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New Risks Favor Defensive Currencies

We have turned tactically positive on the yen on safe-have appeal, but are now negative on the more cyclical and commodity-linked currencies such as the Australian dollar, the Canadian dollar, the New Zealand dollar and the Norwegian krone.

The bank failures in March have increased the chances of credit tightening and a recession led by the US later in 2023. This likely skews yields, equity markets, and credit to the downside, and shifts the currency market outlook. More defensive currencies such as the yen and the euro are likely winners, while more cyclically sensitive currencies—such as the Australian dollar, the New Zealand dollar, and the Norwegian krone—would likely suffer. The US dollar is stuck in the middle, and might lose its usual role as the preeminent safe haven, but is still likely to outperform those highly cyclical currencies if growth and equity markets falter, as we expect.

For long, we have called for a bumpy ride for currencies in 2023 (“Bumpy Ride for Currencies in 2023?”). The banking stress and the volatility of March are perfect examples of that path. We expect more of the same throughout the year—hopefully with few bank failures. We see economic resiliency, in the face of this uncertainty and the likelihood of further monetary tightening, as a key driver of currency markets over the next several months, but are under no illusions that the risks are confined to the US; they are global.

Figure 2: March 2023 Directional Outlook

March 2023 Directional Outlook

US Dollar (USD)

We believe that the failure of Silicon Valley and Signature Bank will hasten the outflow of banking deposits, encourage banks to increase capital buffers, and result in tighter US credit conditions. That, in turn, means that the US is likely to lead the global economic slowdown and eventually the reversal of monetary tightening to the detriment of the US dollar. However, we see room for a near-term rebound in both short-end US yields and the US dollar after the extreme weakness in March. Beyond that, we favor expressing short US dollar views vs. the euro and the yen given their lower sensitivity to equity market weakness and the potential for their central banks to tighten policy after the Fed pauses.

Canadian Dollar (CAD)

Our models are negative on the Canadian dollar on weaker commodity price trends, poor relative local equity market performance, and expectations of a deeper economic slowdown. Also, Canada and the Canadian dollar are heavily exposed to the weakening US growth outlook. However, recent economic data in Canada have been surprisingly resilient and the immediate impact of lower US yields benefits the Canadian dollar against both the US dollar and the more cyclically sensitive Australian dollar, New Zealand dollar, and Norwegian krone.

Euro (EUR)

We are positive on the euro on an improving economic outlook powered by the lower-than-expected energy prices and decent fiscal spending. Meanwhile, the stubbornly high core inflation is likely to keep the European Central Bank on a tightening path, while the Fed and a number of other G10 central banks have stopped, or will soon stop, tightening policy. The euro is also likely to benefit from its relatively low correlation to global equity volatility, which makes it less sensitive to risks that global monetary tightening will trigger a recession.

British Pound (GBP)

Better-than-expected recent growth data and a reasonably well-capitalized banking system helped the British pound weather the volatility in March. But we believe it will be increasingly difficult for the pound to extend recent gains due to the weak economic outlook, the Bank of England’s cautious policy tightening, global growth risks, and a lingering (large) current account deficit.

In the long term, 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 turns sustainably higher.

Japanese Yen (JPY)

The Japanese yen reclaimed its historical role as the preeminent safe-haven currency, rising sharply during the mid-month banking crisis, a role it is likely to fill going forward if our expectations of declining growth and fragile equity markets prove true. On top of the safe haven, relative interest rate differentials favor the yen as global yields fall from their highs. The yen should also find support as low unemployment, stronger-than-expected wage gains, and a continued rise in core inflation increase the chance of the Bank of Japan tightening monetary policy later this year.

Swiss Franc (CHF)

We are neutral on the franc in the near term. The currency remains expensive in our estimates of long-run fair value, and growth data continue to soften, both of which point to a lower franc. These negative drivers are largely offset by lower yields across the G10, which improve relative Swiss interest rates. In addition, the Swiss National Bank should be incentivized to intervene in currency markets to maintain a strong currency rather than depend on interest rate increases to contain inflation as higher rates may put further stress on Swiss banks.

Norwegian Krone (NOK)

We expect the Norwegian krone to struggle on weak/volatile oil prices, a recent slowing in domestic growth, and a higher risk of global recession following the banking sector stress in March. The krone is highly 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 Norwegian 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.

Swedish Krona (SEK)

We are close to neutral on the Swedish krona. The recent hawkish shift by the central bank and ongoing positive inflation surprises are supportive, but the Swedish krona may continue to struggle for a number of reasons: namely, falling home prices, soft growth data, and the risk that the central bank fails to back up its hawkish comments with more aggressive policy tightening.

From a long-run perspective, the krona is significantly below its long-run fair value and has ample room to rally, though we do not see a ready catalyst for krona appreciation so long as economic data and the global outlook remain challenged.

Australian Dollar (AUD)

Weak/choppy commodity prices, slowing consumer activity, negative real wage growth, rising equity market risk, and a more cautious Reserve Bank of Australia present meaningful headwinds for the Australian dollar in the near term. We think that the Australian dollar downside may be limited as improved China growth begins to show up in the data. That said, we do not think that China growth will be enough to warrant outright Australian dollar strength, because it is likely to be concentrated in domestic services.

In the longer term, the Australian dollar outlook is mixed. It is cheap vs. the US dollar and the Swiss franc, and has room to appreciate but expensive against the British pound, the yen, and the Scandinavian currencies.

New Zealand Dollar (NZD)

We are negative on the New Zealand dollar in the near term. High yields should help support the New Zealand dollar. However, that positive impulse is likely to be more than offset by weaker growth, fragile global risk sentiment, and downside risks to equity markets as global recession risk rises.

In the longer term, our New Zealand dollar outlook is mixed. It is cheap vs. the US dollar and the Swiss franc, and has room to appreciate, but 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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