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FX: Mean reversion for the big 2021 moves and lots of volatility

John Hardy

Head of FX Strategy

Summary:  Forecasts for any time horizon should always be hedged with some degree of uncertainty. And in early 2022, with inflation raging and major geopolitical risk afoot, it feels like forecasts for unanticipated outcomes need the most leeway since the pandemic outbreak hit with full force back in early 2020. A couple of developments that we are looking for this year, however, include mean reversion in some of the most stretched valuations in major currencies like the Japanese yen and Chinese renminbi.


USD and CNY(CNH): The fiscal cliff and a Fed that will hike until things break while China set to ease

Entering 2022, it seems that every appearance from the Fed is more hawkish than the last. Meanwhile China has signalled the opposite: that it will bring easing and support for a Chinese economy heavily impacted by official moves against excesses in its enormous real estate sector along with a crackdown on tech companies, both of which have dented markets there as well as the real economy. The overlay of a “zero tolerance” policy on Covid has seen additional limits on economic activity.

It is hard to find historical parallels for the current degree of policy and economic performance divergence between the US and China, but it’s similar to the late 2014 comparison of the US with Europe, when the Fed was ever so slowly tightening while the ECB was set for a very delayed debut with its first proper QE policy. Eventual USDCNH moves in 2022 are hardly likely to resemble the almost cataclysmic slide in the EURUSD from late 2014 into early 2015, although it does appear likely that broad CNH softness should mark much of at least the first half of 2022. This comes after the policy shift toward easing was made clear by Chinese officialdom and has crystallised in December with a cut to banks’ reserve ratio requirement, at a time when virtually all other major central banks are in some form of policy tightening. That includes the Powell Fed, which signalled an acceleration to the end of its QE programme at the December FOMC meeting. The minutes of that meeting released in early January even indicated a robust discussion of whether outright quantitative tightening should be pursued simultaneously with rate hikes in 2022. This was something the Fed only did in 2018 (eventually triggering a market crash late that year) once it had several rate hikes under its belt. 

China is starting its easing cycle with the renminbi having run, by the end of 2021, to its highest level against an officially designated basket of currencies since late 2015. This policy was perhaps in part based on a desire to reduce the inflationary impact of rising prices from commodities in 2021; with the policy divergence and valuation extreme, the CNY looks set to weaken for much of 2021. An additional concern for China is the degree to which climate priorities see the country sanctioned with new trade policies aimed at its carbon-intensive energy mix. See more in the chart below.

The US dollar could prove resilient for some of the early part of 2022 against the usual pro-cyclical currencies. However, it’s likely to have a hard time launching a broad, aggravated extension of the strength we saw in late 2021, as the longer end of the US yield curve may prove relatively anchored. The latter is possible, despite high inflation rates, as the market probably correctly anticipates that the Fed can only perform quantitative tightening and raising rates for so long before breaking something, like the markets first and eventually the economy itself with an incoming recession risk. And even if the Fed is behind the curve, the bounce-back in the US economy will also be tamed by the tightening in real GDP from the huge rise in energy prices from pandemic lows, as well as prospects for sustained high prices going forward, especially from the green transformation. In the background a fiscal cliff, or drag, is baked into the cake for next year. Once the Fed “achieves” this outcome, we will see—you guessed it—a new round of fiscal easing that brings with it a new round of inflation even if the latter falls back considerably from an early 2022 peak and bases at a still-high level.

EUR and JPY: Yen far too cheap. ECB capitulation could support Euro

The euro and particularly the JPY performed poorly in Q4, with Europe finding itself in a very bad place as natural gas and power prices soared to multiples of their former highs. This was in part down to reduced Russian natural gas supplies and the geopolitical situation over Ukraine that is still weighing heavily as of this writing. Not least among the negative impacts on Europe in Q4, the latest wave of Delta-variant Covid took Europe all the way back to piecemeal lockdown mode before the wildfire of Omicron (hopefully) marks the sudden end of Covid by spring of this year. Come March and even February, the ECB may find itself in hot water for its insistence on maintaining a negative-policy rate. A possible and likely eventual capitulation this year on the need to start on the path to hiking the policy rates back to at least 0 percent could see a considerable back-up in the EUR across the board, setting EURUSD on the path toward 1.2000 by the year end, if not sooner.

In Japan, still relatively anchored long US treasury yields and very weak US real yields, together with volatile asset markets and possibly troubled times for bond investors (does credit risk not exist anymore?) offer solid conditions for JPY strength. In addition, Japanese policy focus under the new leadership of PM Kishida is on stimulating demand domestically to address the inequality from Abenomics—this could spark domestic demand. Meanwhile, the Bank of Japan quietly more or less stopped expanding its balance sheet in 2021 and stopped other QE asset purchases last year as well. As the chart below shows, the yen is at an historic low in valuation terms and could be set for a sharp mean reversion for a considerable portion of 2022.  

Chart: JPY vs. CNY – a tale of two extremes

The Chart below shows the JP Morgan Real Effective Exchange Rate (CPI adjusted and trade weighted) for the Japanese yen (black) and the Chinese renminbi/yuan (blue). Note that this is not the first time we have seen a remarkable divergence in relative strength and that on the prior similar episode starting in late 2015, the mean reversion was profound.

Source: Bloomberg

The “G10 smalls”: rocky risk sentiment to keep a lid on commodity FX 

For the small G10 currencies, the outlook may prove straightforward in early 2022 if risk sentiment and volatility is a primary concern, with varying shades of weakness as energy prices may support CAD and NOK in the crosses. A former high-flyer like the kiwi (NZD) could continue to weaken broadly as its first-mover status on tightening policy in 2021 has aged poorly in relative terms, with other central banks in catch-up mode and the RBNZ having de-escalated its forward guidance. Given the longer-term priorities of the green transformation (metals-heavy and possibly uranium-heavy) we will look for value in any deep sell-off in the Aussie as a long-term opportunity.

GBP: tight fiscal and tight monetary policy - hmm.

The golden combination for a currency, provided there is no glaring sovereign risk, is a loose fiscal policy and a tight monetary policy. For the UK, it looks as if we will see tightness on both fronts and thus a mixed bag for the currency. The UK government is in a very different place than the US and other countries in signalling a strong desire to get the country’s finances back on a sustainable track. The UK has proven heavily supply-side constrained as well. Given far less restraints on the UK economy than on mainland Europe and the fiscal drag relative the Euro Zone, any post-virus bounce-back this spring could prove more modest and sterling’s strong end to 2021 and start to this year may fade to a broadly neutral performance. The UK economy could decelerate rapidly later in the year. 

CHF: ECB capitulation, and SNB intervention to keep a lid on CHF and maybe even weaken it.

The SNB may have the luxury not needing to intervene in FX if the ECB finally capitulates and signals an eventual tightening of rates toward zero as inflation remains elevated in Europe after a post-Omicron bounce-back. CHF lower versus the JPY is another currency pair worth looking at for mean reversion in addition to the EURCHF rate reverting toward the heart of the 2021 range.

EM currencies. Ex CNH: With markets likely volatile in 2022 as the market adjusts to a more hawkish Fed and its reduction of liquidity, emerging market performance broadly speaking could continue to see a rocky performance for at least the first half of 2022, or until the Fed and US fiscal policy are forced into a more accommodative mood again somewhere down the road due to the threat of a market train wreck and/or the threat of a recession. As long as the US dollar is the global reserve currency, volatile markets and tightening Fed in a world swimming in USD-denominated debt make for a tough backdrop. Additionally, 2021 showed us some dramatic specific weak EM stories on policy missteps, from Turkey’s misguided rate cuts sending the Turkish lira into a steep devaluation, to the Chilean peso (CLP) completely losing its status as a proxy for copper as the country lurched leftward politically and considered virtual nationalisation of mining profits above a certain threshold, discouraging investment. The Mexican peso was a reasonably calm port in 2021 and may remain so longer term on US supply chain diversification priorities away from Asia after the pandemic saw epic disruptions that are mostly still present in early 2022.

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