Foreign exchange market trading, let alone predicting currency movements, is often a fool’s errand. John Maynard Keynes reportedly lost his shirt and nearly bankrupted himself at times speculating on currencies. Even if one gets the trend right, getting the timing wrong can prove fatal.
Yet macro hedge funds had a great 2022 and their leaders were again anointed with ‘swashbuckling master of the universe’ status. But one didn’t need to be a rock star trader to make money. Given large Federal Reserve rate hikes and the energy market fallout from Russia’s war against Ukraine, the ‘masters’ only had to go long with the dollar and short with practically everything else.
2023 will be much tougher. Masters and rock stars may have to earn their keep.
The trade-weighted dollar is likely to remain historically strong. The dollar may well weaken over the course of 2023, more in the second half of the year.
The dollar has already peaked against major currencies as the Fed approaches its likely destination and backs off from 75 basis point hikes. But it remains sky high and considerably ‘overvalued’. The US will also need to finance a large current account deficit, likely to be 3% to 3.5% of gross domestic product, down slightly from near 4% in 2022.
Figure 1. Dollar remains considerably overvalued
Source: Federal Reserve
Those factors might augur a sharp tumble. But don’t bet on it, especially in the first half of 2023.
Uncertainties hang over the outlook for monetary policy, especially in the US. Foreign exchange traders will need to be nimble in parsing out US inflation data. Core inflation may prove tough to bring down convincingly towards the 2% inflation target due to robust labour markets and buoyant service price inflation. As suggested already by the dot plot, that could cause the Fed to lift the Fed Funds rate above market expectations and hold throughout 2023, underpinning US capital inflow. US energy independence is another supporting factor. Geopolitical risks could also be dollar positive.
However, if services inflation comes down more sharply than anticipated – especially on the back of recession, the dollar could find itself on offer.
On balance, the Fed will most likely maintain a tightly restrictive posture, especially in the first half of 2023 if modest recessionary forces are pushed back towards the second half. Market yields may soften later in the year, bringing the dollar more forcefully on offer.
But an exchange rate is two-sided, depending not just on the US but also the other leg of the currency pair.
Europe faces bigger questions than the US. It’s more susceptible to the fallout of Russia’s war. Headline inflation is now much higher in the euro area than the US. The European Central Bank hawks have seized the narrative and do not think the 250 basis points of rate hikes will suffice. The ECB’s rhetoric is now even more hawkish than the Fed’s.
Europe’s inflation though is overwhelmingly supply-side driven, unlike in the US where demand side elements are present, and there are few signs of wage price spirals. Central banks can’t do much about cost push forces. Europe is also most likely already in recession.
Contrary to the hawks’ wishes, the ECB may change its tune when prices start coming sharply down, while recession bites. That could sustain interest differentials favouring dollar assets and curb the euro’s upside against the dollar.
The Japanese yen, pummelled in 2022 by Fed hikes and the strong dollar, is positioned to rise against major currencies. With inflation – at least temporarily – having climbed out of its decades’ long stupor, jumping to the exorbitant level of more than 3%, Japan intervened to support the yen and the Bank of Japan, much to everybody’s shock, upped the yield curve control range, sending 10-year government bonds soaring towards a whopping 0.5%.
Governor Haruhiko Kuroda, the leading proponent of sustained highly accommodative monetary policy, will step down this spring after an extraordinary career as one of the most distinguished and outstanding public servants in Japan’s history. His successor may well further ‘tweak’ the YCC framework, bolstering the yen. But financial authorities will remain sensitive to outsized yen gains as those could raise the spectre of a return to lowflation, which regardless may be inescapable.
The trade-weighted renminbi will remain soft, even if the renminbi rises somewhat against the dollar. Reopening the Chinese economy may not significantly boost growth if surging Covid-19 cases dampen near-term activity. It may boost tourist outflows and reduce the current account surplus. Authorities will offer only modest macro support.
Foreign investors’ fear of missing out on Chinese capital markets is increasingly receding because of President Xi Jinping’s authoritarianism; global fragmentation including China’s tacit backing for Russia and tense relations with the US; and the plethora of fundamental challenges facing China’s economy, such as demographics, an inefficient growth model centred on state credit, excess investment and infrastructure, and housing woes.
Sterling will be weighed down by the UK recession, the large current account deficit, perennial low UK productivity growth, departure from the European Union and the weight of blunders made by former Prime Minister Liz Truss’s government.
The Canadian dollar and Mexican peso merit special attention, together accounting for more than one-quarter of the trade-weighted dollar. Both central banks, given their economies’ interconnectedness with the US, will guide monetary policy in line with US developments, keeping their currencies in a fairly narrow range against the dollar.
Emerging market central banks with solid buffers that raised rates pre-emptively are in a good position to see their currencies hold steady and even modestly rise if a durable downshift in US market yields develops later in the year.
2023 will be a year replete with clouded directional foreign exchange bets and even more difficult timing judgements. We’ll soon learn who the true rock stars are.
Mark Sobel is US Chair of OMFIF.