Global FX: volatility to persist as fundamentals assert through 2023
An update on Westpac's medium-term FX forecasts.
The past month’s trading has been acutely focused on risk. Throughout, evidence for the US and elsewhere of persistent weakness in activity and a nascent downtrend in actual and expected inflation has been quickly discounted, with the market instead focused on the possibility of event risks and the hawkish rhetoric of policy makers.
In light of these developments, we have flattened out our profile for the US dollar into year end when we expect the developed-world hiking cycles to conclude. DXY is now only expected to fall around 2.0% to 107.3 by end-2022. Admittedly though, this revised forecast is 4% lower than the most recent peak for DXY of 110.8 seen a week ago.
Looking further out, we continue to expect real economic fundamentals to re-assert. Specifically, US economic weakness on an absolute and relative basis is expected to weigh heavily on the US dollar through 2023 and to mid-2024, DXY falling 10% cumulative to December 2023 and a further 2% in the first half of 2024. A period of stability is seen thereafter with the US likely to be running a consistently large negative output gap in the order of 3-3.5ppts from end-2024, with growth near trend, and the fed funds rate back towards a neutral level. Note, 95 is not an outright weak level for the US dollar, being in line with the average of the past 5 years.
The bilateral movements that underpin this index forecast highlight that, for it to be achieved, risk aversion must abate. This is true with respect to geopolitical concerns as much as it is inflation.
From USD1.00, EUR/USD is forecast to rise only slightly to USD1.02 by end-2022, but then more sharply to USD1.12 at end-2023 and USD1.15 by mid-2024. While we expect the overnight interest rate differential between Europe and the US to remain significant over the forecast horizon, term interest rate differentials should narrow on both a nominal and real basis as inflation rates normalise and risks recede. With the help now being offered to households in Europe, and rapid moves to diversify away from Russian gas, the real term interest rate differential could provide significant support to Euro through the first half of 2023, as long as we do not see a further material escalation by Russia. A rebound in activity growth from mid-2023 will add support to this trend.
Sterling has generally shown greater momentum than Euro on rebounds against the US dollar over the past year. However, there seems a high chance that Sterling will now underperform through to end-2023. While the support to households to combat high energy prices is substantial, the UK is yet to put forward a concrete plan of action with respect to energy efficiency and supply diversification akin to the European Commission’s RePowerEU initiative.
Uncertainty around activity growth is therefore higher for the UK than Europe once the immediate risk posed by cuts in Russian gas supply are countered. It also seems likely that the UK will face higher interest rates for longer given the breadth of inflation pressures; while the UK’s labour market also has less spare capacity to provide additional momentum – or, to put it another way, potentially has further to fall if conditions surprise to the downside. Versus the Euro’s 12% appreciation to end-2023, we look for Sterling to rise only 8% to USD1.25. In 2024, a similar pace of appreciation against the US dollar is seen to USD1.27. That said, all going well, Europe could see further outperformance in 2024 and beyond, especially if its efforts to rapidly replace its existing power supply with renewables succeed.
Turning to Asia, it is striking that Japan’s Yen has depreciated sharply against the US dollar despite a circa 30% fall in price of oil – a material positive for Japan’s trade position. It is also notable that this weakness has been seen just as Japan’s economy experienced a strong rebound in activity through mid-2022, and with expectations over the outlook favourable on both an absolute and relative basis. Instead, the weakness stems from the Bank of Japan holding policy rates at the lower bound and persisting with open-ended QE, in stark contrast to the West.
As risk appetite returns and investors look for growth opportunities across the world, it seems inevitable that we will see a material retracement of recent Yen weakness. However, even as major central banks cut policy rates from end-2023, USD/JPY is likely to hold above its pre-pandemic levels with a wide interest rate and inflation differential to persist. From JPY143 currently, we look for USD/JPY to fall to JPY132 end-2023 and JPY128 mid-2024.
China’s Renminbi meanwhile is likely to experience sustained gains versus the US dollar. While this month the market’s focus has been on the Renminbi’s near 4% bilateral depreciation, the trade-weighted CFETS index has held firm. Moreover, the US dollar weakness we expect to see to mid-2024 will coincide with fruit from China’s latest structural reforms and development, giving the Renminbi the potential to outperform to mid-2024 and beyond, with CNY6.00 in sight late-2024.
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