Two main forces to drive currencies

The surge in energy prices and tightening by the Fed is creating a deadly cocktail of increasing debt finance costs, rising inflation, slumping growth and generally much tighter financial conditions.

The first is largely within Europe where currencies are under severe pressure because of the surge in gas prices resulting from the Ukraine/Russia conflict. A second, and related, force is primarily aimed at riskier developed currencies and emerging market currencies and this stems from the tightening of financial conditions caused by Fed rate hikes and quantitative tightening.

Some of the worst performing currencies so far this year lie in emerging Europe. The likes of the Turkish lira, Hungarian forint, Policy zloty and Czech Koruna have all tumbled against the dollar and fallen (albeit by less) against the euro as well. These currencies have the double whammy of the surge in gas prices and the sharp rise in the US fed funds target.

In contrast, a number of emerging market currencies in South America such as the Brazilian real and Mexican peso have made modest gains against the dollar and big gains against the euro. And, while Asian emerging market currencies have fallen against the dollar, it has been far more modest than we’ve seen amongst emerging European currencies, and the Asian EM’s have also seen currency strength against the euro.

All this suggests to us that currency markets are responding in the right way to the various threats that exist at the moment. This leads to two questions. The first is whether these currency movements will persist if European energy prices continue to rise and the Fed pushes on with rate hikes? A second issue is whether the persistence of these strains could cause new tensions to emerge and so push currencies in different directions?

The answer to the first question seems pretty straightforward in our view as Eastern European emerging (and developed) currencies seem likely to be the weakest global performers if European gas prices continue to climb and the Fed continues to hike. Of course, by the same token, if there’s a rare ray of sunshine from the Ukraine/Russian conflict that causes gas prices to tumble we could see these Eastern European currencies staging the strongest rebound; something that could be re-doubled should the Fed start to signal an end to rate hikes. For the moment, though, we think it is best to assume that the dark days for Europe will continue.

The second question is more interesting. For instance, the surge in energy prices and tightening by the Fed is creating a deadly cocktail of increasing debt finance costs, rising inflation, slumping growth and generally much tighter financial conditions. This could put highly indebted countries at greatest risk of major currency weakness whether they lie in the European hotspot or not. Should surging gas prices be the dominant factor going forward it will likely be high-debt European currencies that suffer the most and these won’t just (or even necessarily) be emerging European currencies.

The euro could actually be at greater risk than emerging market European currencies by virtue of the fact that the highest debt loads are to be found in the euro zone – particularly Italy. If we add this to the particular political risk in Italy at the moment surrounding the September general election, we could find that the euro is the weakest performing currency both inside and outside Europe through the rest of the year.

In contrast, if Fed tightening is the most pressing issue through the rest of this year rather than European gas prices, the currency risk may fall more on highly-indebted emerging market currencies that lie outside of Europe and particularly those with hefty vulnerability to higher US rates and a higher dollar.

Financial markets currently price in falling gas prices over time and a lower fed funds rate. This offers some hope for European currencies and emerging market currencies more generally. But while that might describe how gas prices and US policy rates will move through the second half of 2023 and beyond, the next 6-12 months still looks tough and European/emerging currencies are best avoided until the dust has settled.