Asset Class Roundup | Currency

FX: Eat Your Greens

December 6, 2022 | By: Tom Nakamura

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.

Percentage of currencies with a lower yield than the U.S. dollar

A graph showing the percentage of currencies with a lower yield than the U.S. dollar

Source: JP Morgan

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.

U.S. growth not lagging significantly

A graph showing CEDI US-G9 Spread over the last year

Source: Citigroup as of November 24, 2022

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.

Tom Nakamura
Tom Nakamura, CFA®
Vice-President and Portfolio Manager, Currency Strategy and Co-Head of Fixed Income
AGF Investments Inc.
Vice-President and Portfolio Manager, Currency Strategy and Co-Head of Fixed Income

With more than 15 years of experience managing a wide array of fixed-income portfolios, Tom is a key contributor to the team's analysis of the global macroeconomic landscape, with specific emphasis on currencies. He is responsible for developing currency strategy and providing counsel on the implications of currency moves on fixed income. He also serves as a portfolio manager of AGF Total Return Bond Fund/Class, AGF Emerging Markets Bond Fund and AGF Global Opportunities Bond ETF.

Tom previously served as a Vice-President and Portfolio Manager on AGF's Fixed Income team with lead management responsibility for AGF Emerging Markets Bond Fund.

Tom earned a Bachelor of Commerce from the University of Toronto. He is a CFA® charterholder and a member of CFA® Society Toronto.

Registered as a Portfolio Manager under AGF Investments Inc. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

The views expressed in this document are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.

The commentaries contained herein are provided as a general source of information based on information available as of December 6, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.

This document may contain forward-looking information that reflects our current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties, and assumptions that could cause actual results to differ materially from those expressed herein.

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Investments LLC (AGFUS) and AGF International Advisors Company Limited (AGFIA). AGFA and AGFUS are registered advisors in the U.S. AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income, and balanced assets.

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RO: 20221128-2610809

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