Latecomers to tightening party, EUR and JPY, may prove safest harbours in the first half. Latecomers to tightening party, EUR and JPY, may prove safest harbours in the first half. Latecomers to tightening party, EUR and JPY, may prove safest harbours in the first half.

Latecomers to tightening party, EUR and JPY, may prove safest harbours in the first half.

John Hardy


Oversigt:  2023 could be a tough year for currencies but EUR and JPY may have some upside.

Q4 saw a massive retreat in the US dollar as the market ignored the Fed’s pounding on the table on the need to keep the policy rate ‘higher for longer’, profoundly inverting the US yield curve. Meanwhile, the ECB played catch-up with its tightening cycle, the JPY bounced back with a vengeance on the Bank of Japan arriving to the tightening party just before central banks elsewhere are trying to shut it down, and the Chinese renminbi came back from the brink as well on a disorienting policy about-face. 2023 is likely to prove a rough ride for currencies if the USD bear market fails to continue in a straight line, but EUR and JPY may outperform.

As 2023 gets under way we see the market expressing increasing confidence in a disinflationary outcome for the US. Despite the Fed’s persistent ‘higher for longer’ narrative and the FOMC having placed the median dot plot Fed Funds rate forecast above 5 percent for this year at its December 2022 meeting, the market is happy to continue to mark Fed expectations lower by the end of this year. In the early weeks of this year, the market has priced in accelerating rate cuts for 2024 after recent data points have shown significantly weaker ‘soft’ data, including a weak ISM Services survey for December, but also as several inflation data points have come in softer than expected. Emboldening traders to price an easier Fed beyond the hump of perhaps two more 25 basis point hikes over the next couple of quarters is that annualised inflation from the last several months, minus the notoriously lagging and heaviest component of the official CPI data series, the owner’s equivalent rent, is practically back within the Fed’s target range of 2 per cent. As our The Models are Broken theme for this outlook argues, however, we find it highly unlikely that the disinflationary backdrop can persist for long in an under-invested world that is scrambling to transform itself away from fragile, globalised supply chains, to upgrade and green its energy system, and to arm itself for new national security imperatives.

Thus, any nominal growth slowdown will prove shallow and growth will re-accelerate on the bounce-back in demand for commodities as China comes back online. In the meantime, the USD may occasionally rally hard if the market has to second guess its expected path for the Fed next year, and if that adjustment sees new bear market lows in risky assets, particularly US stocks. The ingredients for a sustained USD sell-off would include the Fed providing liquidity and a global rebound in risk sentiment, with the latter as important as the former. In the past two cycles, the big USD sell-offs have come only on the Fed providing massive liquidity after some sort of global crunch. But this Fed is still tightening! So how has the USD weakened in Q4 and into early Q1? That has largely been down to falling yields as the market prices the Fed to roll over but easily as importantly, also due to other factors that have helped offset the Fed’s tightening, including a US Treasury that continues to aggressively draw down its account at the Fed, adding liquidity to the system, and banks shifting of reserves and the drawdown in usage of the Fed’s reverse repo facility that can act as a king of ‘stored QE’. The latter is unpredictable, but the US Treasury contribution to liquidity will rapidly run dry in coming months and will then actually drive a liquidity headwind when it rebuilds its account, sooner or later, after the latest ridiculous spectacle of Congress clearing the debt-ceiling issue sometime in Q1. 

In the meantime, a slowdown in corporate profits and recession fears could bring a comeback in the USD as a safe haven at times in the first half of this year, even if it falls short of the cycle peak. Further out the curve, far beyond the purview of Q1, when inflation reaccelerates beyond a possible short-term growth scare and the current misleading comedown in inflation, the USD may finally turn significantly lower on the Fed having to provide liquidity to ensure an orderly treasury market, even without significantly cutting rates or cutting them at all. Think QE with no ZIRP – a new paradigm that breaks the old model.

Rounding out the G3: win-win for the JPY. EUR steady. The JPY looks the win-win setup for Q1 and possibly into early Q2, even after its significant repricing higher versus the USD from the incredible extension higher in USDJPY to above 150 late last year. December saw a surprise tweak in Bank of Japan (BoJ) policy after Japan drew down a significant chunk of its reserve to defend its yield-curve-control band. While Governor Kuroda failed to follow this up with a further shift in January, the overall sense that Japan is set to exit its extreme monetary policy experiment of the last 10 years continues, with Kuroda set. The ‘win-win’ setup is that the JPY can rise on the anticipation that the BoJ is set to normalise policy at a time when other central banks are easing off the pedal and even if it entirely fails to shift, yield spreads could continue to come crashing down on uglier-than-expected outcomes for the global economy earlier this year, the traditional source of JPY strength. The ideal ingredients near term for further JPY strength are both tepid to lower yields this quarter and a growth scare that further aggravates risk sentiment. A vicious rally in energy prices sooner rather than somewhere in late Q2 or later would challenge the recent JPY rally, unless the BoJ front-loads its shift away from the Kuroda era.

Source: Bloomberg and Saxo

Graphic: A recap of the chart of G3 currencies (USD, EUR & JPY) from the Q4 outlook. Then, we noted that for the USD and JPY "the jaws are widening perilously!". Well since then, they widened even more before finally beginning to snap back the other way, if somewhat tentatively. Note how modest the JPY comeback has been so far. For the rest of 2023, we would look for the two currencies to continue converging, with the EUR a bit more sedate middle ground, if still firm relative to the US dollar and elsewhere.  

For the EUR, we have an ECB that found the rate-tightening religion late in the game at its December meeting and is signalling further strong tightening from here, emboldened by a collapse in natural gas and energy prices on a mild winter (even if these prices are above historic ranges). The fiscal outlook is more robust for Europe than almost anywhere else, and the anticipation of a return of Chinese demand could keep downturn risks very shallow. Long term energy and power issues are a concern for the long term, but supplies concerns are not an issue through this winter. Solidly positive bond yields in Europe, even if real yields remain quite negative, could help to keep a domestic investor focus. The EUR may prove a relatively steady ship in rough seas this year. Sterling would benefit most, meanwhile, from a very soft landing elsewhere and steady global markets. Not sure that is what we will get, and sterling risks getting painted with the same balance sheet challenges noted for the ‘G10 smalls’ below, although it is tricky to understand sterling risks when the currency is already heavily discounted, even after the Truss trauma of last fall.

The G10 smalls: balance sheet recessions offsetting eventual commodity strength. The G10 smalls are all small open economies, where housing markets largely got a free ride, or only suffered a bad blip, during the 2008-09 global financial crisis. The G10 smalls suffered horrendous volatility back then, some from over-exuberant carry trading (AUD, NZD and NOK) while others enjoyed pro-cyclical strength on the commodity angle (CAD and SEK), or both, with the exception of SEK. Forced to gut interest rates in a competitive devaluation move post-GFC, housing markets were set on fire in these economies and were super-charged yet again during the pandemic response of 2020-21. Now, with a steep rise in longer lending rates like these economies haven’t seen in decades, housing markets are set for a further massive correction, one that is already under way. Real estate is a notoriously illiquid asset and absorbing the impact of the rate rises in the back will take time. But there will be rolling and tremendous impact on both construction sector activity as well as private balance sheets and likely on consumer sentiment more broadly in these economies, especially for those housing markets highly vulnerable to floating rate mortgages, including Australia, Sweden and Canada. While our longer term commodity outlook is very constructive to say the least and will provide some offsetting strength in the next growth cycle for the commodity have-alls like Australia and Canada, the bloated leverage in the private sectors in all of these smaller economies could significantly offset their upside potential. The risks in Sweden could get downright systemic and require significant intervention. This could already be behind the SEK’s notable weakness in late Q4 and into early Q1. 

China and EM: Much has already been priced for the CNY after its powerful comeback from the brink on the huge policy pivot described in Redmond’s outlook for China in Q1. The coming quarter may prove less remarkable in fx terms as investors have already front-run a good deal and China will want to prevent excessive CNY strength on wanting to keep its exports competitive, even as it moves up the value chain. The rest of the EM may be in for a bumpier ride early this year on the global growth scare after very strong performance since late last year as the market pummelled the USD and rates fell, offering strong performance for EM bonds in local currency terms. But value shopping for commodity-leveraged FX in the coming quarter is worth consideration (BRL, IDR, ZAR and others).


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