Global FX: the weight of reality is hitting the US dollar
FX participants are beginning to look past immediate inflation risks to the state of the global economy in 2023/24.
Having reached a new cycle (and multi-decade) high of 114.1 in late September, the US dollar DXY index has since been locked in a relatively tight trading range between 110 and 113, currently 111.1.Expectations and risks related to inflation continue to dictate moves within the range; although, over the past month, participants have been showing greater concern over the consequences of tight policy for the economy, and consequently a growing belief that the peak in rates is nigh.
Available activity data certainly argues for this being the case. US Q3 GDP showed that growth in private final demand (household consumption and investment) has slowed to a crawl, the annualised rate of change printing at 0.6% compared to 0.9% and 2.2% in Q2 and Q1 2022 respectively. Looking through the month-to-month volatility, the US labour market is also clearly softening; most notable this month was evidence of businesses reining in wage and benefit growth – Employment Cost Index total compensation growth decelerating from a circa 6% annualised pace in Q2 to near 4.5% in Q3.
Although the direction of travel for the US economy, and by association consumer inflation, is clear, markets are still apprehensive to step out and take risk, particularly while the FOMC holds onto its hawkish stance, evinced again by Chair Powell this week. Into year end, we expect this to remain the case. 2023 is likely to be very different, however. From 111, we look for DXY to fall to 103 by end-2023 and 96 end-2024 – declines of 7% and 13% from spot – with Euro and Sterling key to the result.
While it increasingly looks as though Euro Area activity growth will outpace that seen in the US through 2022 and 2023, this is not the primary factor behind our forecast. Instead it is the removal of downside risks related to European energy supply, with the Continent’s gas stores essentially filled ahead of winter and the infrastructure necessary to allow the replenishing of reserves through 2023 now in place. Our central expectation is for Euro to rise from below USD0.99 currently to USD1.07 and USD1.14 at end-2023 and 2024 respectively. If the winter weather proves benign as the market is increasingly suspecting, upside risks for Euro may build in the new year.
Sterling meanwhile looks to have come out of September and October’s political malaise in good form, having held near USD1.15 the past week before briefly dipping to USD1.12 on a dovish 75bp hike by the BoE last week. Still, the road ahead is fraught with risk as Prime Minister Rishi Sunak’s Government hold off on further stimulus and likely tighten their stance while the economy is very weak. Inevitably, market confidence and reduced energy and inflation risks are expected to win out, sending the currency higher – to USD1.20 and USD1.27 come end-2023 and end-2024.
The Canadian dollar has recently found itself in an interesting position, USD/CAD remaining near its cycle highs despite the Bank of Canada delivering outsized rate hikes and signalling there is more to come; meanwhile, in our view, their economy has shown greater resilience than the US, Europe or the UK. This status quo is unsustainable, so we continue to project USD/CAD to lose altitude, targeting CAD1.28 and CAD1.26 as end-of-year levels for 2023 and 2024.
Then to Japan’s Yen. Although we also expect the Yen to benefit from the coming US dollar downtrend, it is likely to lag, with risks to remain skewed against the currency. Note, despite an almost 30% depreciation since February and rapid global price growth, Japanese consumer inflation ex fresh food and energy is still below 2.0%yr. Unsurprisingly, the Bank of Japan continues to dismiss any and every call for even a hawkish bias let alone a policy tightening.
Interest rate differentials with the rest of the world are then set to remain wide for the foreseeable future. What the Yen has on its side is the chance to benefit from the economic development of Asia. If Japanese industry leverages this momentum, activity gains could support a material reversal in Yen, along with risk sentiment. For the time being however, we remain cautious, forecasting only a staggered and partial unwind of 2022’s USD/JPY gains, from JPY147 to JPY136 and JPY126 end-2023 and end-2024. It is worth repeating that risks to this view are skewed up (i.e. towards a weaker Yen).
Finally, to China. As discussed on page 16 of our November Market Outlook, the 2022 National Party Congress saw a strengthening of the status quo, with President Xi’s third term confirmed and his influence over the Standing Committee increased further. While the initial market reaction was negative, the need for President Xi to pursue growth and development to preserve his social contract with the people has the capacity to create significant opportunity for China’s economy and the Renminbi.
Investment in pursuit of export market share and a reduced need for imports will, over time, give the Renminbi greater strength and acceptance globally. With those developments should also come less volatility. Our end-2024 target for USD/CNY is CNY6.10 from just above CNY7.00 through late-2022/ early-2023.
The analysis was initially released as part of Westpac Economics’ Market Outlook November 2022.
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