Why the war against Ukraine is also a turning point for the markets


Countries like Germany and Italy have built much of their economy around cheap energy from Russia. That must now change, which means lower growth, wider budget deficits and more debt.

The debt nexus for Europe is tricky. There have been many voices in recent days criticizing Germany for its low levels of public debt, with many treating Russia’s invasion of Ukraine as a sort of “I told you so” moment. But that’s misguided.

If the last two years have taught us anything, it’s that big negative shocks can come out of nowhere – recently COVID-19, then variants of COVID-19 and now Russia’s invasion of Ukraine. If that’s not an endorsement to keep powder dry in an emergency, then what is?

In the eurozone, this argument takes on particular urgency because markets were already reluctant to buy COVID-19 debt issuance in the run-up to all of this. For a key peripheral country like Italy, the net issuance of new debt was largely financed – indirectly – through the European Central Bank’s quantitative easing program of buying assets to support markets.

With this latest shock, the markets’ current reluctance to finance highly indebted sovereigns will only increase with larger fiscal spending needs on the horizon.

If we are correct, the fact that inflation is no longer a concern makes things easier. This is no longer the time for the ECB to worry about policy normalization.

Relative price changes in the Eurozone inflation basket are unlikely to turn into generalized inflation, meaning the way is clear for continued accommodative monetary policy and, importantly, QE which, from a budgetary point of view, is absolutely necessary.

So there will be a fundamental decoupling of monetary policy, with the US Federal Reserve continuing to normalize, while the ECB – given the much larger shock Russia’s war represents for Europe – continues to relax.

The markets are far from recognizing or valuing this. They assess the prospect of monetary policy normalization and rate hikes in the Eurozone on par with the United States. Speculative positioning in the currency markets began to create a significant ‘long’ position in the euro against the dollar last week.

In short, the decoupling of the Eurozone from the United States – in terms of growth and politics – is not yet remotely priced into the markets.

We have seen all of this before. Think back to 2014, which was also a turning point for the markets. Russia annexed Crimea earlier this year. And then the oil price floor fell, as US shale took the world by storm.

Amid all this, markets were slow to assess the massive policy shift unfolding at the ECB that would eventually lead to QE in 2015.

That’s because there were real mixed signals. Markets believed that QE would never be possible given the traditional importance of inflation hawks in the euro zone. It’s the same now. High inflation is the mixed signal currently holding markets back. But this is old news, reflecting the world as we knew it a week ago. A big divergence and weakness of the euro against the dollar is ahead.

The author is chief economist at the Institute of International Finance.



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