Financial markets were sent into a tailspin on Thursday on the news that Russia had begun a full-scale invasion of Ukraine, launching land, air and sea attacks on military bases, airfields and many of the country’s major cities.
Despite a whole raft of warnings from world leaders, and President Putin himself, financial markets have been caught wrong-footed by the news, holding onto misplaced optimism that a peaceful solution could be found that would avoid bloodshed. Ukraine has declared martial law, with residents fleeing the capital Kyiv and seeking shelter in metro stations and air raid shelters, while neighbouring countries have already begun taking in refugees. Over a hundred military and civilian fatalities have so far been reported and, unfortunately, the situation looks set to deteriorate before it gets better.
How have financial markets reacted so far?
Unsurprisingly, the initial reaction in markets was to pile into the safe-haven assets at the expense of higher-risk ones, a traditional response to periods of intense uncertainty. Equity markets have sold-off across the board, notably in Europe – Germany’s DAX index index, for instance, was down by around 5% to its lowest level in nine months, with most of the other major European indices nursing similar losses. Eastern European stocks have been hit particularly hard, down well in excess of 10% for the day in some cases. Russia’s MOEX index declined by 45% at one point, ending the day 34% lower.
The sell-off in currencies has been led by the Russian ruble itself, which at one stage collapsed by almost 10% to a record low versus the US dollar, albeit some of these losses were partly recouped as European trading progressed. Most major currencies in the CEE region have followed suit, given both their close economic ties to Russia and physical proximity to the conflict. The Polish zloty and Hungarian forint fell by more-or-less 4% against the USD, with the Czech koruna down in excess of 2% on Thursday. Indeed, few emerging market currencies were spared from rather violent sell-offs. Many were down by more than 1% or more yesterday, with the exception of most of those in Asia, which have managed to hold up reasonably well, notably the Chinese yuan.
Russian invasion of Ukraine upends world markets
In the end, US intelligence warnings were fully vindicated as Putin launched a full-scale invasion of Ukraine on Thursday.
For the next two days, markets girated wildly, but a sense that Western sanctions would avoid cutting Russia off entirely from the financial world fuelled a late rally on Friday on most risk assets. As this is written, this is already outdated, as Western sanctions escalated over the weekend and Putin put nuclear forces on alert. We have seen a fresh flight to safety and a complete collapse of the Russian ruble, which was down by almost 30% against the US dollar at one stage this morning. This forced the Central Bank of Russia to more than double its interest rates: the reference rate was increased from 9.5% to 20%, the highest level in nearly two decades. The reaction of the currency market shows that while investors perceived initial sanctions as fairly mild, cutting off selected Russian banks from SWIFT and targeting the Central Bank of Russia, limiting its ability to defend the ruble are very strong, decisive steps that will cause enormous damage to Russia’s economy.
Two themes could be discerned from last week. First, the US dollar is back as the safe-haven of choice among investors. The Swiss franc and the Japanese yen outperformed, albeit to a much lesser extent. Second, commodities rallied, led by the energy complex, as did the currencies of commodity exporting countries, with the obvious exception of the ruble. The Norwegian krone rose sharply against almost every other currency in the world.
Currency markets now will be driven by the developments out of Ukraine and Russia, but also the reaction of the world’s central bank to the crisis, which will likely exacerbate inflationary pressures while also adding downside economic risks, particularly in Europe. The outlook is extremely uncertain, but we will do our level best to keep you posted on key developments.
Russian invasion of Ukraine resulted in a downward pressure on regional currencies including koruna, which sold off by 1.7% against the euro. At its weakest point on Friday, koruna fell to its lowest level this year, with the EUR/CZK jumping above the key 25.0 level before partly reversing the move.
Nevertheless, koruna ended the week with smaller losses than its main regional peers, the Polish zloty and Hungarian forint, which could be a consequence of slightly different risk profiles between currencies as well as CNB’s rhetorics suggesting the bank keeps tabs on the situation in the markets and may use its tools to help bring it back to normal. In a statement following the meeting of the Bank Board, the CNB stated that it’s ‘ready to react at any time to excessive koruna exchange rate fluctuations’ and that it has ‘sufficient international reserves’. Those reserves, at 175 bn USD (~11 months of imports), are one of the largest in CEE even in nominal terms and more than enough to keep the pressure off koruna if the bank deems it necessary. Mention of a limited trade relationship between Czechia and Ukraine, Russia and of the short-term inflationary effect of the situation further boost the argument in favour of propping up koruna should the situation warrant.
Today the koruna weakness continues as additional severe sanctions on Russia disrupt market sentiment. The pressure on the currency may remain if there is no peaceful resolution in the near term and could increase if there’s further escalation. That said, it seems likely we’d see an intervention from the CNB if the currency weakens too much.
The key question for the euro now becomes the extent to which the ECB delays tightening in response to war in Ukraine. The harsher sanctions announced over the weekend increase the risk of disruption of Russian energy supplies to Europe, which will be both inflationary and detrimental to production capacity across the economy, a nasty mix the response to which is not immediately obvious.
Ordinarily the February inflation data out Wednesday would dominate the week, but obviously the developments in Russia and Ukraine and the reaction from ECB officials will be far more important this week.