FX: Eat Your Greens

FX: Eat Your Greens

Currency markets are likely to be broadly rangebound and continue to be characterized by high volatility.

Every single morsel. Not a grain of rice left in my bowl. Growing up, our dishes needed to be licked clean before dinner could give way to dessert, but the anticipation of a sweet treat kept me going.
Like me, the markets, too, are looking forward to their dessert. If inflation-taming rate hikes are the main meal we have been forced to eat in 2022, the prospect of an after-dinner delight seems a just dessert. But is it even on the menu? The answer to this question will be the key for foreign exchange (FX) markets in 2023, especially for the U.S. dollar (USD).

We project a more subdued year for FX than what we saw last year. The bar is very high to match 2022’s large currency moves, let alone exceed them. Rather, we think the FX markets are likely to be broadly rangebound and continue to be characterized by high volatility. Economic uncertainty continues as a major theme for markets. A lot of focus will remain on central bank policies, and how much appetite they will continue to have for ever-tightening policy to combat inflation. A slower ascent in policy rates is likely to culminate in a pause. This consensus scenario will dull the USD rally, but we would need to see more than this for us to be convinced that a bear market will ensue.

Currency markets are largely driven by economic activity, and the economy is undergoing adjustment. What we transition to will dictate the broad themes that will dominate FX markets. Here are some possibilities:

Economies avoid recession; inflation recedes, but remains at or above central bank tolerance upper bounds
In this scenario, central bankers will have no appetite to ease policy, and they may even indicate that the next action is as likely to be a hike as it is a cut. The USD benefits from its status as a safe-haven currency, its relatively high yield and an economic backdrop that is likely to see other economies struggle to attract capital.

Recession is accompanied with a sharp fall in inflation
Central bankers quickly adopt an easier policy stance. Financial conditions loosen and prospects of a recovery start to percolate. After one last surge higher for the USD, reflationary impacts of easier central bank policy will awaken a taste for risk and lead to flows into economies leveraged to a rebound in growth. In developed markets, we see the Australian, New Zealand and Canadian dollars leading the way in this scenario, while the currencies of Brazil, Korea and South Africa will benefit amongst their Emerging Market (EM) peers. EM currencies would outperform developed market currencies

Recession is accompanied with stubbornly high inflation
This scenario leads to a dispersion of central bank policies as choices are made between defeating inflation or supporting flagging economies. Economies that balance both and provide a credible path to future growth opportunities are going to attract flows. A combination of monetary policy settings that have room to adjust and flexibility in fiscal policy will be the focus. A lot will depend on the course of actions taken between now and the point it becomes clear we are in this scenario. Policy normalization laggards are likely to be punished, as are those that are already at the limit of credible fiscal policy. Relative growth has been an important long-term factor for the U.S. dollar, and policy choices made will set the tone for the next economic cycle.

While there are other possible economic scenarios on the menu for 2023, we think these are the most likely and important ones to watch out for. As we progress through the year and gather evidence of what lies in store for us, we are ever mindful that we are still in the midst of digesting past tightening moves and that the sweetest course is not necessarily the one that we will get next.