The conflict in Ukraine is primarily a humanitarian tragedy. It also has significant consequences for currency markets following the large rise in prices for a range of commodities. Both Ukraine and Russia are major exporters of a range of energy, industrial and agricultural products; replacing supplies that are disrupted or sanctioned will be challenging. Trade in the affected commodities represent around a quarter of total global trade in all goods, with energy products representing the largest share.

The relative movement in import prices and export prices, or terms of trade, are always a cornerstone of our analysis of currency fundamentals. As we work through the impact on global trade flows, we focus primarily on the effect of price changes. Some reconfiguration of trade flows is likely over time, but for now the effect on developed market currency flows is determined primarily by the price effect from the limited ability to reduce energy consumption in the short term. We focus on regional benchmark prices for key energy commodities to account for the differing impact on regional markets. This approach also captures the price distortions resulting from infrastructure bottlenecks in the near term.

Historically, oil has dominated global energy trade and has acted as a global benchmark. However, over the last decade the importance of natural gas has been rising following investment in transportation infrastructure. As the Western world attempts to abandon Russian energy supplies, both gas and coal have recently taken a far more prominent role as idiosyncratic markets.

Our estimates of the terms of trade impact on economies highlight the limited direct exposure of the North American economies. This is due to a combination of more limited movements in regional prices and broadly balanced energy trade. In contrast, Europe is exposed to the greatest price movements with little positive offset from energy production, which translate to a significant economic risk. Across Asia, there are a number of countries where the impact has the potential to be even larger than in Europe due to the high share of energy imports. Asia has historically made greater use of long-term contacts and may face less geopolitical pressure to abandon Russian supplies, which could mitigate the impact somewhat. Meanwhile, the benefits from higher energy prices are concentrated in a limited number of smaller economies, such as Australia and Indonesia.

Exhibit 1: Balance of payments impact of price rises in oil, coal and gas (% GDP)

Source: Bloomberg, DataStream, BP and J.P. Morgan Asset Management. As at April 2022.

Changing FX reserve allocations

Prior to the conflict in the Ukraine, currency markets were already seeing some signs of FX reserve allocations shifting away from the US dollar. We ascribed this to a few factors, including some concern that the US approach of using financial sanctions for geopolitical objectives had perhaps boosted the attraction of more diversified reserve portfolios. The rising role of the Chinese renminbi and increased foreign participation in Chinese bond markets also appeared to be supporting a growing allocation to China (see exhibit 2). The recent escalation of financial sanctions could reinforce this trend.

Exhibit 2: US dollar allocation in global FX reserves were already falling, with the Chinese renminbi gaining share

Source: IMF COFER, as at April 2022.

Incorporating traditional currency drivers

The impact of recent shifts in flows needs to be balanced against traditional drivers of currencies such as the monetary policy outlook and valuation levels. With rises in energy prices translating into broad inflationary pressures around the world, central banks are responding with rate hikes at a speed not seen for decades. For now, the movements in rates have been broadly comparable between most major currencies and so have not acted as a significant driver of currency markets. Should rate hikes prove more sustainable in countries facing smaller negative impacts from energy trade, we could see greater policy divergence ahead.

The Japanese yen has underperformed significantly, partly due to the Bank of Japan standing out as the lone central bank resolutely committed to easy policy. But Japan is also highly exposed to rising mineral fuel import costs and has a rising trade deficit. The yen now appears significantly undervalued on our long-term metrics, however our approach of cross-checking valuations with balance of payments dynamics keeps us cautious about the prospects for a recovery in the yen until the effects of the energy shock dissipate.

Emerging market currencies with significant interest rate support have traded far better than typically expected against a backdrop of significant policy tightening in the major economies. Markets such as Brazil and South Africa have also benefitted from favourable terms of trade tailwinds.

Overall, we find most support for commodity exporter currencies with a favourable domestic growth situation. The Australian dollar and Canadian dollar screen well in this regard. Both have positive terms of trade dynamics and central banks that are tightening policy but with a more constructive outlook on terminal rates and less desire to reach restrictive policy settings. We see the greatest challenge for importer currencies where policy tightening is more fully priced and there are greater risks to the growth outlook. The British pound and New Zealand dollar both screen poorly, with rate markets that have seen hikes priced for some time, poor dynamics on their current accounts and signs that growth may have peaked.

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