High inflation and global economic data slowdown pushed the USD to new cycle highs in the first half of July. The USD gained versus all the G-10 currencies and the EUR and the currencies of its regional neighbors led the downside due to fears around further cuts in Russian gas supplies and political turmoil in Italy. The second half of the month brought a major rotation as recession fears led to reduced central bank policy tightening expectations through 2023. Equity and credit markets bounced back and the USD fell versus all G-10 currencies. The EUR continued to lag most G-10 currencies except for the USD, while the more deeply oversold currencies such as the JYP, the NOK and the SEK led the gains.
Figure 1: July 2022 Currency Return vs. G-10 Average
The bad news is good news dynamic — a dynamic in which bad economic news will drive supportive monetary policy and push risky assets higher — that drove currencies and risky assets higher in July looks unsustainable. Inflation remains sticky and at extremely high levels that it would constrain the ability of central banks to respond to recession. The rebound in risk assets, lower global yields and continued strength in labor markets globally increase the chances of inflation lingering longer than desired. Therefore, our base case is that short-end global yields will likely rebound and the recent equity market rally will falter. In turn, we expect the scenario to support the USD and weigh on risk-sensitive commodity-linked currencies as well as the EUR, which should continue to struggle under energy-supply constraints and political risks.
Figure 2: July 2022 Directional Outlook
Review and Outlook by Currency
US Dollar (USD)
The USD reversed a near 2.5% gain mid-month to finish July down 0.5% relative to the G-10 average. Its early month strength was powered by stronger-than-expected non-farm payrolls, durable goods, factory orders, retail sales and a fresh new high in inflation at 9.1% year-over-year (YOY), 0.3% above expectations. The resilient data and rising inflation introduced concerns that the Fed might raise rates by a full 1% at its meeting on 27 July, strengthening dollar. The second half of the month brought less robust data with existing home sales falling 5.4% month-over-month (MoM), weak housing starts and a negative shift in regional Fed business surveys. Consequently, expectations for a 1% policy rate faded back to 0.75% and the USD began to trend lower. The Fed raised the key policy rate by 0.75 bp but Fed Chair Jerome Powell indicated that policy would be more data dependent and the current policy rate was around neutral. Markets judged this as a dovish sign. The US was deemed near the peak in policy tightening, prompting US yields and the USD to accelerate lower in the final days of the month.
The USD is historically expensive and overbought. From that perspective, the late July sell-off makes sense and we have high conviction that the currency will be materially lower over a 3–5 year horizon or even sooner. But in the current fragile macro environment, with the Fed firmly committed to fighting inflation, we see US short-term yields elevated for an extended period, high risks of recession and further periods of equity market weakness. That environment is not conducive to a weaker USD and thus, we remain tactically positive on the USD. We may have seen the cycle high in broad USD during July, but there are risks that individual currencies could set new lows over the next several months.
The EUR was the worst-performing G-10 currency, down 3.1% relative to the average. Losses were spread throughout the month. Worries that Russia will further restrict or completely shut off natural gas supplies in addition to the stress of high inflation and falling real wages weighed on investors who rightly saw greater downside tail risks to European Union’s (EU) growth. Evidence of those risks was apparent in the German ZEW business survey, which fell to -53.8, its lowest level since the early 1990s. The European Central Bank (ECB) raised rates by 50 bp to get back to a zero-policy rate slightly faster than expected, but that gave little solace to investors who were more focused on recession risk.
Another concern that pushed the EUR lower and muted the market’s response to the ECB tightening was the risk of a spike in peripheral spreads, particularly in Italy. The ECB announced a new transmission protection mechanism (TPI) aimed at preventing a major debt crisis like in 2011–2012. However, details were vague and implementation is entirely at the discretion of the ECB’s governing council. We interpreted the new tool and the lack of specific details to signify that ultimately the ECB will do what it needs to prevent a catastrophic credit event. That said, we expect the backstop to be implemented in extreme circumstances and the path to that point will likely be tumultuous and uncertain. The ECB is likely to apply significant pressure to maintain fiscal prudence and that could involve a period in which Italy seeks assistance and it is initially refused. Over the past 10 years, Italy has been reasonably prudent fiscally, even under populist governments. The new government may be tempted to stray from that prudence, but in the end, we think they will conduct themselves well enough to ensure ECB support if needed.
We are bearish on the EUR. The economic tail risks related to Russian energy supplies that pushed the EUR lower will continue to be a serious issue over the next 6–12 months as will the risks of further volatility in peripheral sovereign credit spreads. The ECB is in a tough spot due to the economic slowdown and higher downside tail risks. That is likely to limit its ability to forcefully raise interest rates to battle inflation and defend the currency. Long term, the EUR outlook is more positive, particularly versus the USD. The EUR is already about 20% cheap to the USD, while the ECB is likely to maintain positive policy rates for several years. The EU unemployment is at record lows, consumer balance sheets are reasonable, and we appreciate the potential for attractive long-term investments in areas such as digitization, green technology and semiconductors.
British Pound (GBP)
The GBP lost 0.3% relative to the G-10 average in July. Contrary to ongoing fears of a UK recession, falling real wages and a relatively cautious Bank of England (BoE), economic data is holding up reasonably well. Composite purchasing managers’ index (PMI) slowed to 52.8 from 53.7 in June, similar to global levels and much better than Germany’s dip into contractionary territory below 50. Employment data once again surprised to the upside, +296k new jobs compared to 170k expected on a 3M/3M basis. Even retail sales, which have been chronically weak, expanded by 0.4% MoM in June compared to -0.4% expected. The UK is not a negative outlier; actual data trends are middling compared to G-10. This has helped support the currency over recent weeks. On the political front, the resignation of Prime Minister Boris Johnson has had little impact on the currency as the new leader will also be from the conservative party and a general election is not imminent. Additionally, the policy platform of Liz Truss, the leading contender, is tilted toward some fiscal stimulus, which would support the economy and may encourage further BoE rate increases, both supporting the GBP marginally.
In line with the July performance, we are tactically neutral on the GBP relative to G-10. We see room for additional underperformance versus the generally less risk-sensitive USD, CHF, and JPY, but expect it to perform better against the EUR given the continent’s higher sensitivity to Russian gas supplies. We also see the GBP holding up well against commodity-exporting currencies, which are more sensitive to global recession risks. Longer-term outlook is also mixed. Once inflation normalizes and the global slowdown is behind us, the GBP has ample room to appreciate relative to the expensive USD and CHF, but it is likely to underperform the deeply undervalued NOK and SEK, which also tend to outperform the GBP during healthier economic environments.
Japanese Yen (JPY)
The JPY broke its two-month losing streak with a sharp rally late in the month to finish as the second-best performing currency in G-10, +1% on the month. The currency reached its lowest level versus the USD since 1998 on 14 July. The JPY jumped to 139.39 intraday but finished the month closer to 133 as the USD sold off on lower yields and recession fears. Relative to G-10, the JPY was more resilient throughout the month. During the first half of July, it was up relative to G-10, thanks to significant outperformance versus the EUR, the NOK, the SEK, and the GBP, which were held back by fears of a regional slowdown in Europe and weaker oil prices in the case of the NOK. As equity and commodity markets began to recover mid-month, oversold EU regional currencies bounced back, sending the JPY down nearly 1%. Late in the month, the market’s dovish interpretations of the ECB and the Fed sent global yields sharply lower, triggering a short covering rally that pushed the JPY rapidly higher to finish July with a gain.
We are tactically neutral on the JPY against G-10 and see renewed downside versus the USD over the near term. However, with global yields and commodities well off their highs and economic activity broadly slowing, we see continued upside potential for the JPY against the EUR and the commodity currencies over the next several months. Sustained strength versus the USD may have to wait a while, but July indicated the potential for significant gains as we head into next year. Slowing growth and expectations of the Fed’s rate cuts, even 9–12 months out, make for a strong JPY environment. We think markets have become a bit too optimistic about peak monetary policy rates and the potential for rate cuts next year, but once we get to early next year, that is likely to be an accurate view regarding behavior in late 2023 and 2024. If so, it could enable the JPY to sustain a strong recovery against the USD in 2023 for the same reasons we saw the late July rally.
Swiss Franc (CHF)
The CHF lost 0.1% versus the G-10 average in July. Early in the month, it gave back some of its strong gains following the June Swiss National Bank (SNB) rate hike, trading lower alongside general weakness in the EUR and EU-sensitive currencies such as the NOK, the SEK and the GBP. From there, the currency traded broadly sideways before recovering into month end, likely on a safe-haven bid as investors reacted to Russia’s announcement that it would cut EU gas supplies through the Nordstream 1 pipeline to 20% of their normal volume. Higher-than-expected June manufacturing PMI, retail sales, and core inflation were also quite supportive of the CHF. These factors indicate that the SNB is likely to continue its policy-tightening path, which includes rate hikes and a greater tolerance for CHF appreciation.
We are tactically positive on the CHF as it tends to weather global fragilities well, given its large positive net foreign asset position. Switzerland is also showing greater economic resilience, which is likely to keep the SNB on course to tighten further. Longer term, the outlook is decidedly negative. The SNB declared that the CHF is no longer expensive versus the long-run fair value. Our models suggest that it remains quite expensive, though far less so compared with 3–5 years ago. Swiss yields and inflation are rising now, but we expect both to remain among the lowest among G-10 currencies on a structural basis. Therefore, a stronger CHF now is a logical trade during this period of high inflation and global economic slowdown (stagflation). However, looking through the business cycle, the currency is unlikely to hold those gains as the economy and inflation recover to longer-term trend levels.
Canadian Dollar (CAD)
The CAD gained 0.2% relative to G-10 and 0.7% versus the USD. The CAD followed the USD higher versus G-10 during the first half of the month despite disappointing jobs numbers, -43.2k versus +22.5k expected, weak oil prices and a steady deterioration in the Bank of Canada’s (BoC) business outlook survey. The economy still remains hot, with unemployment at 4.9%, a near 50-year low. Rising inflation prompted the BoC to appropriately raise its policy rate by 100 bp. The surprisingly strong BoC policy response did little to help the CAD after Governor Tiff Macklem implied that the front loading of rate hikes will not necessarily change the ultimate peak policy rate. Thus, the currency continued to follow the USD lower versus the G-10 average throughout the second half of the month. Just as the CAD has benefited over the past year from close ties to the US economy and synchronized monetary policy outlooks, the weaker US outlook and the USD weighed on the CAD this month.
Our tactical CAD view is modestly negative as we begin to see weakness in economic data and softer commodity prices. As the BoC continues to tighten, we will also have to confront the potential impact of higher yields on elevated household debt levels and extremely high home prices. While we have lost our enthusiasm for long CAD positions, we are not calling for a substantial move lower. This is because the absolute level of economic activity is very strong and therefore we expect further rate hikes from the BoC. We also see the USD being well supported, which will spill over to support the CAD to some extent. From the perspective of long-run valuation (a 3–5 year horizon), the CAD is cheap and has potential for sustained appreciation versus the USD and the CHF, but it is expensive versus the GBP, the JPY, and the Scandinavian currencies, and may underperform.
Norwegian Krone (NOK)
After a very difficult Q2, the NOK led G-10 with a 1.7% gain versus the average. The month began with a jump higher on better-than-expected manufacturing PMI and a bounce higher in oil prices. Oil quickly reversed and trended lower into mid-month on rising recession fears, NOK followed. Disappointing May mainland GDP, -0.2% MoM vs. +0.5% expected, did not help. As oil and equity markets recovered in the second half of the month, the NOK rose steadily. Another positive surprise in core inflation, which came in at 0.5% MoM for June relative to 0.4% expected, also helped underpin the case for further Norges bank policy tightening and a stronger currency.
Our models have shifted neutral on the NOK over the tactical horizon. Medium term economic trends and oil prices are positive factors for the currency. However, over the very short term, next 1–2 months, we have a more negative bias for the currency. Growing recession fears are likely to keep oil prices exposed to bouts of weakness in the near term. We also see ongoing downside volatility in equity markets given the tenuous global macro outlook which will likely cause the same behavior in the NOK. Over the medium term, the outlook is a bit more positive. Oil price downside is likely limited even in a recession due to US and OPEC supply constraints and geopolitical risks to Russian supply. Although the benefits of high oil profits will likely be partly diluted by the Norges bank’s daily sales of the NOK. Over the long run, the NOK is historically cheap relative to our estimates of long run fair value and is supported by steady potential growth. We expect strong gains eventually but reiterate that the NOK faces a tough near-term environment.
Swedish Krona (SEK)
investors worried about heightened recession risk with the EU, a key regional trading partner. In the beginning of July, the somewhat disappointing Riksbank’s policy forecast at its meeting on 30 June, steady rate hikes to 2% by early 2023 and the bank shifting to a holding pattern weighed on the SEK. The minutes of that meeting, released on 11 July, helped turn the tide in favor of the currency. Governor Stefan Ingves expressed concern that a 2% policy rate may not be enough to control inflation. A few days later, a big upside core inflation surprise, +0.7% MoM for June versus 0.4% expected, built on the minutes, furthered expectations that the Riksbank would have to be more aggressive than they forecast. As a result, the SEK trended steadily higher before it weakened a bit toward month end in apparent sympathy with a negative shift in the EUR sentiment.
The SEK remains among the cheapest G-10 currencies relative to our estimates of long-run fair value. Our models also like it over the tactical horizon primarily due to relative economic strength. We also see potential that high inflation will push the Riksbank to tighten policy further than they expect. Despite a positive tactical and long-run outlook from our models, the SEK remains an uncomfortable currency to buy. It depends little on direct Russian gas imports but crucially on the EU’s growth outlook, which faces significant tail risks. It has also been quite sensitive to equity market volatility this year and we think that we will see further spikes in equity volume this year. For now, it may be best to express a positive SEK view versus the EUR and to neutralize some of those EU growth and Russia-Ukraine War risks.
Australian Dollar (AUD)
The AUD rose steadily to finish with a gain of near 1% relative to the G-10 average and more than 1.5% versus the USD. The month began on a positive note with a 50 bp rate hike from the Reserve Bank of Australia (RBA) at its meeting on 5 July, along with a comment that the new rate of 1.35% was well below neutral. The improved Chinese growth outlook resulting from the gradual lifting of the COVID-19 lockdowns and hopes for increased fiscal stimulus supported the currency. As the month progressed, good news continued to flow. On the 13th, employment data surprised to the upside, bringing the unemployment rate down to 3.5% versus 3.8% expected. These positive data corresponded with a strong recovery in risk sentiment and equity markets, which tends to help the AUD. The currency understandably outperformed.
Despite that strong story for July, we are cautious. Like much of the world, we can see signs of economic weakness in Australia. The Westpac-Melbourne Institute consumer sentiment index and leading indicators continue to decline. June retail sales were +0.2% MoM down relative to expectations of +0.5% and significantly below the May growth rate of 0.9%. CoreLogic’s measure of home prices fell 1.4% MoM, a third consecutive monthly decline. Alongside these early signs of economic deceleration, key commodity prices such as iron ore remain well off their recent highs and we see the potential for further sharp declines in equity markets. Thus, the balance of risks points to near-term challenges for the AUD, which are likely to keep it under pressure before it can sustain a medium-to-long-term rally once we can see through the current global economic slowdown to the next recovery cycle.
New Zealand Dollar (NZD)
The NZD gained 0.4% versus the G-10 average in volatile trade. During the first half of the month, rising recession fears, the strong USD, weak commodity prices, and sluggish equity markets held the risk-sensitive NZD down. Unlike the AUD, the NZD did not enjoy a string of positive data releases. Home sales fell more than 38% YoY while home prices continued to slide. BusinessNZ’s manufacturing PMI dipped below 50 into the contractionary territory at 49.7, reversing last month’s surprise gain. The Reserve Bank of New Zealand delivered its third consecutive 50 bp rate increase, and a fresh new high in Q2 core inflation at 6.1% YoY points to continued policy tightening. However, this is not a massive help to the currency as other central banks are also tightening policy aggressively.
We are negative on the NZD due to weaker economic growth, weaker commodity prices and ongoing fragility in global risk sentiment. The early signs of optimism we noted last month, such as stronger-than-expected PMI and resilient credit card sales data, quickly evaporated in July. Longer term, our NZD view is mixed. Relative to long-run valuations, the currency appears attractive against the USD and the CHF but is not as cheap as the other commodity currencies.
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