further is OPEC’s open coordination on oil markets with Russia as part of the group formally called “OPEC+” – navigating the politics of working with the west while keeping coordination with Russia may be tricky. More broadly, several OPEC+ nations have already struggled to meet the relatively modest, pre-scheduled monthly increases in supply quotas.

Finalise the Joint Comprehensive Plan of Action (JCPOA) deal with Iran

Finally, it’s difficult not to draw some parallels between the significant stress in global energy markets and reports of renewed momentum behind revival of the JCPOA. A completed deal could bring as much as 2 million barrels per day back into global oil markets over time, though the speed of which those barrels would return depend critically on how quickly sanctions are removed. Despite some optimism around the JPCOA, however, some fundamental disagreements between the US and Iran on some of the deal’s key terms, such as the timing of sanctions relief, leave us sceptical that an agreement will be concluded soon.

To get insights into the latest themes and events moving markets, please get in touch with your NatWest representative.