Three Questions: Week of March 28

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we're watching:

1. Will the ruble keep climbing?

According to legend, Grigory Potemkin, one of Catherine the Great’s courtiers, once executed an elaborate ruse to convince the visiting Empress that his lands were prosperous and well-run. Even as his people starved and lived in tumbledown dwellings, he dressed them in fanciful garb and ordered the construction of facades painted to resemble thriving towns along her travel route.

Today’s ruble exchange rate has a lot in common with these “Potemkin villages”.

From a distant perspective, things are improving. The offshore ruble rallied more than 6 percent last week, and is now trading near the 100 mark against the dollar - up strongly from its nadir near 138.

Energy exports - largely exempt from Western sanctions - have played the biggest role in driving the currency higher. Long-standing contractual arrangements have kept oil and gas flowing through pipelines, and seaborne cargoes are rebounding as buyers and intermediaries learn to navigate new rules. According to a calculator published by the Centre for Research on Energy and Clean Air, Europe has spent more than $22.3 billion on Russian oil, gas and coal since February 24 - and central bank rules are forcing exporters to convert more than 80 percent of their revenues into rubles, ensuring a consistent source of demand.

However, on closer inspection, it is clear that the ruble is no longer functioning as a convertible currency.

New restrictions have driven a collapse in goods and service imports, with businesses and citizens largely unable to buy products on international markets, or travel outside the country.

The central bank has banned foreign currency transactions and capped the amount Russian citizens can withdraw from foreign-denominated bank accounts. Foreign companies and investors can’t liquidate onshore assets. Short-selling is effectively impossible. And on international markets, the ruble is a one-way ticket, with liquidity typically available to buyers, rarely sellers.

In essence, ‘one-way valve’ has been created, with money allowed to flow in, and not out.

To some extent, we have seen a similar dynamic play out in China over the last four decades. By manipulating the flow of capital across borders, authorities were able to limit household consumption, subsidize strategic industries, and build up immense foreign exchange reserves. The renminbi exchange rate painted an illusory picture of the economy and investment misallocation problems grew to a colossal scale, yet the country grew to become the world’s most dominant manufacturer.

But with few of China’s structural advantages, a deep rot is setting in behind the Russian facade. The economy is likely to contract more than 20 percent this year as investment levels plunge and consumer demand is crushed by soaring prices. The manufacturing and high-tech industries will suffer as Western export controls make it difficult to maintain complex machinery. And the energy sector could shrink as European countries take steps to reduce dependence on Russian supplies.

So the ruble could continue to climb, but Western financial sanctions and Russian countermeasures have turned the external exchange rate into an artificial construct that tells us very little about the state of the economy.

Potemkin would be proud.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

2. Will data and events ratify the Fed’s increasing hawkishness?

A slew of incoming data on inflation, employment and business sentiment this week will come on the heels of recent Federal Reserve messaging that has led the market to sharply increase its monetary tightening expectations.

While the dot-plot released on March 16 suggested a 25-basis point rate hike would come at each of the six remaining meetings this year, comments from Chair Jay Powell and other speakers have now pushed investors closer to expecting several 50-basis point moves, with rates climbing by a full 2 percent by year end.

The extent to which the Fed’s and the market’s 2022 policy expectations have been recalibrated – from 75 basis points in hikes to 2.25 percent - has likely raised the bar for data surprises to intensify inflation and rate angst.

Key data points this week include the Fed’s preferred core inflation measure (expected to show a rise of 0.4 percent month-on-month in February); payrolls, where the Fed is more likely to pay attention to wage increases and participation trends; and the Institute for Supply Management’s business-sentiment surveys.

Evident in the Fed’s messaging and rate projections is the view that it has secured its mandate for maximum sustainable employment, even as its inflation mandate is increasingly at risk. In addition, global events, such as the war in Ukraine or Covid-related disruptions of the supply chain in China, are seen as posing significantly higher risks to inflation than to growth.

This baseline in Fedspeak and in market pricing could create potential asymmetries in responses to data or events. Signs of lower business and household optimism, improving US labor supply, slower nominal wage gains, or diplomatic progress in Ukraine may lead to a bigger rethink on inflation fears than the opposite exacerbates such worries.

- KARTHIK SANKARAN, MARKET STRATEGIST

3. Will Japanese authorities do anything to counter the yen's fall?

As the yen moves beyond its all-time lows in terms of its real effective exchange rate, events this week could determine the tolerance of Japanese officials for further currency weakness. As the currency approaches the psychological level of 125 to the dollar, jawboning against further weakness is likely to get louder even if an actual shift in monetary policy is unlikely.

One critical indicator will be Friday’s quarterly Tankan business survey, which is expected to show a deterioration of headline sentiment (from 18 to 10). Concerns about cost-push inflation could lead to a downside surprise.

Last week has seen some concern at the pace of yen depreciation and hints of differences between the finance ministry and the Bank of Japan on the costs and benefits of a depresssed currency.

Finance Minister Shunichi Suzuki said the government was carefully watching the currency markets, but Governor Haruhiko Kuroda reiterated his view that “a weak yen is generally positive for the Japanese economy,” citing increased yen profits recorded by Japanese companies operating overseas rather than a rise in export volume.

Energy inflation, already running at 20 percent year-on-year in February is likely to have risen significantly in March, depressing incomes and confidence. However, the deputy cabinet secretary said over the weekend that countermeasures would take the form of targeted fiscal expansion rather than monetary tightening. Such a package is expected this week.

Still, an accelerating yen decline that reduces domestic purchasing power (and runs the risk of annoying the US Treasury) could bring forth other responses short of actual monetary tightening. Expressions of concern about inflation passthrough will likely escalate, and if the pace of depreciation picks up, there could be hints of changes in the pace of portfolio outflows from government-allied institutions.

- KARTHIK SANKARAN, MARKET STRATEGIST

CATALYSTS

TUESDAY

CAD Survey of Employment, Payrolls and Hours, January

USD Job Openings and Labour Turnover Survey, February

USD Federal Reserve Speech, Harker

WEDNESDAY

EUR European Central Bank Speech, Lagarde

GBP Bank of England Speech, Broadbent

USD ADP Employment Change, March

USD Personal Consumption, Q4

EUR European Central Bank Speech, Panetta

USD Department of Energy Weekly Inventories

USD Federal Reserve Speech, George

CNY Manufacturing Purchasing Manager Index, March

THURSDAY

GBP Current Account Balance, Q4

EUR European Central Bank Speech, Lane

CAD Gross Domestic Product, January

USD Weekly Jobless Claims

USD OPEC+ Meeting

FRIDAY

EUR Consumer Prices, March

USD Non-Farm Payrolls

USD Unemployment Rate

USD Baker Hughes Weekly Rig Count

COUNTERPARTIES

“…unless the Russian petroleum supply shortfall can be contained, it appears necessary for the price of oil to increase substantially and to remain elevated for a long period to eliminate the excess demand for oil.”

Dallas Federal Reserve: The Russian Oil Supply Shock of 2022

“Now that we have been shaken awake, most of our attention is on the bloodshed in Ukraine, and rightly so. But just as World War I mattered for reasons beyond the slaughter of millions of human beings, this conflict could mark a lasting change in the way the world economy works — and the way we all live our lives, however far we are from the carnage in Eastern Europe.”

Bloomberg: Putin and Xi Exposed the Great Illusion of Capitalism

“Circumstances change, but people’s reactions don’t. Technologies evolve, but insecurities, blind spots, and gullibility rarely does.”

Collaborative Fund: How People Think

“The policies are, of course, wildly popular. But they are not only economically wasteful, they will also do geopolitical damage. Fuel tax cuts are essentially a subsidy to Vladimir Putin, and they hurt the effort to end the war in Ukraine.”

Bloomberg: Oil Tax Cuts Help the Kremlin and Punish Ukraine

“The result is that fertilizer is about three to four times costlier now than in 2020, with far-reaching consequences for farmer incomes, agricultural yields and food prices.”

Wall Street Journal: Fertilizer Prices Surge as Ukraine War Cuts Supply, Leaving Farmers Shocked

“That translates into huge demand for the metals, such as cobalt, copper and nickel, that are vital for the technologies underpinning everything from electric cars to renewables; the IEA reckons that the market size of such green metals would increase almost seven-fold by 2030.”

The Economist: The Transition to Clean Energy Will Mint New Commodity Superpowers