The US dollar bounced back from its four-month decline in February as markets anticipate a prolonged period of restrictive monetary policy. The yen performed the worst, while the Swedish krona performed the best. We now expect near-term weakness in the pound.
Strong economic data triggered a sharp rise in yields as investors priced in tighter monetary policy to combat greater inflation. This tighter-for-longer monetary policy reignited fears of recession, weighing on risky assets and growth/rate-sensitive currencies to the benefit of the US dollar.
We continue to see a bumpy ride for risk assets and currencies through 2023 and into 2024. Restrictive monetary policy will likely bring inflation under control, and we will likely see a sustainable recovery regime that will see the US dollar trend materially lower and pro-growth currencies higher. But we expect that path to normalization, and global recovery, to be one of increased economic stress and high market volatility – an environment that is likely to see the US dollar remain supported, with pro-cyclical currencies under stress and the euro somewhere in the middle.
Figure 2: February 2023 Directional Outlook
As inflation and monetary policy normalize and the world finds a path to sustainable growth recovery, we expect the US dollar to move broadly lower by up to 15% over the next few years. But those benign conditions have not yet materialized and may not materialize in 2023.
If growth or inflation is better or worse than expected, the US dollar is likely to remain strong, accompanied by high yields and elevated levels of equity and interest rate volatility.
Shaky commodity market performance, potential housing market risks, and a more cautious Bank of Canada are likely to keep the Canadian dollar on the weak side vs. the US dollar for now, despite it being nearly 10% below its long-run fair value. Against non-US-dollar currencies, we expect the Canadian dollar to largely follow the US dollar, given their strong historical correlation and close economic ties.
That means there is room for some near-term Canadian dollar outperformance on US dollar bounces, but the Canadian dollar will likely be flat to lower against most non-US-dollar currencies over the longer term.
Our outlook on the euro has steadily improved as lower energy prices boosted the growth outlook, while sticky core inflation and a rebound in the services Purchasing Managers’ Index (PMI) increase the likelihood of policy tightening by the European Central Bank (ECB).
The euro is also likely to benefit from its relatively low correlation to global equity volatility. However, there are also risks that greater ECB tightening could reignite recession fears and/or that an intensification of the Russia–Ukraine war could reintroduce the euro risk premium.
A return of fiscal responsibility and a modestly improved economic outlook justify the pound remaining well off its panic low from September, but the weak economic outlook, the Bank of England’s cautious policy tightening, and a lingering (large) current account deficit suggest some weakness, or at least limited upside for the pound from current levels.
In the long-term view, the pound is extremely cheap vs. the euro, the US dollar, the Australian dollar, the Swiss franc, and the Canadian dollar, though it is unlikely to realize its potential until inflation is under control and UK growth bottoms.
Most of the other major central banks are likely to tighten further and keep rates at a high level for an extended period, while the Bank of Japan (BoJ) is likely to take a slower-than-expected path toward major policy changes.
We expect the yen to remain weak in the near term. In the medium to long term, we are more constructive. The Japanese yen also has an advantage as a hedge against a deflationary hard landing as it would benefit from the rapidly falling global yields and would benefit a bit as a safe-haven bid. Eventually, we expect the BoJ to further tighten policy.
Recent support from a stronger euro, and expectations of tighter monetary policy, will likely give way to a lower franc as the recent weakness in Swiss growth and the eventual global disinflation turn sentiment and prompt a dovish shift from the Swiss National Bank (SNB).
In the longer term, the Swiss franc is materially overvalued relative to our fair value estimates and is likely to remain one of the lowest-yielding currencies in the G10. It may linger near recent levels while the market anticipates the next SNB meeting, but we see ample scope for weakness over the long run.
The krone is likely to remain under pressure alongside choppy oil prices and a relatively dovish Norges Bank. It has been extremely sensitive to equity markets, and we expect further downside pressure on the currency as we expect periods of higher volatility this year.
In the longer term, the krone is historically cheap relative to our estimates of fair value and is supported by steady potential growth. Thus, we expect strong gains eventually, but reiterate that the krone faces a tough near-term environment.
The krona bounced nicely in February, but may continue to struggle for a number of reasons: namely, falling home prices, soft growth data, and risk that the central bank might fail to back up its hawkish comments with more aggressive policy tightening.
Our models have a small positive bias in favor of the krona in the near term, and it is significantly below its long-run fair value, but we urge caution. We do not see a ready catalyst for the krona’s appreciation so long as economic data remains challenged.
The Australian dollar is likely to remain under pressure due to weak/choppy commodity prices, slowing consumer activity, and tepid wage growth, which suggest a more modest trajectory for the Australian economy and monetary policy. China reopening from COVID-19 lockdowns and positive inflation surprises should provide some support, but are not enough to overcome aforementioned negative forces.
In the longer term, the Australian dollar’s outlook is mixed. It is cheap vs. the US dollar and the Swiss franc, and has room to appreciate, but is expensive against the pound, the yen, and the Scandinavian currencies.
We are neutral on our outlook for the New Zealand dollar in the near term. Our expectation of a global bumpy landing, marked by periods of increased equity market volatility, should weigh on the risk-sensitive New Zealand dollar. However, high local yields and some signs of stabilizing growth data provide support. In the longer term, the New Zealand dollar’s outlook is mixed. It is cheap vs. the US dollar and the Swiss franc and has room to appreciate, but is fairly valued vs. the Canadian dollar and the euro, and expensive against the Australian dollar, the British pound, the yen, and the Scandinavian currencies.
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