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Edward Bell - Senior Director, Market Economics
Published Date: 14 January 2022
Policy differentials will be the main driver of currency markets this year with the Federal Reserve’s shift to a much more hawkish stance on inflation helping to support the US dollar against its peers. After an increase of more than 6% on the broad DXY index in 2021 we expect the USD to remain well supported in H1 2022 at least. The outlook for the rest of the year will depend on whether other developed market central banks turn their focus to inflation and begin their own process of policy normalization.
Low yielders will lag in H1 at least
The gap between the Fed and European Central Bank remains quite evident with the ECB maintaining a policy of QE this year, even as some of the more extraordinary pandemic related stimulus is pulled back, and rates are likely to be held still below 0. Just like in the US, inflationary pressures are running hot in the Eurozone: headline inflation in December rose to 5% y/y, its highest ever level, thanks to surging energy prices in particular. But market expectations are for inflation to subside across the rest of the year and ECB officials appear to have a mixed perspective on inflation with some holding to a “transitory” narrative, while others have said the ECB will do whatever needs to be done to bring prices on target.
Unless there is a dramatic shift in policy tone from the ECB in the next few months, which we don’t see as likely, we would expect to see yield differentials move in favour of the USD as the Fed brings an end to quantitative easing, hikes rates at least once in H1 and firms up its plans for drawing down its balance sheet. We are targeting a EURUSD level of 1.12 by end of Q1 and 1.10 by Q2. In H2 we would expect to see some more policy convergence as the ECB begins to consider policy normalization with a Q4 target of 1.13.
Japan looks to be the outlier on global inflation pressures with CPI still far below the Bank of Japan’s target of 2%. While some acknowledgement of high global inflation, particularly among commodity prices, is likely to filter into BoJ dialogue this year we don’t see any material change in policy. Governor Haruhiko Kuroda did say he expects inflation to pick up “gradually” but likely based on external factors such as energy prices, rather than a reflection of domestic pressures such as wage growth.
Barring some major risk-off move, for instance following an outbreak of a more virulent strain of Covid-19 or geopolitical tension, we see little scope for JPY to appreciate this year. We are targeting USDJPY at 115 by end of Q1 before gaining further to 118 by year end.
Bank of England starts off with hikes
The Bank of England was first off the blocks among major developed market central banks in hiking rates, lifting the bank rate by 15bps at the December MPC meeting. After some apparent miscommunication from BoE leadership in Q4, when markets widely expected a hike as early as November before a seeming headfake from the bank, the outlook for 2022 is for rates to move steadily higher. Swaps markets are pricing in as many as 4 hikes from the BoE by the end of the year, taking policy rates up to more than 1% by December. Like the US, inflation pressures in the UK are high and don’t show much sign of abating: most commercial firms are planning to raise prices this year as material and labour shortages bite.
The risk of political disruption in the UK remains high with Prime Minister Boris Johnson under pressure over his comportment early on during the pandemic. However, it doesn’t seem likely to affect GBPUSD or other UK assets this year as markets focus much more on the recovery out of the pandemic and the lingering consequences of Brexit Britain. The potential of a trade dispute with the EU remains salient to the outlook and could derail growth, albeit likely at the cost of higher prices in the UK. We expect to see GBPUSD appreciate, hitting 1.40 by the end of the year.
Commodity currencies could outperform
The outlook appears brighter among the commodity currency central banks. The Bank of Canada has already ended its quantitative easing programme in October 2021 and may push ahead with rate hikes this year as the economy, and labour market, appear in good shape. High energy prices, which we expect will last for H1 2022 at least, along with elevated inflation will likely give the BoC room to raise rates. Swaps markets show the BoC raising rates as many as five times by the end of the year with terminal rates up to 1.4%. We expect that the loonie will record another year of gains with USDCAD moving to 1.22 by year end, compared with around 1.25 at present.
Among the antipodean currencies, the RBNZ has already begun to tighten policy by raising rates twice in Q4 2022. Inflation in New Zealand is running well above target and the country’s perennial housing affordability issue may prompt the RBNZ to step in and hike rates several more times this year. We expect to see a moderate appreciation in the kiwi to around 0.71 by year end. For the RBA it has yet to fully pull the trigger on normalizing policy. The RBA ended its policy of yield curve control in November 2021 but has pledged not to raise rates until inflation is sustainably in its target range of 2-3%. Inflation in Australia fell back in its most recent print to 3% y/y in Q3 2021. Like the kiwi, we expect AUD to show a soft appreciation this year provided that the growth and inflation story remain on track.
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