Financial markets have been whiplashed by the Russia-Ukraine war, but surging inflation dynamics and the resultant central banks' move to policy tightening will drive currency markets, wrote Chris Turner, Global Head of Markets at ING, in a note titled, "from trading war to trading monetary restraint."
"Yesterday's trading session was a good example of the futility of trying to pick a top in the rates markets. It seems too early in the cycle, especially with so many central bankers ready to stamp on the brakes to prevent inflation from getting out of hand. Aggressive tightening and perhaps a more difficult risk environment will dominate FX now," he said.
Since Russia invaded Ukraine late in February, commodity prices have spiked on supply disruptions from the sanctions on Moscow by Western countries. In turn, that has pushed up inflation globally.
With runaway inflation a reality, major central banks were expected to shift to an aggressive monetary tightening policy to tame rising price pressures. The US Federal Reserve is predicted to lead the way, with expectations firming for more significant and faster rate hikes.
The dollar index (DXY), which measures the greenback's performance against six of its peers, has risen to two-year highs this week, rising above the 100-level mark,
"In a week of IMF meetings, we have heard from quite a few central bank speakers, and the message from the likes of the Federal Reserve and the Bank of Canada is that the policy rate needs to be taken to neutral as quickly as possible. Even the Bank of England's Catherine Mann hinted at the need for a quicker pace of tightening," said Mr Turned.
"Expectations of central bankers hiking in 50 basis points or even 75 basis points increments are now contributing to the volatility in rates markets. This theme looks set to be with us over coming months and may well become the dominant market driver instead of the war in Ukraine, which, away from the human tragedy, has largely been treated as a commodity supply shock," he added.
While resource-heavy currencies have gained since the Ukraine conflict, the US dollar has been on the rise tracking Fed policymakers' calls for extremely aggressive rate hikes.
"Do not try to fight the strong dollar bull trend, and the DXY can probably hold above 100," said Mr Turner.
"What does this potential shift in focus mean for FX markets? The war in Ukraine and its implications for commodity prices had seen FX trade through the terms of trade lens - or winners and losers in the commodities war," said ING's global head.
"If we are to shift to a more difficult risk environment on the back of what we call involuntary tightening - where real yields go more deeply into positive territory - we could start to see some of the pro-risk commodity pairs hand back some of the war-inspired gains," he added.