How traders can prepare for a worsening Ukraine crisis

Until recently the market had largely ignored the growing crisis in Ukraine but that appears to be changing. As the situation intensifies investors are paying closer attention and adjusting their investment strategies accordingly.

In Ukraine, people are dying on the ground while the U.S. and Russia have been ratcheting up their rhetoric. U.S. Secretary of State John Kerry recently threatened that if Russia didn't change course, "the world will make sure that the costs for Russia grow. We are ready to act." Yet, Russian President Vladimir Putin has been hinting that Russia is ready to take military action in Ukraine, something he carefully avoided saying when the crisis was contained to Crimea.

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On Thursday, the gold price shot up on news reports concerning the region while the U.S. dollar fell. Ultimately there were no new developments and prices fell back, but it's clear that market investors – who seem to have been "whistling past the graveyard" up to now and assuming that nothing serious was going to come of this crisis – have taken note.

As Howard Marks, co-founder of Oaktree Capital Management, once said, "[While] you can't predict, you can prepare." With that in mind, how can investors prepare for a worsening of tensions in Ukraine?

Positioning in the FX market

In theory, the obvious way to prepare in the FX market should be to sell the Russian rouble, but that might not be the best way. The Central Bank of the Russian Federation has some $482 billion in foreign exchange reserves and gold – more firepower than the market can throw at it. Moreover it can and does intervene to support its currency; in fact, its strategy for intervention, how much it will intervene and at what levels, is a matter of public record.

However, the currencies of the other Eastern European countries are more vulnerable. Poland has $103 billion in reserves, while the Czech Republic has $58 billion and Hungary has 32 billion euros. Coupled with the fact that they don't use the same sort of fixed intervention policy as Russia this puts their currencies at risk.

In 2008, when Russia invaded Georgia, the Russian rouble depreciated but other Eastern European currencies fell even more. The volatility of those currencies also rose far more than it did for the rouble and indeed rose above the average volatility for emerging market currencies at that time, providing more opportunities for traders.

I expect something similar this time around. Anyone who looks with concern at the events in Ukraine and believes that the market is underestimating the likelihood of something serious happening may want to consider positioning for it by going short the other Eastern European currencies.

On the flip side, which currencies should we go long? The Japanese yen and Swiss franc would be the default purchases. The yen probably has more room to appreciate, because the franc is constrained through the EUR/CHF floor, which prevents the franc from appreciating more than euro does.

Separately, I believe the New Zealand dollar is likely to continue rallying because of the Reserve Bank of New Zealand's (RBNZ) unique stance. It's the only central bank that's taking an overtly hawkish view and promising to tighten. While the New Zealand dollar is clearly overvalued on a purchasing power parity basis and that clearly worries the RBNZ, I think it can still gain further as investors search for yield.

The author is the Global Head of FX Strategy at IronFX Global, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.