Higher yields and weaker equity markets from April carried over into early May, keeping upward pressure on the USD. Middle of the month, global yields began to fall alongside equities as investor focus shifted toward recession risks. The rising risk aversion not only continued to support the USD but potentially other traditional safe-haven currencies such as the JPY as well. Investor sentiment found some relief toward the end of the month due to talks of a possible pause in policy tightening by the US Fed; easing of US tariffs on China; and plans to ease COVID-19 lockdowns in China. Equities rallied and the USD gave back all of its early month gains, while risk-sensitive currencies, such as the NOK, the NZD and the AUD recovered.
Figure 1: May 2022 Currency Return vs. G-10 Average
Despite the modest rally in risk assets over the past few weeks, the macro environment should be extremely challenging in the next couple of quarters. Global growth is slowing and we expect inflation to begin to stabilize and moderate this year albeit at historically high levels. Weaker growth and higher inflation will keep central banks on the defensive and introduce substantial uncertainty for investors.
The big if is whether a hard-landing, recessionary scenario, which may be required to tame inflation, would materialize. Even if we were to avoid such a recessionary scenario, it should still entail monetary and fiscal tightening sufficient to cause a material slowdown. Cross currents from the highly uncertain economic outlook coupled with the ongoing risks from further lockdowns under China’s zero-COVID policy and the Russia-Ukraine War portend further turbulence in financial markets. In such situations, it is difficult to identify high-conviction positions in currency over the near term, as evidenced by the large number of neutral signals in our tactical outlook.
Figure 2: May 2022 Directional Outlook
US Dollar (USD)
The USD lost 0.5% versus the G-10 average, a minor retracement of its stellar 4.7% gain in April. During the first half of the month, the USD continued its dramatic appreciation with better-than-expected employment data, another positive inflation surprise, and a 0.5% rate increase from the Fed on 6 May. This positive data pushed yields higher, supporting the dollar. However, those higher yields also rattled equity markets, sending the markets sharply lower and adding a safe-haven bid to the USD. After a near 2.5% gain, the USD completely reversed, pushing it into negative territory by the month-end. Mid-month, attention shifted toward recessionary risks after the University of Michigan Consumer Sentiment Index, the Empire State Manufacturing Survey, the Philadelphia Fed Manufacturing Index, and new home sales all disappointed expectations. That USD sell-off continued through the month-end alongside a relief rally in equity markets after Atlanta Fed President Raphael Bostic mentioned the possibility of a pause in rate hikes in September, US President Joe Biden commented on the possibility of a reduction in China tariffs, and both the European Central Bank (ECB) and the Swiss National Bank guided for a faster-than-expected path toward rate increases.
The USD is highly overvalued from a long-run perspective – over 19% expensive relative to the currency basket in the MSCI World ex USA Index, a level which has tended to precede a significant multi-year depreciation. At these valuation levels, the USD is clearly at risk over the longer term. However, it is difficult to see the currency falling while the US rates continue to rise rapidly and uncertainty from the Russia-Ukraine War and supply chain disruptions from COVID-19 remain elevated. Until the macro environment stabilizes, the USD is likely to continue to find support. That said, our 3-5 year USD outlook remains firmly negative. We believe that we are in the process of forming a top to the eleven-year USD bull market. At some point, inflation will roll over, US monetary policy expectations will peak, and many of the stresses holding back the economic outlook outside the US will abate. In this context, cheaper non-US assets will look much more attractive, incentivizing outbound capital flows and a weakening of the USD.
The euro was the top-performing G-10 currency, up 0.90% versus the average. The month began on a positive note, with the EUR holding up well relative to the USD and appreciating strongly against the more cyclically sensitive currencies as equity markets sold off. Mid-month, as equity markets bottomed and the USD fell back, the EUR remained well supported as several ECB members raised the idea of 0.5% policy rate increases, beginning with Governor Klaas Knot of the central bank of the Netherlands. ECB President Christine Lagarde did not go so far as to promote a 50 bp hike, but on 23 May she noted upside risks to inflation and indicated that the policy response should adjust. Local economic data shows signs of slowing with consumer confidence in the negative territory and softer manufacturing and services Purchasing Managers' Index (PMI) survey results. However, while the PMI data disappointed, it remained above 50, indicating continued expansion. Thus, the weaker growth data had little impact on the EUR, while higher inflation prints helped the currency by reinforcing the need for ECB policy tightening.
We are near neutral to slightly negative on the EUR due to the risks to growth, which may soften the monetary policy response to high inflation and disincentivize capital flows into the region. The European Union’s (EU) growth forecasts are competitive with the US and much of the G-10, but disruptions from the war introduce greater downside risks to those forecasts. The ECB’s shift to a hawkish inflation fighting stance is unlikely to provide significant, sustained support for the currency because the ECB’s policy rates would still likely remain dramatically lower than the G-10 average. On a positive note, the near-term positives from the greater-than-expected monetary tightening and the EUR’s tendency to perform well during times of market turbulence (thanks to its high liquidity and current account surplus) provide near-term offsets to the downward pressure from low yields and greater growth uncertainty.
Longer term, once the uncertainty over the Russia-Ukraine War subsides (which could take very long in the worst-case scenario), we see room to have a more constructive discussion on the EUR. The current conflict is a clear negative for now, but over the medium term it also incentivizes greater EU integration, higher fiscal spending, and a more rapid transformation toward alternative energy sources. All these factors should ultimately promote a higher, long-run potential growth rate and support a sustained post-crisis recovery in the EUR.
British Pound (GBP)
The pound overcame a sharp sell-off after the Bank of England (BoE) meeting on 5 May to finish the month down only 0.1% relative to the G-10 average. The headline news out of that meeting made the GBP appear positive. The committee raised rates by 25bps, with three members voting for a 50bp hike, more hawkish than the previous meeting. However, accompanying statements did not clearly endorse a clear policy tightening path going forward and forecast revisions called for negative 2023 GDP growth of 0.25% and peak inflation of over 10% later this year — currencies do not respond well to stagflation. The GBP fell more than 2% versus the USD on the day and 0.74% versus the G-10 average. The currency climbed back into positive territory over the next couple of weeks helped by March unemployment rate of 3.7%, the lowest in nearly 50 years. The GBP was unable to hold those gains into month-end as consumer confidence dropped to a record low of -40 and May services PMI plummeted to 51.8 from 58.9 in April.
Like the EUR, we are neutral on the GBP with a small negative bias. Economic risks from a potential slowing of the UK’s growth, current account deficit, fiscal drag, and eroding consumer purchasing power from elevated inflation are negatives for the GBP. The BoE’s hesitancy in tightening policy, despite near the 40-year high in inflation, also weighs on the outlook. Despite these challenges, we remain near neutral over the tactical horizon. The UK’s data has slowed and the drop in services PMI coupled with poor consumer confidence may foreshadow greater problems ahead. Overall, the UK is not slowing much more than most economies, and the employment picture is extremely healthy.
Longer term, we are more constructive. Once the geopolitical uncertainty resolves, we see greater room for a sustained GBP appreciation powered by its cheap valuation versus the long-run fair value, an eventual recovery in fundamentals, rising policy rates, and our expectation for broad, long-run USD weakness. The obvious complication being that timing the start of a longer-term recovery is difficult. For the foreseeable future, risks of a more significant global slowdown and intensifying stagflation risks in the UK may delay any long-run recovery in the GBP, even as late as H2 2023 or beyond.
The yen was near flat, up 0.1% versus the G-10 average. Once again, the JPY followed global yields and equity markets — rising yields and equity prices hurting the currency and falling yields and equities helping. At the start of the month, yields rose and equities fell, creating a mixed picture, which held the JPY in a tight range. As investors began to contemplate recession risk, both equities and yields fell mid-month, prompting the currency to rally almost 3.5% relative to the G-10 average. Late in the month, an equity market recovery and range bound to slightly higher yields triggered a reversal of that mid-month rally to leave the JPY flat for the month.
Our tactical models have shifted to a more neutral JPY forecast. Japanese growth and core inflation are among the weakest in the G-10, incentivizing the Bank of Japan (BOJ) to stick to its ultra-loose monetary policy, which in contrast to elevated global yields continues to pressure the JPY lower. Slowing global growth and turbulent equity markets are likely to counteract that negative impact, leaving the currency in a noisy range. That said, the immediate, short-term trend going into June is for improved equity market performance and rising yields, which may see the JPY back to and even moderately through its year-to-date lows. Should that happen, we expect higher yields to eventually threaten growth expectations that should prompt another equity market correction and limit the JPY downside.
Longer term, the JPY looks very cheap and is now near its 30-year low on a real effective exchange rate basis. The weakness in the currency appears to be a rational response to underlying cyclical fundamentals. Once the cycle turns — global inflation and growth roll over in coming quarters, bringing down expectations of monetary tightening — the JPY has ample room to appreciate back toward its fair value.
The CHF gained 0.6% against the G-10 average, largely in response to the prospect of the SNB’s interest rate hikes and reduced pace of currency intervention judging by sight deposit growth. The month did not start on a positive note. The CHF bucked its usual pattern of appreciating during periods of equity market turmoil as rising global yields pushed it lower. That changed mid-month after SNB Chairman Thomas Jordan indicated that the governing board was ready to raise rates as it was required to control inflation. The CHF jumped nearly 2% in the following days before pulling back slightly as global risk sentiment and equity prices rebounded toward month-end. Sight deposit creation, a proxy for the SNB’s intervention in the foreign exchange market, also slowed dramatically after 20 May, likely helping the CHF hold on to most of its mid-month rally.
Near term, we have been neutral on the CHF as its economy is less sensitive to spillover risks from the Russia-Ukraine War and it tends to do well during periods of high uncertainty and volatile equity markets. The recent prospects of a monetary policy tightening cycle and lower rates of intervention to weaken the CHF also provide support. We stop short of an outright positive view due to ultra-low yields compared to the rest of the G-10 (which we expect to be true even if they raise rates), lower than G-10 average inflation, and the likelihood of a reacceleration of SNB’s intervention to limit further CHF gains. Longer term, the outlook is decidedly negative. The currency is expensive versus its long-run fair value. Extreme valuation, in addition to structurally lower levels of inflation and interest rates, is likely to depress the CHF versus most G-10 currencies over the long run.
Canadian Dollar (CAD)
The Canadian dollar gained 0.6% versus the G-10 and regained its spot to become the top-performing G-10 currency. The CAD underperformed the USD as risk aversion rose and equity markets sold off. However, due to a strong domestic economy and the currency’s high correlation to the USD, it outperformed most of the G-10 currencies, up 1.2% versus the G-10 by 15 May. The reverse was also true. As the USD fell back on weaker economic data and falling yields, the CAD followed and ultimately moved into negative territory before the recovery surge in oil prices and stronger than expected core retail sales toward the end of the month pushed it up.
Our CAD view remains neutral to positive due to rising yields, continued positive inflation surprises, high commodity prices, and a strong domestic economy. The strength and breadth of our signals across equity markets, commodities, economic growth, and interest rates provide a basis for some additional appreciation. However, the currency has already performed very well through 2021–2022, and it looks overbought in the short term against the broad G-10 universe. This limits our enthusiasm for further gains over the near term. We also expect volatility to remain elevated given the growing uncertainty of the impact from rapid monetary tightening. Longer term, the CAD outlook is mixed. The currency is cheap and has the potential for sustained long-run appreciation versus the USD and the CHF, but it is expensive than the GBP, the JPY, and Scandinavian currencies, and may also underperform.
Norwegian Krone (NOK)
The krone lost 1.4% versus the G-10 average, a repeat of its 1.4% loss in April. The NOK closely followed equity markets falling steadily through 20 May before both equity prices and the NOK rebounded toward month-end. Local economic data was mixed and had little impact on the currency. April manufacturing PMI surprised higher at 60.6 versus expected 57.5 to start the month followed by a surge in inflation at 0.9% MoM vs. 0.6% expected. Toward the end of the month, the data was less impressive with consumer confidence dipping into negative territory and April retail sales falling 0.9% MoM compared to +3.3% the prior month.
We are positive on the currency over both short- and long-term horizons based on its strong fundamentals. However, we also see continued high levels of short-term risk due to its sensitivity to equity market volatility. The NOK is historically cheap relative to our estimates of long-run fair value and is supported by steady growth, high oil prices, and rising yields. Although the benefits of high oil profits will likely be partly diluted by the Norges Bank’s daily selling of the NOK. We expect strong gains over time but reiterate that the NOK faces continued near-term volatility as markets grapple with bouts of global risk aversion and downgraded global growth expectations.
Swedish Krona (SEK)
The krona lost 0.5% against the G-10 average in choppy trade. Despite a positive jump in April and services PMI of 68.1 versus expectations of 63.0, the SEK fell alongside equity markets, reaching a low of -1.3% versus the G10 on 9 May, before finding some support. After a quick bounce off the lows, the SEK moved sideways in a range for the remainder of the month. Inflation data published on 12 May surprised higher at 6.4% YoY compared to expectations of 6.2%, underscoring the need for the Riksbank to continue to raise interest rates after its initial increase on 28 April. On 17 May, the Riksbank’s Henry Ohlsson suggested that there could be a scenario where the bank would deliver a 50 bp hike. His comments were far less convincing than those from several ECB members, but the combined impact of hawkish comments from the ECB, the SNB, and the Riksbank increased focus on the need for monetary tightening in the region and helped to support the SEK even as equity markets set new lows mid-month.
The SEK remains among the cheapest G-10 currencies, but it is likely to remain weak near term, leaving us largely neutral over the tactical horizon. The shift in Riksbank’s policy is welcome, but expected rate increases remain small compared with that of several other G-10 central banks. The ongoing uncertainty regarding the EU’s growth outlook and the Russia-Ukraine War are also likely to be a drag. We see room for recovery once we gain even a modest amount of clarity on the war and the gap between Swedish monetary policy and that of the US and other G-10 countries begins to contract. For now, it may be best to express a positive SEK view versus other low yielders such as the EUR and the CHF that also have exposure to the EU’s growth and the Russia-Ukraine War risks.
Australian Dollar (AUD)
Aside from some early month volatility, the AUD was surprisingly quiet for most of the month despite large gyrations in global equity and rates markets, ending May up 0.4% versus the G-10 average. On 3 May, the Reserve Bank of Australia (RBA) initiated a rate-hiking cycle, with a 25 bp policy rate increase along with a recognition that additional increases would likely be required going forward. The AUD jumped nearly 1.25% relative to the G-10 over the following 3 days. The rally was short lived as global risk aversion rose, sending equity markets sharply lower, and concerns over the economic impact of the COVID-19 lockdown in China weighed on the regional outlook. By 12 May, the AUD not only lost all its post RBA gains, it fell an additional 1%. From there, the currency recovered back to flat as investors focused on the relatively strong domestic economy, the likelihood of larger policy rate hikes revealed in the RBA’s minutes of the meeting released on 17 May, and prospects for at least a partial Chinese reopening in June and July. Ultimately, the rebound in equity markets and broader risk sentiment toward month-end helped the AUD grind higher to end in positive territory.
Economic data was slightly disappointing, with April retail sales at 0.9% MoM versus the 1% expected, Q1 wages only growing 0.7% QoQ versus the 0.8% expected, and a modest slowdown in May manufacturing PMI to 52.5 from 55.9 in April. However, the softening in the AUD economic data was minor compared to similar slowdowns across the G-10. The upgraded RBA’s policy outlook was a major support for the currency, and the impact on the AUD was negligible.
We remain broadly positive on the AUD due to elevated commodity prices, prospects for the RBA’s rate hikes, and the strong domestic economic outlook. However, over the very near term, we tilt more to neutral due to the deterioration in global risk sentiment and higher equity market volatility. Chinese pledges to increase economic stimulus and lift many lockdown measures in June should provide near-term relief, but China’s zero-COVID policy remains in place and the possibility of new lockdowns over the coming months are a further headwind for the AUD. Thus, the balance of risks points to near-term challenges for the currency, which are likely to keep it in a range before it can sustain a medium to long-term rally.
New Zealand Dollar (NZD)
The New Zealand dollar overcame a steep downtrend through 12 May to finish down only 0.2% versus the G-10 average. Like the AUD, the NZD local economic data was not particularly important in driving the currency as rising risk aversion and falling equity markets prompted a sell-off during the first half of the month despite a strong Q1 employment report. Unlike the AUD, the NZD did not enjoy the RBA driven early month rally; it simply started falling steadily from the start of the month. Deterioration in New Zealand’s terms of trade through mid-May also fostered the currency’s weakness. As the equity market found a base, both the AUD and the NZD began to recover. In the case of the NZD, the recovery accelerated sharply following the Reserve Bank of New Zealand’s policy meeting on 24 May. They surprised markets with a larger-than-expected 50 bp policy rate increase and increased their end 2023 policy rate forecast to 3.9% from 3.4% at the last meeting.
Our tactical models turned negative on the NZD in March and remained in negative territory due to the deceleration in economic activity, weak domestic equity markets, and deteriorating global risk sentiment. Yields remain relatively attractive, but the relative advantage is limited as other central banks are also becoming more aggressive in tightening policy. Longer term, our NZD view is neutral. 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.
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