Have FX Traders Fully Priced in Russia / Ukraine Risk? Parallels with Crimea Incursion

• Have FX Traders Fully Priced in Russia / Ukraine Risk?
• Sterling Hits July Lows as Yield Spread Narrows
• Euro Fails First Test of 1.35
• Behind the Resilience of AUD
• CAD: Hotter CPI
• Big Week for New Zealand
• JPY Crosses Recover as Risk Appetite Improves

Have FX Traders Fully Priced in Russia / Ukraine Risk?

More than 24 hours after Malaysian Airlines Flight 17 crashed in the Ukraine, currencies, equities and Treasury yields recovered nearly half of Thursday's losses. Governments around the world including that of the U.S. believe the jetliner was shot down by Russian-backed separatists and have put pressure on Russia to end the violence in region. The growing possibility that the crash was not caused by a mechanical accident should have triggered additional risk aversion but instead of fear, it created relief in the markets. For many investors the speed and magnitude of the rebound in currencies and equities on Friday is befuddling but if we take a look at how various instruments reacted to Russia's incursion into Crimea, the recovery is not unusual. On March 3rd, Russia sent troops into Crimea and effectively seized control of the region. The fear that this would spark an international military response caused the Dow to fall 150 points, 10 year Treasury yields to drop to a 1 month low, oil to hit a 5-month high of 104.92 and the EUR/USD and USD/JPY to fall approximately 50 pips. However the move lasted for only 1 day. Oil peaked at 104.92 and hit 98.20 ten days later while stocks, currencies and yields rebounded. At the time, the market was quick to price in the potential disruption in supply and accurately predicted that the international response would be weak and the overall impact would be small. The thinking is the same this time around as well. While there's always the risk of a stronger response from the international community, no one wants to engage Russia militarily. Further sanctions from the U.S. and Europe are likely but the impact on the broader market will be limited. At best we can hope that this will pressure Russia and Ukraine to kill the separatist movement as quickly as possible. So in a nutshell, caution is warranted but for the most part, investors have priced in Russia/Ukraine/Israel/Gaza risk.

Sterling Hits July Lows as Yield Spread Narrows

While rumors of dovish comments from Bank of England Governor Carney sent sterling to its weakest level this month versus the U.S. dollar, this was not the reason why sterling struggled against the greenback. The BoE actually denied the rumors by saying that Carney has no interviews this weekend. So instead the underperformance of sterling can be attributed to the widening gap between U.K. and U.S. bond yields. With 10 year Gilt yields falling 1.5bp on Friday and Treasury yields rising 5bp, the spread fell sharply in favor of the dollar. The steep decline seen in the following chart (green line is GBP/USD, orange line is UK-US yield spread) says it all and on top of that signals the potential for further losses in GBP/USD. In the coming week, the main focus will be the Bank of England minutes and U.K. retail sales report. Even with Friday's decline sterling remains surprisingly resilient because investors expect the BoE to be the next major central bank to raise interest rates. Whether these expectations change will hinge in large part on the tone of the BoE minutes and retail sales. If there is more skepticism and reluctance to raise rates this year, sterling could test 1.70.

Euro Fails First Test of 1.35

Throughout this week we have talked about the importance of the 1.35 level for EUR/USD. On Friday, the currency pair broke below 1.35 for the first time in 5 months and unsurprisingly, the first attempt to close below 1.35 failed. Today's decline was driven by the recovery in U.S. yields and drop in the Eurozone current account surplus. As we e mentioned before, 1.35 is an important psychological level for EUR/USD but the February low of 1.3477 is the key technical level. The euro has actually been surprisingly resilient given recent geopolitical tensions. If one currency were to fall on these developments it should be euro because the Eurozone's oil supplies is the most directly affected by the geopolitical tensions. However even with today's pullback, the current account balance is above the 6-month average. U.S. yields increased but they have been extremely volatile. Without a strong and sustained rally in yields or a clear sign that the ECB is planning to ease, a move below 1.35 is more likely to be fake-out than a breakout. The last time EUR/USD experienced a clean break of 1.35 was in November when the central bank surprised with a 25bp rate cut and even then 2 weeks later the pair was back above this level. Eventually 1.35 will give way but that may not happen until the fall when the Fed ends Quantitative Easing and shares its exit strategy. Nonetheless traders should still keep an eye on the ongoing developments in Russia, Ukraine, Israel and the Gaza Strip. In terms of data, next week's Eurozone flash PMI and German IFO report can also have a significant impact on the currency.

Behind the Resilience of AUD

All three of the commodity currencies traded well on Friday, rebounding against the U.S. dollar. While the recovery in risk contributed to the move, domestic factors added to the strength of these currencies. The Australian dollar has proven to be surprisingly resilient in the face of geopolitical risks and was in fact Friday's best performing currency. No economic data was released from Australia and while gold prices rose on Thursday, they pulled back on Friday. Property prices in China declined from record highs, which should have been negative for Aussie. However instead the currency found support from Australian Treasurer Joe Hockey's comments. He expressed optimism about Australia, said he is confident that there will be stronger growth and attributed the rise in the currency to inflows and investor demand. He also felt that the government should not overreact to A$ strength which suggests that he does not support intervention. We will hear from more Australian policymakers in the coming week with RBA Governor Glenn Stevens and Debelle scheduled to speak. The Reserve Bank of New Zealand's monetary policy announcement will be the main focus but we'll discuss that further on Monday. In the meantime, the Bank of Canada Governor Poloz's view that the rise in inflation was temporary came into question on Friday as consumer prices grew another 0.1% in June. This brought the annualized pace of growth to a whopping 2.4%, the highest pace since February 2012.

JPY Crosses Recover as Risk Appetite Improves

With no major Japanese economic reports released overnight, the Yen traded primarily on risk appetite. The rebound in U.S. Treasury yields helped to lift USD/JPY while the recovery in U.S. stocks reversed demand for Japan's currency. Considering that Japanese markets are closed for a holiday on Monday, risk appetite will continue to drive Yen flows. The focus for Japan in the coming week will be on trade, manufacturing activity and inflation. These reports will tell us whether additional progress is made on price pressures and economic activity. According to the Cabinet's monthly report, "the Japanese economy is on a moderate recovery trend and a reaction after a last minute rise in demand before a consumption tax increase is easing." Their assessment on the economy is virtually identical to the Bank of Japan's and represents a minor upgrade from the previous month when the Cabinet noted weakness after a burst of spending in March. Demand in June was still negatively affected by the sales tax hike with the annualized decline in Nationwide department store sales reaching -4.6% from -4.2% in the month prior but this represents a significant improvement from the 12% year over year drop observed in April.