Markets exploring alternative currencies despite dollar dominance

OMFIF panel weighs in on foreign exchange outlook

The outlook for foreign exchange markets in 2023 will be heavily shaped by the course of the global economy and especially relative monetary policy stances. What should economists expect?

In the aftermath of Covid-19, a period of war-kindled inflation appears to be easing in many countries. While further monetary policy tightening may be due in key economies, there are signs that the global economy may prove more resilient – albeit sluggish – than previously thought and interest rate hikes may not necessarily induce a deep recession (or hard landing) as feared.

And yet, the consequences of the slowdown in labour markets, elevated interest rates and high energy prices may be slow to emerge and latent in their effects.

On 23 January, OMFIF hosted an off-the-record roundtable to discuss the outlook for foreign exchange markets in 2023. Led by Mark Sobel, OMFIF US chair, the panel included Christian Kopf, head of fixed income at Union Investment, Rebecca Patterson, former chief investment strategist at Bridgewater Associates, and Ebrahim Rahbari, global head of foreign exchange analysis at Citi.

At the core of this discussion was whether conditions in the macroeconomy might be improving and how uncertain macroeconomic policies and geopolitical events might be shaping foreign exchange markets. Panellists first noted that the apparent slowdown of inflation was an auspicious signal, which might encourage the Federal Reserve to reduce the pace of its interest rate increases. There was some concern that tightening monetary policy might weigh on the economy. But the panellists also commented that it was unlikely the Fed would reverse course by lowering interest rates in 2023, as many market participants expect.

The discussion underscored the difficulty in deciphering global macroeconomic conditions. One panellist noted that, earlier in 2022, the German economy was expected to contract sharply this year but is now expected to experience an expansion in late 2023. Others pointed to several potentially damaging macroeconomic hazards that might portend a latent downturn. This includes not only the spike in energy costs, but also the accumulation of household debt. As companies and families burn through their savings, the prospect of rising interest rates creates the potential for recessionary pressure.

Various panellists noted that, with the Fed approaching its terminal rate and slowing down the pace of hikes, the dollar had come off its highs and had scope for further easing. They also indicated an expectation that the euro would appreciate against the dollar slightly by the end of 2023, borne in large part from improving conditions in the European macroeconomic forecast. The European Central Bank was seen as more hawkish than the Fed at the moment, which would also support the euro against the dollar. Meanwhile, one panellist predicted that the yen would appreciate through 120/$ largely due to more favourable rate differentials. Yen strength and Bank of Japan tightening would depend on domestic inflation, they said.

There was more uncertainty regarding sterling. One panellist putting a positive spin on it commented that a resurgence would ultimately be contingent on the ability of the UK economy to overcome self-inflicted wounds, including its departure from the European Union, a poor pandemic response and the loss of international credibility brought on through travails in the Conservative party leadership. There are obvious difficulties in accomplishing such a feat, and the International Monetary Fund has predicted that the UK will be the only western economy to fall into recession this year.

What do these elements mean for the dollar’s longer-term role in the global monetary and financial system? The panel broadly maintained that dollar dominance would persist. It also noted that central banks may be moving towards several alternative assets – such as the Australian and Canadian dollars – but that these currency allocations would remain largely on the margins.

The panel predicted that Chinese attempts to improve the global standing of the renminbi would continue but remain hampered by countries’ geopolitical concerns and China’s economic woes. Many emerging markets appear to be increasing their allocation of gold, which does not have the liquidity of US treasuries (bonds generally) but is offering emerging markets and China an opportunity to attain some modest diversification, including protection against ‘western’ sanctions.

And so, the panel’s 2023 foreign exchange prediction in short: continued dollar systemic dominance but some weakening off from its late-2022 highs, a stronger euro, a potentially strengthening yen and exploration of alternative currencies and commodities by several emerging markets.

Julian Jacobs is Economist at OMFIF

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