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Edward Bell - Senior Director, Market Economics
Published Date: 24 November 2022
The US dollar has taken a substantial turn downward in Q4 as markets are aligning on an eventual end to the Federal Reserve’s hiking cycle in Q2 2023. The broad DXY index—weighted heavily against the Euro—has fallen more than 7% as of late November from 20 year high in late September. Much of the softness in the dollar has been caused by US-specific factors. The softer than expected October CPI print for the US—where headline inflation rose by 7.7%, down from 9.1% as of June—has prompted a belief in markets that inflation has peaked and is now on a slowing trajectory. Inflation expectations—as measured by the University of Michigan—have also cooled marginally on the back of a drop in gasoline prices.
Beyond the improvement in the inflation dynamics in the US, Fed officials also seem to accept that a slower pace of rate hikes is warranted from here on out. After hiking by 75bps at the past four FOMC meetings, the Fed looks prepared to downshift to a 50bps hike in December with smaller 25bps hikes spaced out over next year. Fed officials have reiterated that a single month’s improvement in inflation doesn’t qualify as a trend but the minutes from the November FOMC showed that policymakers are looking for the cumulative effects of the tightening taken so far. With an improvement in inflation and a peak in the Fed funds rate on the horizon, potentially within the next six months, the endemic US factors supporting a strong dollar are faltering.
For the major peer currencies, sterling has been the outperformer this quarter with GBPUSD rising by 13% to 1.2104 as of late November from its end of September low of 1.0689. While a softer dollar has helped, investor sentiment toward the UK has also improved substantially after a change to the two key officers of government: the resignation of Liz Truss as PM and her replacement with Rishi Sunak and the replacement of Kwasi Kwarteng as chancellor with Jeremy Hunt. A wholesale deconstruction of the Truss administration’s efforts to boost growth via unfunded tax cuts has helped to improve perceptions of the UK’s fiscal responsibility although it is coming at the cost of substantial cuts to government spending and a pending recession in 2023.
The Bank of England will also need to maintain a hawkish stance on policy given the inflation challenges in the economy. Inflation in the UK rose to 11.1% in October, its highest level in 40-years, and market expectations for the next MPC decision are split as to whether the Bank of England will hike by 50bps or 75bps. The BoE looks as though it will roughly track the Fed in terms of moving rates to a peak by mid-2023 though the starting level is lower.
We had previously been expecting a substantial deterioration in the level of sterling, falling to as low as parity against the dollar before a slow appreciation over the rest of 2023 and 2024. That view now looks too pessimistic though the prospects of a tough recession in 2023 means that sterling does not face plain sailing just yet. Conditions for the British economy are hardly better now than they were ahead of the Truss administration’s tax cut plans so the improvement in sterling likely reflects a degree of investor repositioning: short positions on GBPUSD futures held by asset managers have fallen below their Q2-Q3 levels as some short positions are closed out. We expect to see some consolidation of recent gains before the negativity around the economy takes hold again and pushes GBPUSD lower by end of Q1 2023 to 1.10 and then improving over the course of 2023 to around 1.18 by the end of the year.
For the Euro, some of the improvement that we had been expecting for 2023 looks as though it has been brought forward. Part of this again will be down to a softer dollar on the back of US-specific dynamics but a steady increase in the hawkishness of the ECB is also helping to support the single currency. Christine Lagarde, president of the ECB, said earlier in November that “withdrawing accommodation may not be enough” to win the fight against inflation while other ECB officials have been more unequivocal about following up the 75bps hike in late October with another large move. Market pricing is split at the moment between a 50bps and 75bps hike and will likely depend on near-term data. Preliminary November PMIs for the Eurozone still showed the economy declining though at a slower pace than in October while price pressures eased.
The Eurozone economy remains under pressure from high inflation and its exposure to the war in Ukraine which will act as a drag on growth. We expect that EURUSD can improve over 2023 but it won’t get to levels where we would describe the euro as strong. We expect EURUSD to end 2022 at around 1.03 before improving in 2023 to 1.075 by year end.
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