G10: Less trend, more volatility

The final quarter of 2022 saw a break in the otherwise orderly dollar uptrend – a trend that was worth 5% per quarter in the first nine months of the year. This rally in the dollar had been largely driven by a Federal Reserve wanting to take politics into restrictive territory – a trend that was only exacerbated by the war in Ukraine.

Despite all the current talk of the dollar peaking and the peak of macroeconomic pessimism, we think it’s still worth considering whether the conditions will be in place to generate an orderly dollar downtrend in 2023. We think not and here are three reasons why:

  1. Driving the dollar’s uptrend since the summer of 2021 has been a Fed that first abandoned average inflation targeting and then tried to outpace the surge in inflation. A call for a benign decline in the dollar in 2023 forces the Fed to step back. It seems unlikely. The clear message from the Fed’s Jackson Hole symposium and the IMF’s fall meetings was that central banks should avoid easing too soon in their battle against inflation – a move that would inflict the pain of recession on them without no sustained gains on inflation. We believe it will be too soon for the Fed to appear relaxed at its December 14 meeting and March 2023 could be the first opportunity for a watershed moment in Fed rhetoric.
  2. While a looser Fed profile may be a necessary condition for a dollar turnaround, a sufficient condition requires a global economic environment attractive enough to draw funds from the dollar. Global growth forecasts for 2023 are still being revised downwards, driven down in particular by the recession in Europe. ING expects global merchandise trade to grow below 2% in 2023 – not a particularly attractive story for trade-sensitive currencies in Europe and emerging markets.
  3. A liquidity premium will be required for currencies other than the dollar. 2023 will be a year when central banks sink further into recession and shrink their balance sheets. The Fed will reduce its balance sheet by another $1.1 billion in 2023 and the European Central Bank will also consider quantitative tightening. Falling excess reserves will further tighten liquidity conditions and increase levels of currency volatility. Again, the bar for not investing in dollar deposits remains high, especially when those dollar deposits start earning 5% and the dollar retains its crown as the most liquid currency on the planet.

What do these trends mean for the G10 FX markets? This likely means the dollar can rebound near the highs rather than embark on a sharp downtrend in 2023. Should the dollar decline significantly, we would favor defensive currencies such as the outperforming Japanese Yen and Swiss Franc. Here, the positive correlation between bond and equity markets may well break down as the bond market rallies against the backdrop of a US recession and Fed policy easing. ING expects 10-year US Treasury yields ending 2023 at 2.75% – USD/JPY could trade at 130 in this scenario.

The recession in Europe means that EUR/USD could trade in a range of 0.95 to 1.05 for most of the year, where fears of another energy crisis in the winter of 2023 and l uncertainty in Ukraine will hold back the euro. The pound is also expected to remain fragile as the new government attempts to restore fiscal credibility with Austerity 2.0. We can’t see the pound being rewarded much more by austerity and suspect GBP/USD is struggling to hold its gains above 1.20.

Elsewhere in Europe, a differentiation could emerge between the Scandinavian currencies. The Swedish krona may struggle to enter a sustained uptrend next year given its high exposure to Eurozone growth, while the Norwegian krone may benefit from its attractive exposure to commodities. However, the NOK is an illiquid and more volatile currency, and thus would face a bigger downside in a risk aversion scenario.

As the chart below shows, commodity currencies look undervalued against the dollar on a fundamental basis. However, a stabilization of risk sentiment is a necessary condition to close the valuation gap. For the Australian and New Zealand dollars, an improving medium-term outlook for China is also essential, so the Canadian dollar could appear as a more attractive pro-cyclical bet given the low exposure to Europe’s economic difficulties. and China.

Another factor to consider is the magnitude of the next house price contraction. We believe that central banks will increasingly take this into account and try to avoid an uncontrolled fall in the real estate sector. However, this is a potentially very significant downside risk, especially for the currencies of commodity-exporting countries, which typically have the most overvalued property markets in the G10.

To conclude, we believe that currency trends will become less clear in 2023 and volatility will continue to increase. The volatility of FX options may seem expensive compared to historical levels, but not at all compared to the volatility that FX pairs actually offer. We suspect that risk management via forex options could become even more popular in 2023.