Currencies In Crisis

Market participants should expect significant additional hand-wringing in the new week about the outlook for the euro, pound and yen, all of which have come under enormous pressure in the face of an inexorably stronger dollar and rapidly deteriorating fundamentals.

The yen will remain in the limelight as traders, on tenterhooks, ponder a possible intervention to stem a harrowing slide that’s upended traditional correlations and threatens to undermine public support for the Bank of Japan’s prolonged adventures in monetary Neverland.

As discussed here at some length over the weekend, the BoJ has no good options for adjusting (let alone scrapping) its yield-curve control regime, and that assumes Haruhiko Kuroda is open to adjusting it in the first place, a questionable proposition if ever there was one.

A lot hangs on the trajectory of US real yields, and I’d reiterate that absent a willingness on Kuroda’s part to at least adjust YCC, intervention, even if coordinated with the US, would surely fail. “The main question from here is if USDJPY at higher levels in the coming months could prompt direct FX intervention or an earlier-than-expected shift in BoJ policy,” Goldman’s Kamakshya Trivedi said, noting that the bank’s “relatively high conviction view that YCC will remain in place until at least the end of Kuroda’s term leaves little left in the way of further USDJPY upside, as long as US yields continue to trek higher.”

I should emphasize that the tension is running very, very high. It’s not a stretch to suggest that one more leg up in US reals could be the final straw for Japanese officials if it catalyzes another sudden bout of depreciation pressure. The yen enjoyed a bit of respite Friday on the back of what counted as conciliatory remarks from Kuroda. That raises the stakes for this week’s spate of key US data. If US CPI and retail sales merely match consensus or come in below expectations, the yen may win a longer reprieve. If not, not. A fresh read on Japan’s trade balance is due as well. That’ll be watched closely.

Meanwhile, the euro will continue to eye progress (or a lack thereof) on officials’ fraught plan to intervene in energy markets. Apparently, the EU will pursue price caps, only not on gas itself, but rather on “excess” revenues of non-gas energy producers. There’s also support for a plan to provide emergency assistance to power firms struggling to cope with unfathomable margin requirements, which present operational and market function risks. Earlier this month, Norway’s Equinor suggested $1.5 trillion is needed to help ameliorate the increasingly untenable cost of managing derivatives positions.

“The EU’s windfall plan, yet to be fleshed out, would see governments skim off excess revenues from wind, nuclear and coal-fired power plants that can currently sell their power at record prices determined by the cost of gas, and use the money to curb consumer bills,” Reuters said, summing up the latest brainstorming session in Brussels. Governments may also impose a “solidarity contribution” tax on fossil fuel companies.

Hungary expressed reservations about capping Russian natural gas — Viktor Orban’s cozy relationship with Vladimir Putin is a perpetual stumbling block for EU officials. Putin shut the Nord Stream altogether this month, and countries still receiving Russian gas aren’t excited about the prospect of losing whatever flows they’re still receiving. A universal price cap (i.e., a price cap that doesn’t single out Russia) would be difficult to implement and could choke off alternative supplies at a time when Europe needs them most. “I would not say there was broad support for a broad gas price cap,” a Dutch official remarked. Notably, two floating LNG terminals set up in a Dutch port began operating this month.

On Sunday, during an interview with ARD, Lars Klingbeil, co-head of Olaf Scholz’s SPD, described Germany’s predicament in straightforward terms while suggesting the government may move to cap gas prices. “We have to pay the bill anyway. The question is whether we do this now at the beginning, by intervening in the markets, or whether it comes later, through insolvencies and unemployment,” he said. “I want us to take the initiative and intervene now.” Scholz on Saturday claimed Germany is prepared if Russia cuts all supplies. The Scholz government has already committed nearly €100 billion to crisis-fighting measures.

Last week, Bloomberg reported that Germany is struggling in its efforts to secure more “gas solidarity agreements” with ostensible partners in the EU. Some of the country’s neighbors, Arne Delfs wrote, “refuse to engage in ‘constructive negotiations’ about such bilateral deals,” according to a report attributed to Economy Minister Robert Habeck.

This comes as the Russian military suffers significant setbacks in Ukraine. It’s worth considering the possibility that Putin eventually resorts to more extreme measures in the event his army isn’t able to hold newly captured territory. I realize the prevailing narrative centers on the notion that Western governments, under pressure from voters weary of sky-high inflation, will waver in their support and that time favors Russia. But Western funding and armaments for Volodymyr Zelenskyy aren’t some under-the-table, shoestring-budget CIA operation — Putin is battling the well-funded army of a sovereign state fighting to preserve its independence. There’s an outside chance he could lose, unless he resorts to a no-holds-barred approach that risks dragging in NATO.

As a quick aside, it’s important that market participants seeking to make sense of the conflict understand that Putin is in the final stages of a decade-long transformation from cynical KGB kleptocrat to delusional ideologue. This descent began in earnest sometime around 2012, and although Putin’s deep suspicion of the West and profound distrust of NATO is routinely cited (including by Putin himself) as a justification for Russian military projection, the quest to conquer Ukraine is a manifestation of an imperialist fever dream cobbled together from various sources ranging from the wholly legitimate to the lunatic.

Zelenskyy claims Ukraine’s aim is to liberate the entire country from Russian occupation. If, against the odds, such an outcome began to seem even a semblance of likely, it’s difficult to overstate how psychologically devastating that would be for a man (Putin) experiencing a kind of identity crisis disguised as a cultural awakening. That poses significant escalation risk, and I’m quite sure markets aren’t priced for it because virtually no one who operates in them (markets) understands the nuance.

In any case, the medium-term outlook for the euro remains very challenging, and as discussed at length here following the September policy decision, the ECB’s efforts are a sideshow. All that matters are energy prices, the war and, as trite as this sounds, the weather. In a radio interview Sunday,  Bundesbank President Joachim Nagel called the ECB’s 75bps hike “a clear sign” and emphasized that “if the inflation picture stays the same, further clear steps must follow.” Nagel’s correct. “Further clear steps” are indeed necessary. It’s just that they don’t have anything to do with monetary policy.

In the UK, the Bank of England decision originally scheduled for this week was pushed back as the nation mourns Queen Elizabeth II. But gilts and the pound will continue to struggle with an impossibly convoluted outlook. Liz Truss’s plan to cap household energy costs will tamp down near-term inflation and thereby reduce the urgency of BoE rate hikes, while raising the odds that inflation becomes entrenched, thereby making it more difficult for the BoE to pivot later. Just as vexing: Financing the Truss plan could entail a deluge of gilt issuance just as the BoE embarks on an effort to actively shrink its holdings. UK inflation data for August is due this week. As far as I can tell, all scheduled releases from the UK will go ahead. ONS did postpone last Friday’s publications out of respect for what it called “the profoundly sad announcement of the death of Her Majesty.”

As for the contention (popular in some circles) that the UK is one currency crisis away from becoming an emerging market, Goldman seems to doubt it. “[A] potentially much more active fiscal response under the new PM… has prompted fresh questions regarding the UK’s fiscal position and whether we are heading for an ‘EM-style’ BoP crisis,” the bank wrote, noting that although the UK economy is indeed “suffering from a significant fundamental shock, with higher energy prices clearly weighing on the external balance,” Goldman doesn’t “see the makings of a fiscal crisis. “Historically, ‘sudden stop’ episodes are catalyzed by pressures on a fixed exchange rate regime featuring external debt denominated in a foreign currency,” the bank said. “The UK is a long way from this dynamic, and recent currency depreciation is consistent with a natural adjustment process to a negative external shock.”

If there’s a silver lining in all of the above, it’s just that the euro, the pound and the yen have fallen so far, so fast, that the odds of additional sharp depreciation in the very near-term are perhaps less. “The aggressive fiscal reactions to higher energy prices support a view that while we may not have seen the dollar’s peak, it isn’t very far away,” SocGen’s Kit Juckes remarked, adding that with “a lot of bad news embedded in current FX levels,” a period of consolidation in “low ranges” is more likely than a “fresh 10% fall.”

Juckes was less optimistic about the longer-term outlook for sterling, though. “GBPUSD is still above the 1985 low, but this is set to see the lowest annual average level ever unless something very strange happens in the coming weeks,” he said, adding the following, which I’ll quote without further comment:

There’s a strong chance that King Charles III will be the first British monarch to pay more than a pound for a dollar, or more than a pound for a euro, or both. Neither is likely this year, but sterling’s post-GFC downtrend won’t end until there’s a seismic change in the direction of economic policy and the economy. After Blair/Brown’s ‘Cool Britannia’ decade of 3% growth was allowed to get out of control on the back of inadequate financial regulation, GDP growth has averaged a measly 1.5%, and the current account deficit has averaged almost 4% of GDP. The sad truth is that while Queen Elizabeth was great, her recent governments haven’t been.