While the financial press has been reporting on the see-sawing of global stock markets, up one day and down the next, there has been some huge moves elsewhere this week, most notably the FX market. In recent memory (months and years) the FX market has been something of a wall flower compared with other asset classes. No more: FX has come roaring back, the dollar is centre stage, the yen is wilting quicker than you can cook spinach and FX volatility is taking centre stage.

There are three things in financial markets right now that make this economic cycle feel very different from others. Firstly, the strength of commodity markets at the same time as the dollar is close to a two-year high on a broad-based basis. Secondly, the weakness of the yen and its failure to act as a safe haven during the biggest threat to geopolitical security in our lifetime, and lastly, the disconnect between surging volatility in the FX market, at the same time as volatility is falling sharply in equity markets. We will take a look at all three below.

1, The dollar and commodities

The war in Ukraine has boosted commodities on a broad basis. The price of natural gas, industrial metals, agricultural goods and oil have surged in recent weeks and this turbo-charged super cycle in commodities is showing no sign of stopping. The fact that Russia and Ukraine are such large producers of certain commodities, along with the fact that oil is a key element of the economic war that the West is waging with Russia in response to the Ukraine invasion, is keeping investors nervous and prices propped up. Usually when commodities rise, the dollar is weak and vice versa, this is because most commodities are priced in dollars, so when the value of the dollar rises it should be cheaper to buy a barrel of oil/ a bushel of corn etc. As we mention above, Russia is a big producer of wheat, oil and gas thus, they are in the driving seat right now. For as long as Putin wages his war, then there is upside risk for commodities as it takes a long time to get new commodity supply up and running. This means more inflation and more economic pain for the West, particularly Europe. In times like this you want three things from your investments: to be far away from the epicentre of the trouble, to be an energy producer and preferably self-sufficient, and to hold some of your portfolio in cash. US assets and the dollar tick all of these boxes, which is why we think that the dollar and commodities are likely to remain elevated for some time yet. Some strategists are trying to pinpoint when the dollar will fall, or when the price of oil will fall back. However, while we do expect US growth to slow this year, the Fed is still on a mission to raise interest rates now that the inflation genie is out of the bottle. That is dollar supportive in our view, and we don’t think that commodities will pull back anytime soon, especially now that Putin appears to be weaponizing the ruble and we could be in a more precarious phase of the war now that NATO has said that it will react if Russia uses chemical weapons against Ukraine. This cycle is different and we expect it to last.

2, What’s going on with the yen?

The Japanese yen used to be the safe haven of choice, but no longer. When commodity prices are surging and you are an energy importer, this is toxic for safe haven credibility. Hence why USDJPY has fallen to its lowest level since November 2015. There are two drivers of yen weakness: firstly, a surging Japanese current account deficit, which was at its widest level since 2014 back in January and is only expected to widen further now that the Ukraine war has caused energy costs to spiral upwards. Secondly, the contrasting monetary policy stances between the Fed and the BOJ: the Fed is planning to hike rates 7 times this year, while the BOJ is taking a more cautious stance. The weakness in the yen is not only linked to dollar strength, but the yen index also fell nearly 1% on Thursday and is close to its lowest ever level that was reached back in 2015, as you can see in the chart below. The yen is weakening across the board and it has also experienced steep declines vs. the Aussie dollar. Usually, in times of geopolitical tension, you would not expect the Aussie to outperform the yen, but AUDUSD is now at its highest level since July 2015. Looking ahead, the outlook remains bleak for Japan’s current account deficit, the central bank does not look like it will tighten monetary policy any time soon, and as long as equity market volatility retreats then the yen should struggle, even when USD/JPY is above Y122. We think that Y125 could be on the cards for USD/JPY in the medium term, if the dollar’s upward momentum is maintained.

Chart: Yen index

3, Equity market volatility

The US equity markets have recovered well from the latest hawkish Fed comments earlier this week. The tech-heavy Nasdaq has also started to outperform, which we think is a result of the (near) inversion of the US Treasury yield curve, which reflects well on tech firms’ discounted future cash flows. Added to this, US indices are also benefitting from the TINA effect, “there is no alternative”. The S&P 500 has outperformed the Dax in the past month even though the Fed is expected to be much more hawkish than the ECB, because it is further away from the war in Ukraine and the US economy is less impacted by surging natural gas and oil prices. Of course we expect pockets of volatility to emerge in this highly uncertain geopolitical environment, but overall, US stocks can outperform in the coming weeks and months because of TINA, and the fact that investors are pulling their money out of Europe. According to the latest EPFR data shows that investors have pulled more than $12bn from Western European equity funds since the war began. This means that there is more money to flow into US equity market funds in the medium term, in our view and it is one reason why US stocks are up 7% since the start of the war in Ukraine.

Chart: S&P 500 and the Dax

FX focus: What is going on with the dollar?