Monday’s sharp decline in stock markets came close to crashing before making a remarkable turnaround.

Currencies have been much less volatile, but the risk aversion environment is having an effect.

Who are the winners and losers in the current context?

Recent volatility peaked on Monday as markets plunged after the US open. Midway through the session, the S&P500 was down -3.99% and threatened to crash. Meanwhile, the Nasdaq, already the weakest index, had fallen more than -5% and was -18% from the all-time high; almost bear market territory.

The trigger for these moves was the threat of Federal Reserve tightening, and panic intensified ahead of Wednesday’s FOMC meeting. Volatility was exacerbated by tensions between Ukraine and Russia and over-leveraged long positions, with a large proportion of retail buyers pushing stocks to stretched valuations. These are now quickly coming back to earth and the longs are forced to liquidate.

Just when it looked like the markets were really going to crash around lunchtime in the US, they bottomed out and made a remarkable rally. Surprisingly, the S&P500 and the Nasdaq recovered all the lost ground to get back into the green. What exactly triggered this reversal is not entirely clear, although some reports of the low likelihood of conflict in Ukraine have helped.

During the equity volatility, other markets had mixed reactions. Oil was lower, but gold barely moved. Currencies remained largely unfazed and the classic risk aversion indicator, the USDJPY, fell slightly into a double bottom off the January low and back into positive territory. The US Dollar initially made good gains and hit new highs in two weeks.

Although currency volatility is much lower, there is a clear causal link between the selling of risky assets and the risk aversion environment of recent weeks. AUDJPY is down -4% and high beta currencies are underperforming. Panic selling could become a big problem for some currencies in the coming sessions.

Monetary reactions

Monday’s late rally likely signals the end of panic selling for now. That could resume after Wednesday’s FOMC meeting, but many believe the Fed will take a softer tone in light of recent moves. It may not be dovish, but the hawkish tone could be toned down and that could be enough to spark another rally in equities and reverse some of the currency effects.

Even then, the drivers are likely to persist in currency markets over the medium term, as central banks are unlikely to completely reverse course. Likewise, there is no easy solution to the situation between Ukraine and Russia. Here’s what ING had to say:

“What is clear is that rising geopolitical risk and the ongoing repricing of growth stocks has started to weigh on high-beta currencies and market favorites such as the Canadian dollar and Norwegian krone.

For now, we expect investors to play it safe and favor the dollar for liquidity purposes. European currencies whose economies are more exposed to imports of Russian natural gas are likely to remain more vulnerable.

The outlook for the euro is very mixed in the short term. On the one hand, any softening in the hawkish tone of the Fed and other central banks will give the euro a boost. On the other hand, the situation in Ukraine affects the Eurozone more than the United States and other countries and the economy is ill-equipped to deal with Russian sanctions and the worsening energy crisis.

EURUSD fell below 1.13 in Tuesday’s session and is approaching 2021 lows at 1.12. For now, the backdrop seems to support more sideways trades in the well-established December range, but a worsening of the situation in Ukraine could well trigger a break down to 1.1 and perhaps even the most 2020 low at 1.07.