Stagflation continued to dominate currency markets with emphasis on inflation. The month began with a brief retracement of August moves — commodities and equities higher, the USD lower, and rates markets quiet. That changed abruptly with the US consumer price index (CPI) surprise on 13 September – core CPI +0.6% MoM compared to +0.3% expected. Global interest rates shot higher led by the United States (US) as markets priced a vigilant Fed’s policy response. Risky assets – commodities, equities, credit – fell broadly and the USD appreciated. Despite expectations, the Fed managed to deliver a strong hawkish surprise, forecasting higher-than-expected rates for longer. The risky assets sold off and the USD rally accelerated.
Figure 1: September 2022 Currency Return vs. G-10 Average
Around this dominant stagflation and monetary policy theme that drove the broad currency market, we saw additional volatility in the JPY after the Bank of Japan (BOJ) intervened on 22 September to halt its slide. The following day, the UK announced a supply-side oriented fiscal plan that included aggressive deficit-funded tax cuts skewed toward wealthier taxpayers and corporations. The market reacted harshly, sending the GBP sharply lower and UK interest rates sharply higher, a move which appeared to spill over and put even more upside pressure on global rates. This acted to further amplify global recession fears and USD strength.
Figure 2: September 2022 Directional Outlook
The broad USD appreciation is reaching historic levels, which provide an increasingly attractive long-term opportunity to sell the currency. However, we would take a cautious stance as inflation and yields are yet to peak and recession and earnings risk will continue to grow. As a result, inflation, growth, and monetary policy are likely to continue to dominate all markets. Even commodity terms of trade that helped limit the downside in risk-sensitive currencies earlier this year are turning negative. Commodity markets have recently sold off, with investors focusing more on fear of reduced demand in recession than supply constraints from Russia and a decade of chronic underinvestment in the resources sector. Therefore, the USD should continue to be well supported against a broad basket of currencies due to higher rates, a safe-haven bid as the world’s core reserve currency, and what appears so far to be a more resilient US economy.
Review and Outlook by Currency
US Dollar (USD)
The USD gained 4.4% versus the G-10 average and nearly 9% versus the NOK. The USD story was quite straightforward: high inflation + a vigilant Fed + global risk aversion = USD strength. The month began on a quiet note after the USD surge in August before a surprisingly strong CPI release, core +0.6% MoM versus +0.3% expected, sent expectations for Fed tightening and the USD higher. The Fed meeting on 21 September exceeded the elevated expectations by delivering the anticipated 75 bp rate hike and an unexpectedly hawkish future projection that rates would end 2022 at 4.375% and 2023 at 4.625%. In response, the USD jumped higher while the fear that such significant monetary tightening would cause a recession sent equities, commodities, and credit markets lower.
The USD is historically expensive and near term overbought. Aside from 1985, we estimate that currency is at its most expensive level in the past 50 years. Over the next 3-5 years, we are likely to see ample downside to the USD (15%-20%) as we eventually move to more normal levels of inflation, lower monetary policy rates, and enter the next global recovery cycle. For now, the USD may stay well supported over the coming months.
The exact timing of the USD peak is very difficult to predict. We need to see a peak in interest rates, a credible decline in inflation, and some reliable sense of the trough in growth, especially outside of the US. We are getting closer to peak rates and may have reached them in the US late in the month, with the two-year breaking 4.3% and the 10-year pushing through 4%. Reduced supply chain bottlenecks, improved input/output prices, and declines in used car and home prices indicate that inflation may top soon. But, we have yet to see it in broad CPI and Personal Consumption Expenditures Price Index (PCE) inflation indices. On the growth front, the extent of the global economic slowdown and fall back in equity markets remain highly uncertain due to geopolitical risks, the energy price shock, stubbornly weak Chinese growth, and the ongoing drag from tighter monetary policy. We could see a peak by late Q4 or early Q1 if inflation and monetary policy expectations moderate. But if inflation proves more resilient and/or the expected growth slowdown more severe, the turn may not happen until well into 2023.
We urge caution in assuming that this USD move represents a permanent, structural move higher and urge caution about trying to time the turn too carefully. We can see the growing stress of the strong USD on global financial and economic conditions as well as on the large US current account deficit. We take this as clear evidence that the currency is at unsustainable levels. While we suspect it is slightly early for the USD turn right now, we are much closer to the peak and the eventual downturn could be very quick. We see great benefit for long-term investors to build short USD positions.
The EUR gained 1.7% versus the G-10 average. After a slow start to the month, the currency began to trend higher in response to the European Central Bank’s (ECB) decision to raise interest rates by 0.75% to 1.25%. Rising stores of natural gas also helped to reduce fears of severe shortages in winter, supporting the EUR. However, that was offset by the near complete shutdown of Russian natural gas flows. The Purchasing Managers' Index (PMI) data remains in contractionary territory pointing to recession as the economy grapples with sky-high energy prices, the slowing global economy, and tighter monetary policy. While these factors hurt the EUR, relative to the CHF and the USD, it performed well against more cyclically sensitive and commodity-linked currencies – hence the EUR’s 1.7% gain versus the G-10 average. A massive €200 billion fiscal support package in Germany and expectations for similar, but smaller, support packages across the European Union (EU) also likely helped the EUR appreciate into month end.
We are modestly positive on the EUR relative to the G-10 over the near term, but we see room for some additional underperformance relative to the USD. We expect volatility in equity markets to persist and commodity prices to remain on the weak side as investors grapple with a weaker demand outlook and rising recession risk. Thus, much of the positive EUR view is not due to the EU’s strength on an absolute basis, but rather because we see greater downside risks in cyclically sensitive and commodity-linked currencies, like the dynamic we saw in September. The ECB will also be key to the EUR outlook over Q4. With fiscal stimulus ramping up to offset the drag from high energy prices, the impending recession in the EU should be shallower. However, core inflation should also prove stickier. If the ECB responds with a more vigilant stance to contain that inflation, then the currency is likely to hold up well. Conversely, if we see a harsh winter straining energy supply and the ECB taking a more cautious approach favoring growth over inflation, then we could see the EUR move broadly lower and break to or below 0.95 versus the USD.
British Pound (GBP)
Given the dramatic, negative headlines and extreme volatility in the GBP and UK assets following the mini-budget announced on 23 September, one would expect that the GBP underperformed. On the contrary, the currency gained 0.3% relative to the G-10 average. Until the announcement, the GBP traded in a tight range of +/-0.5% relative to the G-10. It was remarkably uneventful that the election and the announcement of an energy price cap could result in a significant increase in fiscal deficits. We attribute the early month’s resilience to the Truss victory and the fact that the energy price support policy was well telegraphed and had already pushed the currency lower in August. That all changed with the additional deficit-financed supply-side tax cut package announced on 23 September. The UK 30-year yields shot up over 2% in three days, forcing leveraged investors to scramble to meet margin calls and the GBP plunged nearly 3% relative to the G-10 and hit 1.0350 versus the USD, a new 50-year low. The Bank of England (BOE) stepped in on 28 September with a pledge to buy long-end gilts and alleviate the fire sale conditions. Yields fell back sharply, and the GBP recovered from a 3% loss to slightly positive in the final 2.5 trading days of the month.
Our models continue to point to the GBP strength largely due to a short-term oversold condition, even after the late month rally. However, it is difficult for the models to fully appreciate the new fiscal package and the likely rise in deficits. Supply-side reform is needed to revive a decade-long slump in the UK’s productivity. Deficit-financed supply-side tax cuts are another story. The resulting increase in deficits and yields will likely crowd out far more consumption and investment than the tax cuts will stimulate, thereby speeding the descent into recession. This is particularly true for an economy such as the UK, which runs large, persistent current account deficits.
Therefore, we are significantly more cautious on the GBP compared to our model signal. There is a high risk that it trades back down toward its reactionary lows on 28 October, or at least to the 1.07 range versus the USD. It could push even lower, perhaps to parity or below versus the USD, should we see another increase in expected deficits and/or a weak BOE monetary policy response to the expected increase in inflationary pressure.
That said, we do not see the current policy as leading to a large permanent devaluation of the currency. Many components of the plan, such as increased immigration, free enterprise zones, and energy sector reform, should help support long-term growth. We also see a substantial risk that key aspects of the plan are rolled back in response to political pressure from recessionary conditions and the potential for increased inequality. Finally, we expect the BOE to adhere to its inflation-fighting mandate and raise rates which will directly support the currency. Of course, accelerated monetary tightening may also hasten recession which will hurt the GBP. But we do not see that as a structural shift lower in the GBP valuation because recession should help to wring out high inflation more rapidly and improve the current account as saving rates rise and import demand falls.
Japanese Yen (JPY)
The JPY experienced wide swings on its way to a modest loss of 0.3% relative to the G-10 average. Softness in the USD and slightly improved global risk sentiment weighed on the JPY in the beginning of the month. On 6 September, the BOJ increased its plans to purchase Japanese government bonds to protect the 0.25% yield cap. This emphasized the BOJ’s commitment to ultra-loose monetary policy, driving the JPY lower. On the 8th, a joint meeting between the BOJ and Ministry of Finance (MoF) to discuss the currency’s weakness failed to generate any discernable pushback against JPY depreciation, opening the path for further weakness. The JPY hit its low for the month following the US CPI surprise, down 3.2% versus the G-10 average. Around that time, the MoF checked prices in the market, a sign that they may intervene to buy the JPY and halt its slide. The currency began to rally back from that point. After the hawkish Fed surprise, the MoF did intervene by selling around US$19 bn and buying the JPY. The JPY quickly jumped nearly 2% and entered a tight trading range around that level for the remainder of the month.
Going forward, our models have a positive view on the JPY versus the G-10 average but a negative view versus the USD. Further intervention by the MoF remains a JPY positive risk. But we do not think that Japanese authorities will attempt to reverse the trend lower in the JPY or even set a floor on the currency. The ongoing divergence between the ultra-loose monetary policy in Japan and historically aggressive monetary tightening outside Japan is a powerful negative force; too powerful to overcome through intervention alone. As a result, we expect that Japanese authorities will use intervention to slow the pace of depreciation by introducing some two-way price risk and discouraging short-term speculation. Beyond that near-term dynamic, the currency is extraordinarily cheap and we think that we are approaching the high in global yields. Once we set that peak in interest rates and inflation begins to moderate, the JPY can begin to recover on a more sustainable basis. We see the potential for the JPY to be the first currency to turn higher versus the USD as yields peak because it also has safe-haven qualities and should not be severely impacted if the global growth slows more than expected.
Swiss Franc (CHF)
The CHF trended steadily higher to finish up 3.4% relative to the G-10 average and only lost 1% against the USD. The near-complete shutdown of Russian gas flows to Europe raised recession risk, which likely attracted interest to buy the CHF as a regional safe haven. Anticipation of another Swiss National Bank (SNB) rate increase at its meeting also likely added to the CHF buying interest, as did the apparent lack of SNB’s intervention to resist that appreciation. The SNB delivered a 0.75% rate increase on the 22 September and the bank is not scheduled to meet again until 15 December. Markets hoped for a larger rate hike, reflecting the fact that there will likely be at least 2 hikes from both the Fed and the ECB by that time. However, the CHF will not be negatively impacted by the disappointment. The resulting spike in investor risk aversion after the Fed policy and UK budget surprises created safe haven buying pressure that allowed the CHF to continue to move higher despite the softer-than-expected SNB outcome.
We have shifted from slightly positive to neutral CHF over the near term. We expect the CHF to be well supported by high levels of equity volatility, high EU recession risk, ongoing geopolitical risk from Russia-Ukraine War, an unstable UK policy outlook, and the lack of SNB’s intervention to prevent the CHF strength. However, the currency has already appreciated significantly in response to these factors and is expensive relative to our estimates of long-run fair value. Moreover, the tone of the SNB’s action was relatively cautious. The CHF is surely going to remain the second-lowest yield currency in the G-10, and the SNB warned that at some point it will stand ready to resume direct market intervention to sell the CHF. Once the spike in regional political and recession risk settles, the CHF has plenty of room to move lower toward its long-run fair value, though that may take several quarters.
Canadian Dollar (CAD)
The CAD only lost 0.2% versus the G-10 in September but fell 4.7% versus the USD. The month began with a push higher, +0.92% versus the G-10, despite weak building permits and manufacturing PMI data. This rally was most likely in anticipation of an expected 0.75% policy rate increase from the Bank of Canada (BOC) meeting on 7 September. The BOC delivered the anticipated 0.75% rate increase and suggested more rate hikes. However, they did not hint at the magnitude of further hikes, stating that it would depend on incoming data. The CAD was not impacted that much. Incoming employment data on 9 September disappointed, -39.7k jobs relative to +15k expected. This was the third consecutive loss in employment and drove the currency lower. The sell-off accelerated after the positive US CPI surprise, ultimately taking the CAD into negative territory. The currency enjoyed one more bounce in sympathy with the hawkish tone from the Fed on 22 September before falling back down alongside the steep drop in energy and commodity markets.
Going forward, we see further downside for the CAD in response to soft commodity prices and steadily deteriorating employment, home prices, and manufacturing PMI. Monetary policy may also prove to be a drag on the currency. The BOC is unlikely to be able to keep pace with the Fed because transmission of monetary policy tightening is likely more powerful in Canada. Extremely high home prices and elevated levels of consumer debt in Canada should be more sensitive to policy rate hikes relative to the US.
Norwegian Krone (NOK)
The NOK resumed its role as the most sensitive G-10 currency to equity market volatility. Equity markets moved significantly lower after the large positive US inflation surprise. The NOK followed in lockstep, losing 4.5% versus the G-10 average and falling a massive 9% versus the USD. Weaker domestic economic data, Norges Bank monetary policy, and lower oil prices likely amplified the currency’s loss. Core CPI surprised lower at -0.5% MoM versus -0.3% expected, and the regional business survey for the next six months fell into negative territory. This corresponds to the Norges Bank’s statement on 22 September. They raised rates by 0.5% but revised the 2023 growth outlook to be slightly negative and signaled an expected peak policy rate of 3% followed by cuts later in 2023. This is far more dovish than the Fed and even the markets are pricing a 3.05% ECB policy rate by next September.
Our models shifted to a negative tactical NOK view on weaker relative growth, softer oil prices, weaker monetary policy outlook, and rising global risk aversion. In other words, we expect conditions to prevail over the next 1-2 months, at least. 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. Thus, we expect strong gains eventually but reiterate that the NOK faces a tough near-term environment.
Swedish Krona (SEK)
The SEK did well, gaining 0.1% relative to the G-10 and losing 4.3% relative to the USD. However, the weakness in local economic data and the currency’s recent sensitivity to rising equity market volatility suggested a weaker performance. For most of the month, the SEK did follow equity markets in keeping with its recent behavior. It tracked slightly higher from 13 September and then followed equities lower through the 24th. The Riksbank surprised markets with a larger-than-expected 1.0% rate increase but offset that with a forecast of only 0.75% of additional hikes in this cycle and downgraded growth expectations for next year into negative territory. The SEK appears to have been swept up in the dramatic GBP and the EUR rally on the 29th and 30th, which moved it into positive territory to end the month.
We continue to have a negative tactical view on weaker economic data and rising global risk aversion. In fact, despite the near-flat return, we see the SEK as overbought after the large rally to end the month created a misalignment with the weaker economic and interest rate outlook. The ongoing SEK sales to replenish Sweden’s foreign exchange reserves are also likely to weigh on the currency over the coming months. Long term, the currency remains among the cheapest currencies in the G-10 according to our fair-value estimates. However, we will likely have to see growth bottom out and be able to look forward to economic recovery in the region as well as a stronger EUR in order to unlock that value.
Australian Dollar (AUD)
The AUD lost 1.8% versus the G-10 average and 6.3% versus the USD. Losses against the USD were steady after the US inflation surprise. Relative to the G-10, the currency held up reasonably well until a sharp 1% sell-off in the last two trading days of the month. Before that, it was slightly down on a more dovish-than-expected Reserve Bank of Australia (RBA) policy outlook, which pointed to the potential slowing of rate increases, weakness in China’s growth, lower commodity prices, and faltering equity markets. However, much of the negative impulse from those factors was offset by resilient domestic data. The composite PMI is weaker but holding in positive territory, the current account surplus is robust, retail sales surprised to the upside for August, and the labor market is steady and strong. To close out the month, deteriorating risk sentiment on the back of rising global recession worries and falling commodity prices appear to have caught up with the AUD to push it sharply lower. We suspect that investor fears that the RBA would ease up policy at its 3 October meeting may have also contributed to the late month sell-off.
Our tactical AUD view has turned more negative over the month. It is hard to dispute the resilience of economic data in Australia, but the trend is weaker and the global softening of economic data suggests further softness. The cumulative impact of RBA interest rate increases should also begin to weigh more heavily on economic activity and home prices as mortgage rates reset higher. On top of this, the trend lower in commodity prices and continued weakness in the near-term China’s growth outlook are serious headwinds for the AUD. These negative factors point to a more cautious RBA while the Fed and other central banks continue to tighten at a historically rapid pace. Thus, the balance of risks points to near- term challenges, which are likely to keep the AUD 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 lost 3.3% versus the G-10 average and 1.7% relative to the USD. The currency was remarkably quiet until the US CPI surprise, downward acceleration in global equity and commodity markets, and the hawkish Fed surprise pushed the currency steadily lower. The path was remarkably similar to that of broad equity indices and the NOK. In fact, the NZD had a daily correlation of over 45% with the S&P 500. Local economic data continues to show softness but improved on the margin. Negative business sentiment, a worsening current account deficit, soft China’s growth, further drag from monetary tightening, and weaker commodity prices suggest that New Zealand’s economy is likely to remain weak. However, there are some positive signs. The Q2 GDP beat expectations of 0% with a 0.4% gain. Manufacturing PMI rose to 54.9 and credit card spending jumped 5.1% MoM in August.
We are tactically negative on the NZD due to weaker economic growth, weaker commodity prices, and the ongoing fragility in global risk sentiment. We are getting closer to peak interest rates with slowing domestic economic growth alongside a weaker Chinese outlook and persistent global recession risk. Historically, that is not a good time to buy the NZD. That said, the market has been reacting to those negative factors and pushing the NZD steadily lower against the other commodity-sensitive currencies for several months. As a result of that underperformance, the NZD is looking increasingly oversold and could outperform once global macro uncertainty dies down and New Zealand’s growth finds a base. Relative to long-run valuations, the NZD appears attractive against the USD and the CHF, but is not as cheap as the other commodity-currencies, such as the NOK, the AUD, and the CAD.
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