US dollar faces no challengers for now

Currency markets have crossed historic thresholds recently as global growth slows, inflation remains high and central banks scramble to tighten policy. As markets turned to accept that the Federal Reserve isn’t preparing to change its hawkish stance on inflation any time soon, major currency peers have fallen victim to dollar strength: the Euro has pushed below parity and is trading at its lowest levels since 2002, Japanese yen is close to its weakest level since 1998, and the British pound is converging on its pandemic level lows with the next stop potentially a retest of levels last seen in the mid-1980s.

The Fed’s eventual turn to hawkishness and its front-loading of rate hikes is the principal cause of currency misery elsewhere. The Fed has hiked the Fed Funds rate by 225bps since the start of the year, including two consecutive 75bps hikes at the June and July FOMC meetings. That compares with hikes of 150bps by the Bank of England, 125bps from the European Central Bank and none from the Bank of Japan. We expect this wide differential in policy rates in favour of the Fed will persist over the remainder of 2022 and into 2023 though the gap is due to narrow, both as the pace of Fed hikes moderates and other central banks play catchup.

Not just the Fed’s fault

The ebbs and flows of individual economies are also and will continue to exert influence on keeping currencies relatively cheap compared with the US dollar. For the Eurozone, a recession is looking increasingly unavoidable as high inflation, prompted by steady demand outrunning supply in core CPI and enormously elevated energy prices hitting the headline, takes its toll. The composite PMI for the Eurozone has turned solidly below the 50 level demarcating expansion from contraction for two months’ running while national-level data is also discouraging: industrial production in Germany, the locomotive of Eurozone manufacturing, has declined on an annual basis for five months in a row as of July.

The ECB hiked rates by 75bps at its September meeting and signalled further rate hikes ahead. But it faces the risk of hiking aggressively to fight against inflation at a time when the economy will barely be able to afford tighter policy. We expect the ECB to maintain a hawkish bent for the remainder of the year but that the pace of hikes will slow in 2023 before peaking at 2.00% by mid-year, but the hikes come after the damage has already been done and we expect that EURUSD could continue to unwind from its current levels of around 0.99 to as low as 0.95 by the end of the year. In 2023, EURUSD may be able to stage a modest appreciation provided that a recession is manageable and monetary and fiscal policymakers manage to coordinate their support; we are targeting EURUSD getting back to parity by mid-2023 before rising to 1.05 by the end of the year. However, by the standards of the post-global financial crisis, Europe will endure a period of considerable weakness relative to the dollar and the balance of risks looks more weighted to the downside.

Sterling slump to endure

In the UK, the economic challenges for the new administration of Prime Minister Liz Truss are stark and GBPUSD and gilts have been the market’s main expression of the gloomy outlook ahead. Inflation has already risen to more than 10% y/y as of August and while plans to limit energy costs may help stave off some of the more dire predictions of price growth, the new government’s mooted policies could end up seeing fiscal discipline being abandoned and the country’s debt/GDP ratios push higher. Labour shortages, supply chain disruptions and the more apparent negative consequences of the UK’s departure from the EU are compounding the negative effects of higher prices.

Loose fiscal policy to support households will be offset by a steady tightening from the Bank of England, which has so far hiked at every meeting since December 2021. This institutional mis-match will erode market confidence that UK policymakers have a grip on the economic challenges facing the country—the dramatic slump in the August PMI to 49.6 from 52.1 a month earlier highlights the speed at which conditions are deteriorating as consumers pull back on marginal spending. GBPUSD is now within reach of the March 2020 low of 1.1412, which was prompted by the Covid-19 pandemic and related lockdowns. A move below that figure would open up downside risks to levels not seen since 1985.

We expect that there is more downside ahead for GBPUSD with a target of 1.10 by the end of 2022 and dipping to as low as 1.08 in H1 2023 before a nascent recovery over much of the rest of the year.

Bank of Japan shows no signs of shifting

The Japanese Yen has now broken and held above the 140 level, hitting as high as 144 and its weakest level against the dollar since 1998. Here the fault for currency weakness lays at the feet of the Bank of Japan which has maintained an extraordinarily accommodative policy stance and has categorized the inflation Japan is currently seeing as still being driven by exogenous factors. There appears to be no urgency from the BoJ to adjust policy, either by moving rates higher or abandoning its yield curve target, even as the rapid ascent in USDJPY has prompted political figures to intervene verbally.

Standing in USDJPY’s favour is anxiety over a global recession. Should signs of global growth weaken even more—the global composite PMI fell to 49.3 in August, down from 50.8 a month earlier—then Yen may gain from its traditional role as a risk haven. Whether there is enough pull to materially strengthen it though is less certain and we still expect a relative soft yen over the course of 2023.  

Any triggers for reversals?

Measured by their real effective exchange rates the Yen looks the most oversold and capable of a correction. Whether that is prompted by a flight to safety or a change in BoJ policy is still an open question. The Euro also appears relatively oversold compared with G10 peers though the economic challenges ahead are acute. By contrast, Sterling may have more room to run lower as it is still within the range seeming to have been established following the 2016 Brexit referendum.

Inflation-adjusted 10yr yields: US vs peers

Source: Emirates NBD Research

To look at it from another perspective, is there a way for the dollar to start to weaken from endemic US factors? At present it would appear no. Policy rate differentials favour the dollar as do differentials from both nominal and real yields. Moreover, the economic picture, while slowing in the US, does not face the same kind of calamitous downside risks that seem to be affecting the Eurozone or UK at present. A pivot from the Fed would be the strongest factor in supporting a reversal of the current phase of dollar strength but we do not anticipate any cuts to policy rates until H2 2023 at present, and even then from relatively high levels.

Emirates NBD Research FX assumptions