The US dollar's bull market appears to have come to a climactic end late in Q3 22 and early Q4. In the last three months of 2022, the G10 currencies, except the Canadian dollar, rose by more than 5% against the greenback. In addition, six of the G10 currencies appreciated more than 7.5%. Such significant moves are often followed by consolidation and corrections. These countertrend moves can offer new opportunities to adjust currency exposures.

Three main considerations mark the turn of the dollar from valuation levels that were stretched to historic proportions according to the OECD's measure of purchasing power parity. Without getting too granular, the basic premise is that a basket of internationally traded goods should sell for the same price when the currency adjustment is made. To the extent that they do not, it reflects a currency misalignment. Typically, OECD currencies do not deviate much more than 20% plus/minus fair value. However, in Q3 22, the euro and yen were more than 45% undervalued, and sterling was more than 25% below fair value.

First, sterling's snapback was the most dramatic. The return of fiscal orthodoxy was marked by the resignation of UK Prime Minister Truss. As a result, the capital strike against Truss's unfunded fiscal stimulus was called off. Instead, it spurred a dramatic short-covering rally that lifted sterling by more than 10% in less than two weeks following her resignation.

Second, the market's confidence grew that the peak in US inflation was behind it and that the terminal rate of Fed funds would be around 5%. The Federal Reserve's Summary of Economic Projections issued in mid-December confirmed these expectations, with a median estimate of 5.1%. The dollar's rally in 2022 seemed disproportionately fueled by the adjustment to an increasingly higher terminal rate. Moreover, despite pushback from several Federal Reserve officials, the pricing in the derivatives market showed an unambiguous expectation for the first rate cut to be delivered in Q4 23.

Third, the European Central Bank turned increasingly hawkish after a delayed start. Its tightening cycle is expected to extend beyond the Federal Reserve's and into the middle of 2023. This is partly reflected in the US-German two-year rate differential. We anticipated that the US two-year premium would peak before the dollar. The US premium peaked in early August at around 277 bp, a three-year high. It trended low and fell below 175 bp in mid-December. The exchange rate often seems more sensitive to the direction and change than the absolute level.

In our work, we do not find it coincidental that the US 10-year Treasury peaked (~4.33%) on the same day as the dollar peaked against the yen (JPY151.95) on October 21. By the time the BOJ met late last month, the 10-year yield was consolidating after falling to around 3.40%, and the dollar was in a couple-week range between around JPY134-JPY138. Then, unexpectedly on December 20, the BOJ announced it was widening the range of the 10-year yield under yield-curve-control to +/- 50 bp of zero. The yield quickly jumped and approached the new cap. Market participants and the media tended to put more emphasis on the increased cap than the boost in government bond purchases announced at the same time. 

The yen soared by more than 4% on the day of the announcement. Not only was nearly everyone caught wrong-footed, but it immediately was seen as raising the odds of more adjustments next year when the BOJ will have new leadership. Several possible adjustments next year include lifting the target rate to zero from -0.10% and/or raising the midpoint of the 10-year bond range to 0.25% from zero. 

Bank of Japan Governor Kuroda's term end in April, and the two deputy governors' terms end in March. New appointments are typically announced in February. The most likely candidate to replace Kuroda is one of his proteges. Current deputy governor Masayoshi Amamiya has a slight advantage over former deputy governor Nakaso Hiroshi. The BOJ's current charge is to achieve the 2% inflation target at the "earliest date possible," which could be modified to clarify that it is a medium-to-long-term goal.

Looking into 2023, most of the G10 central banks may complete their rate hike cycles around the middle of the year. The unwinding of central bank balance sheets may continue longer, but the amount of reserves that the banking systems need is not immediately apparent. We suspect the floor will only be found when stresses become evident. 

China made a dramatic pivot from the zero-Covid policy, and the surging infection and fatalities risk disruptions to growth and, potentially, supply chains. The government is expected to pursue more pro-growth policies after 2022, which ended on a particularly weak note. Tensions with the US may flair up if the new leadership of the US House of Representatives insists on visiting Taiwan. We are somewhat skeptical of the ability to deny China semiconductor technology, even with Japan and the Netherlands joining. For example, the ability to restrict nuclear technology proved limited, as North Korea and Iran demonstrate.  

China will likely be able to develop seven-nanometer chips from 14-nanometer technology, and Beijing will boost aid to the sector. Consider that the US CHIPS legislation included $1.8 bln to help support the semiconductor industry, while reports suggest Beijing is preparing a CNY1 trillion (~$144 bln) package for its domestic chip industry. Moreover, China's advances in artificial intelligence rest on its accumulation of data, and it continues to show leadership in that space. 

Russia's invasion of Ukraine has impacted geopolitics and economies in ways that were arguably unimaginable to Moscow, Washington, Brussels, Beijing, or Tokyo. Russia's ability to project its military power has been compromised. Ukraine's ability to strike inside Russia appears likely to continue even as it bears a high human cost. Ironically, it is part of the Republican leadership in the US that is questioning the unending support for Kyiv. NATO is larger and will have a greater presence in Europe. As European countries, especially Germany, boost defense spending, they will turn to the US. The US will also replace some of the gas Europe previously got from Russia. 

Moscow's invasion of Ukraine will strengthen forces in Europe that did not or no longer believe that trade foments liberalization in totalitarian regimes, including China. Moreover, the war in Ukraine and China's wolf diplomacy in the Asia Pacific area gave fresh impetus to increased military spending by Tokyo, which has been a longstanding objective of LDP prime ministers for nearly a generation. Japan now aims to double its military spending (to 2% of GDP) and acquire counter-strike capabilities.

Many see stagflation as the most likely scenario amid elevated price pressures and weak growth impulses. However, we wonder if this is not like confusing a snapshot with a video. Although it may not be popular to say, the more likely medium-term outlook is a return to the Great Moderation of slow growth and low-price pressures that characterized the G10 economies before the various systemic shocks. As is often the case, the media and investors elevate cyclical events to structural status, which itself is part of the cyclical phenomenon. If we are right, inflation will trend lower in the coming quarters, barring a new shock. The pace may even accelerate from the middle of the year.  

The flatter and longer business cycles associated with the Great Moderation were overdetermined in the sense that they had many causes. The increased importance of the less cyclical service sector, the less labor coverage of contractual cost-of-living adjustments, better management of inventories, and globalization, among other factors, help explain the Great Moderation. The popular press makes it appear that globalization is the weak link, but since at least the aftermath of 9/11, we have been told globalization was ending. It hasn't. Near-shoring and friend-shoring may shift some supply chains, and protectionism may encourage foreign direct investment instead of exports. Yet, because of automation and other technological advances, production and price efficiencies may still improve. 

One of the implications is that today's labor market tightness in the G10 countries may prove a distraction from what could prove to be a dearth of jobs in the future. This is not about automation replacing a repetitive task in the factory. On the contrary, technological advances are impacting agriculture, the office, and core service jobs. More immediately, the focus on the tightness distracts in another sense. The fact that wages are not keeping pace with inflation means the return to labor is falling in real terms. The resulting cost-of-living squeeze underscores the risk of synchronized economic weakness in North America and Europe. 

Bannockburn's World Currency Index, a GDP-weighted basket of the currencies from the top 12 economies, edged higher in December (~0.8%). It was the first back-to-back monthly gain since the end of 2020. The BWCI recorded its low in early November, marginally slipping through the low recorded in late September. The December gain reflected the appreciation of the yuan (~1.6%), euro (~2.0%), and yen (~2.7%). The Russian rouble was the worst performer in the index, losing almost 16%. The Korean won was the best-performing emerging market currency in the BWCI. It rose by 4%. The Canadian dollar was the weakest of the G10 currencies, depreciating by about 1.4%.  

From its lows, the Bannockburn World Currency Index appreciated by 3.70%. It is the biggest advance since the peak in June 2021. BWCI seems to confirm our sense that a significant extreme in exchange rates is behind us. In line with our expectations for the US dollar to unwind more of its post-Covid gains, we look for the index to advance around 5% in 2023, which would be its best year since 2017.   

Dollar:  If there is a consensus about the US outlook, it is the opposite of 2022, when the economy contracted in H1 and expanded in H2. The resilience of the labor market and the American consumer are expected to carry into the first part of 2023, with the risks of recession increasing later in the year. In the four FOMC meetings in H1 23, the market looks for two quarter-point hikes, with the Fed funds target reaching a terminal rate of 5.0%. If there is a risk, it is that the terminal rate is 5.25% rather than 4.75%. The media and some pundits may have made too much of the divergence of opinion at the FOMC. In the rotation of votes, two hawks (Bullard and George) are replaced with one hawk (Kashkari) and more centrists. Yet Chair Powell has managed the process up until now with few dissents. The more critical tension is between the Fed and the markets. Despite the pushback from officials, the market continues to price in a quarter-point cut toward the end of 2023. In January, we anticipate weak private sector job growth in December (January 6) and soft CPI (January 12), with the headline rate falling below 7% for the first time since November 2021. The core rate may slip below 5.9%, the 2022 low through November. Broadly speaking, we think the dollar's cyclical rally has ended and that it will weaken over the course of 2023. 

Euro:  The prospect of a more aggressive European Central Bank helped lift the euro to new six-month highs near $1.0750 in mid-December before a consolidative phase emerged. A break of the $1.0550 area would signal a deeper correction that could see $1.02. That said, as the divergence of monetary policy begins working in Europe's favor, we anticipate the euro to rise to $1.10-$1.13 in 2023. ECB President Lagarde clearly signaled a pre-commitment to lift key rates another 50 bp at the next meeting (February 2), and the hawkish rhetoric has encouraged the market to price in another half-point move at the mid-March meeting as well. The deposit rate stands at 2.0%, and the terminal rate is seen at 3.50%-3.75%. The maturing long-term loans the ECB granted and the early pre-payment have reduced the central bank's balance sheet by nearly 800 bln euros in November-December. Starting in March, it will not fully re-invest the maturing bonds in its portfolio, initiating a formal quantitative tightening process. Inflation appears to have peaked at 10.7% in October, and the ECB's staff projects it to fall to 6.3% by the end of 2023. Subsidies that are dampening inflation now expire and could see price pressures rise again in the spring. An economic contraction may have already begun, but the ECB's forecasts suggest it may still be short and shallow. 
 
(December 28 indicative closing prices, previous in parentheses)
 
Spot: $1.0610 ($1.0405)
Median Bloomberg One-month Forecast $1.0590 ($1.0320)
One-month forward $1.0620 ($1.0445)   One-month implied vol 8.7% (12.3%)    
 
Japanese Yen: The Bank of Japan caught investors and businesses off-guard last month by doubling the band for the 10-year yield to +/- 0.50%. The yield almost immediately rose to its new cap, and the yen strengthened sharply. Most observers seemed to see the move as a step toward exiting, and the swaps market is pricing in a positive overnight rate (from the current -0.10%) by the end of Q1 23. We are less sanguine. Alongside the 10-year yield cap adjustment, the central bank also announced it would increase its bond purchases (QE) to JPY9 trillion (~$68 bln) a month from JPY7.3 trillion. In addition, the government supplemental budget includes subsidies and other measures that will dampen price pressures. The yen has appreciated 10-11% on a trade-weighted basis, which will also help curb imported inflation. The spring wage round is important, but if the Bank of Japan's 0.2% staff pay increase is anything to go on, wage pressure will remain modest. The BOJ forecasts core CPI, which stood at 3.7% in November, to fall to 1.6% by the end of 2023. Last month, we warned that a break of JPY137.25 could spur a drop to JPY130-JPY133. The greenback tested the lower end of the range with the BOJ's surprise. We now see it has potential to recover back into the JPY136-JPY138 area.  
 
Spot: JPY134.45 (JPY138.05)  
Median Bloomberg One-month Forecast JPY134.70 (JPY138.95)
One-month forward JPY134.30 (JPY137.25) One-month implied vol 12.5% (13.7%)
 
British Pound: Sterling stopped shy of our $1.25 objective, peaking near $1.2450 in mid-December. A break of the $1.1950 area could signal another cent or so decline, but we see this as corrective in nature and not the end of sterling's recovery. To be sure, the further recovery of sterling we envision, which we project can rise toward $1.28-$1.30 in H1 23, is more about a broadly weaker dollar than positive developments in the UK. With the 0.3% contraction in Q3, the UK's recession, which may last into 2024, has begun. Still, with inflation above 10% (November), the Bank of England's tightening is not over. There probably is scope for another 50 bp hike at the next meeting on February 2 (that would lift the base rate to 4.0%) and after at least a couple of quarter-point hikes for a terminal rate of 4.50% and possibly 4.75%. Given the historic cost-of-living squeeze in the UK, it is difficult to envision the fortunes of the Tory Party improving much in the near-to-medium term.  

Spot: $1.2015 ($1.2060)   
Median Bloomberg One-month Forecast $1.1990 ($1.1890) 
One-month forward $1.2020 ($1.2085) One-month implied vol 10.6% (12.6%)
 
Canadian Dollar: Bolstered by a robust economy and an aggressive central bank, the Canadian dollar was the top G10 performer, slipping 1.8% against the strong US in H1 22. However, the process went into reverse in the second half, and the Canadian dollar was the weakest of the major currencies, falling about 5.3% against the dollar. A strong labor market and sticky core inflation measure suggest the Bank of Canada is not quite done with tightening monetary policy. Another quarter-point hike is likely when it meets on January 25, which would take the target rate to 4.50%. Although a pause in March is possible, we suspect another 25 bp hike in Q2 23 will conclude the tightening cycle. This is somewhat more aggressive than the swaps market implies. The US dollar's recovery from the CAD1.3225 low in mid-November was slightly stronger than we expected, probing the CAD1.3700 area. Still, barring a new shock, the mid-October high of almost CAD1.3980 still appears to be the peak. A break now of CAD1.35 would strengthen our conviction. 

 
Spot: CAD1.3610 (CAD 1.3410) 
Median Bloomberg One-month Forecast CAD1.3610 (CAD1.3425)
One-month forward CAD1.3615 (CAD1.3415) One-month implied vol 7.7% (9.3%) 
 
Australian Dollar: The Australian dollar's rally from a 20-month low in mid-October near $0.6170 peaked in mid-December a little shy of $0.6900 and the 200-day moving average, which has largely capped corrections since May. We suspect a correction has begun that may push the Australian dollar toward $0.6550-$0.6600 in the coming weeks. Official comments, signs of economic softness, and a decline in consumer inflation expectations are encouraging the market to lean toward the expecting the central bank to pause when it meets next on February 7. To be sure, the derivatives market does not expect it to be finished, but after hiking the cash target rate from 0.10% as recently as April to 3.10% in December and slowing to 25 bp increments in the last three moves, a pause may be in order. The policy rate is seen to be at least 60-75 higher by the end of 2023. Softer commodity prices may be offset as the year progresses by China's recovery and at least marginally better (trade) relations.  

Spot: $0.6735 ($0.6790)   
Median Bloomberg One-month Forecast $0.6720 ($0.6720)  
One-month forward $0.6740 ($0.6805)    One-month implied vol 12.5% (14.3%)
 
Mexican Peso:  The dollar's sell-off in late November to about MXN19.04, its lowest level since March 2020, seemed to exhaust the bears. It spent December mostly in the MXN19.50-MXN19.80 range. The central bank of Mexico, which some feared would turn dovish with AMLO appointments, has earned the market's respect. It will likely continue to match the Fed's moving in the coming months, suggesting a terminal rate of around 11.0%, even as inflation eases. Following December's correction and consolidation, we suspect the US dollar can retest the Q4 22 lows in Q1 23. The absence of significant fiscal stimulus during the pandemic will help Mexico avoid some funding challenges of other emerging markets. Moreover, the proximity to the US and the USMCA means it is uniquely positioned to benefit from the near-shoring and friend-shoring developments, with knock-on positive implications for its trade balance.  

Spot: MXN19.4375 (MXN19.27)  

Median Bloomberg One-Month Forecast MXN19.48 (MXN18.47)  
One-month forward MXN19.4580 (MXN19.3750) One-month implied vol 11.0% (11.2%)
 
Chinese Yuan: Last month, we anticipated the dollar would fall below CNY7.0, but the driver took us by surprise. After some stutter steps, China backed away from its zero-Covid policy, which spurred a 20% rally in mainland shares that trade in Hong Kong. The dollar also fell against the euro and yen, which, in recent weeks, has been strongly correlated to its performance against the yuan. The greenback spent most of December trading in a narrow range of roughly CNY6.9370-CNY7.000. It is difficult to decipher the intention of the PBOC, but we suspect that the price action in December formed a base from which the dollar can move higher in the coming weeks. We suggest a CNY7.05-CNY7.09 target range. Although the disruption spurred by the surge in Covid cases, leaving aside the human toll, may hobble the economy (with risks to supply chains) in the first part of the new year, we anticipate monetary and fiscal support to help lift the economy.  

Spot: CNY6.9820 (CNY7.0925)
Median Bloomberg One-month Forecast CNY6.99 (CNY7.1210) 
One-month forward CNY7.0150 (CNY7.0150) One-month implied vol 8.9% (8.9%)  

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