The US dollar declined, while the Australian dollar was the big winner in January on China reopening and an improved economic outlook. We are tactically positive on the US dollar, the euro and the Swedish krona.
We see a bumpy ride for currencies through 2023 and perhaps into 2024, despite recent market developments—rising risk assets, falling yields, and the falling US dollar—being consistent with a perfect landing. Over the next 3–6 months, we expect greater volatility and some retracement of the sell-off in US dollar.
Figure 1: January 2023 Currency Return vs. G-10 Average
More pro-cyclical currencies are likely to suffer the steepest pullbacks. In the longer term, nevertheless, the market has it right. The current 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.
Figure 2: January 2023 Directional Outlook
The US dollar declined for the fourth consecutive month in January. As inflation and monetary policy normalize and the world finds a path to a sustainable growth recovery, we expect the US dollar to move broadly lower by 10%–15% over the next few years.
But those benign conditions have not yet materialized and may not materialize in 2023. If growth and inflation are either worse or better than expected, the US dollar is likely to bounce higher, accompanied by another spike in equity and interest rate volatility.
The 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 versus the US dollar for now, despite it being nearly 10% cheap to 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 increased the likeliness of policy tightening by the European Central Bank (ECB). However, short-term gains are likely limited as we expect a partial recovery in the US dollar and the Canadian dollar.
There are also risks of greater ECB tightening, which could reignite recession fears, and/or an intensification of the Ukraine–Russia war, which 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 franc, and the Canadian dollar, though it is unlikely to realize its potential until inflation is under control and UK growth bottoms.
In the short term, the yen has appreciated too much too fast on the back of falling US yields and hopes that the Bank of Japan (BoJ) will tighten monetary policy. 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 BoJ is likely to take a slower-than-expected path toward major policy changes.
We expect the yen to correct lower in the near term before resuming its uptrend. In the medium to long term, we are more constructive. The yen 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 a likely 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 Norwegian 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 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 Norwegian krone faces a tough near-term environment.
The Swedish krona may likely continue to struggle for a number of reasons: namely, falling home prices, manufacturing Purchasing Managers’ Index (PMI) print being in contractionary territory, an unexpected rise in the unemployment rate (from 7.3% to 7.5%), negative retail sales growth, and a fall in the December gross domestic product (GDP) growth rate of 0.8%.
Our models have a small positive bias in favor of the Swedish krona over 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 Swedish krona appreciation so long as economic data remains challenged.
The Australian dollar looks attractive as China reopens from COVID-19 lockdowns and positive inflation surprises pressure the Reserve Bank of Australia to further raise interest rates. But we see limited upside due to weak/choppy commodity prices, slowing consumer activity, and tepid wage growth, which suggest a more modest trajectory for the Australian economy.
We expect there to be more equity market volatility from time to time and expect that to likely cap the Australian dollar’s performance. In the longer term, the outlook for the Australian dollar is mixed. It is cheap versus 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 believe that the New Zealand dollar would face a challenging environment given the steady deterioration in economic activity and the likely slowdown in the pace of Reserve Bank of New Zealand’s policy tightening. Our expectation of a global bumpy landing, marked by periods of increased equity market volatility, should also weigh on the risk-sensitive New Zealand dollar. In the longer term, the outlook for the New Zealand dollar is mixed.
On the one hand, it is cheap versus the US dollar as well as the Swiss franc and has room to appreciate. On the other, it is fairly valued versus the Canadian dollar and the euro, and is expensive against the Australian dollar, the pound, the yen, and the Scandinavian currencies
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