The 2023 IGM FX Outlook

Base case

We are seeing it again. Once bitten, never shy. There have been plenty of USD selloffs outlooks from a myriad of respected firms for 2023.

We have seen 2022 underperformers the SEK and YEN being bandied about as potential big winners next year.

Risk-on is coming, they say, even if we have to wait for H2.

So, we think that yes the USD has likely peaked at those outsize marks of 114.78 (DXY), 151.95 and 0.9536. However, we do not see a one-way street lower ahead.

Amid huge uncertainty still in terms of monetary policy, economic outlooks (and recessions, stagflation etc), COVID, geopolitics we think much of the risk-on talk is fanciful or at least over-optimistic and we expect the USD to have its moments still in 2023.

Volatility could be the ultimate winner, as whipsaw trade might feature heavily.

As ever, we ask what's the alternative? See below, there are potential candidates, but that cocktail of likely weak global growth, a high US carry and its ongoing haven status in an uncertain world should lend the big Dollar support intermittently at least, more likely supported for much of the year.

The G10s

USD - Bias is neutral-to-bearish

In Dec, the Fed slowed the pace of its hikes to 50BPs to 4.50% as expected, but signaled tightening will continue and culminate at a higher level than markets expect/are pricing. The dot plot revised up the 2023 projected peak rate to 5.10%, and CB chair Powell said there won't be any cuts until the Fed is confident inflation is moving back towards 2.0%.

So, the Fed expect to keep rates higher through 2023, with no reductions until 2024, but still they (investors/economists/strategists) say the USD is about to get sold off!

After Q4's fairly dramatic selloff, positioning is fairly clear and we suspect big volatility over big trends will be the main theme.

We do not rule out relative US growth outperformance continuing in 2023. A soft landing is not impossible, with the US economy fairly well sheltered from the big uncertain key drivers ahead of energy and commodities prices movements.

DXY USD Index could hold above 97.50, 95.00 for the very most part.

Any overdone movements lower should prove just temporary.

RISK – The market seems to have gotten itself optimistic again. Optimistic that inflation will fall, optimistic on the great China reopening and optimistic on risk. Throw in the end of war/s and if these factors play out, then risk-sensitive FX should be on to a winner and at the expense of the Dollar. However, we also need to be realistic with our outlooks and cannot build our strategy on what we hope is going to pan out in 2023.

EUR - Bias is bullish

EUR/USD came under huge amounts of pressure during the first nine months of 2022 as the Fed embarked on an aggressive tightening cycle as the ECB stood side, with the latter's first hike not arriving until July despite surging inflation and rising energy costs across Europe.

The war in Ukraine has been a key EUR weight over the past year after Putin completely cut-off its gas supply to Europe, in turn heaping risks on to the European growth outlook weighing heavily on investors' sentiment.

But the outlook for 2023 looks set to tentatively improve.

Indeed, while it's hard to predict when or how Russia's invasion of Ukraine will end, optimism has been more prominent of late. Ukraine has a sustained advantage on the battlefield, there is growing international pressure to end the fighting, and Putin is losing support from his fellow leaders. There remains steadfast Western support for Ukraine, and Putin's act to cut off gas supplies to Europe and threats of nuclear war have backfired. Western arms will continue to flow eastward, and Russian gas will never again flow westward in large amounts.

The OECD estimates that it will cost $2.8trn in 2023. Shortages of arms in the West will become an increasing concern. Expect, therefore, lots of talk in 2023 about the scenarios for peace.

Meanwhile, data out of Europe has been encouraging of late; European energy concerns have abated to a degree, with sentiment readings improving. The ECB has admitted that while a recession is likely, it will probably be shallow and short-lived.

Regarding monetary policy, the ECB delivered a 50bps hike in December and hawkishly signalled more “significant" hikes to come given the fact that inflation remains “far too high". The ECB has also raised its inflation forecasts significantly - the 2025 forecast shows core CPI at 2.4%, failing to converge to the 2% target.

We have been told that QT will begin in March at a measured, predictable pace, while the APP portfolio decline will amount to an average of Eur 15bln per month. The ECB will give APP details sales the February meeting.

Rates now stand at 2.00% with the terminal rate seen at least 3.00%, suggesting two more 50bps hikes in February and March. Core inflation reads will likely prove the determining factor on the size of March's hike, but Lagarde herself has admitted that the ECB will need hike rates by 50bps “for a period of time."

There is now a school of thought that the ECB will soon turn more hawkish than the Fed – the opposite scenario seen for much of 2022 – a theory that certainly justifies fresh EUR strength in 2023.

RISK - Is attached to a deeper European recession than predicted given a prolonged Russian invasion of Ukraine, subsequently higher oil and gas prices and negative impact on households/consumers. China's economic revival also risks upside price pressure for commodity prices. Also, a much quicker than forecast slowdown in EZ inflation, a sooner-than expected neutral shift from the ECB and the subsequent removal of EUR/USD's developing yield advantage.

YEN - Bias is neutral

Recall last week was supposed to be the last big one of the year and this week's BOJ was rubber-stamping ahead of the Xmas break.

Well, by the time of writing (again), USD/YEN has already dumped almost 5.0% and over six big figures to 130.60.

USD/YEN topped out at 151.95 on October 21, as the dominant positive driver of yield differentials finally began to flag. Now sub-140.00 and sub-4.00% in the US 10-year yield amid peaking US prices and a less aggressive Fed. Recall too Japan's MOF spent a record Yen 6.3tln in October on FX intervention.

The catalyst for the pre-Xmas correction though was a shock tweak to the BOJ's yield-curve control policy. Kuroda and co raised the upper band of the permissible range for 10-year JGB yields to about 0.5% vs 0.25%. The BOJ noted bond market functioning had been weakening of late though continued to cite 0% yields as the outright target. The Bank announced an unscheduled bond buying operation after JGB yields surged, while leaving its policy balance rate at -0.10%.

Central bank governor Kuroda tried to play down the move, suggesting in his presser it is not a rate hike; it is not a first step towards an exit; it doesn't see a need to expand its YCC target further; the CB still sees inflation slowing the next fiscal year and the old mantra that the BOJ won't hesitate to add more easing if needed.

There was a very temporary mini-spike after, but despite the protests of Kuroda markets decided the BOJ are laying the groundwork for normalisation.

In our original YEN (neutral-to-bearish) piece, we suggested the BOJ could signal an upcoming end to yield curve control in 2023 or simply exit the policy. However, we think the BOJ maintains the status quo on its target rate at -0.10% amid a global growth slowdown and domestically a lack of a wage-inflation spiral.

We stand by the latter at least, to an extent.

We also thought potential USD/YEN bases at 125, 120 or 115 (and a top roughly around 145) though intermittent YEN strength on the crosses in particular could play out in a volatile year. Defensive FX will win out at times.

RISK - This move has taken place before Kuroda leaves office in April and a new governor enters the fray soon after. Markets inevitably expect a more hawkish replacement to the uber-dovish Kuroda. For now, the OIS market is pricing in a full 25BPs hike in H2 2023. Those earlier estimates would likely become vulnerable and a run on 115-120 doesn't seem impossible in such a scenario. Neutral-to-bullish then? That, of course, is the hawkish scenario. If those other previously hawkish G10 central banks stop tightening on 'peaked prices' and some even consider cuts in a recessionary backdrop would the BOJ really consider beginning hiking when much of that inflation is imported and Japan will likely have plenty of economic concerns of its own?

GBP - Bias is neutral-to-bearish

Talk about volatility. A year much of the country would want to forget, as GBP/USD dumped from near 1.3750 to 1.0350 historic lows. No matter the 325BPs of BOE rate hikes in 2022, it was political unrest and the failed stewardship of Truss/Kwarteng and their planned unfunded tax cuts that weighed on the Pound and sent markets reeling. The snap back from late Sep to just shy of 1.25 has been almost as dramatic.

Despite the positive (or should that be less negative?) of the Sunak/Hunt sensible ticket, we find a lot of public bears for next year still.

In a latest dovish hike, the BOE admitted last week the UK is already in recession, forecasting -0.1% in Q4. The growth picture is weak amid fears of a prolonged recession at the mercy of energy prices moves, while fiscal policy is relatively tight.

So, the UK's C/A deficit continues to deteriorate, driven by the trade balance, while this is increasingly financed by portfolio flows which are less stable than FDI (Morgan Stanley); the external backdrop of risk assets and global stock moves will be a key driver for the increasingly risk sensitive GBP.

RISK – And yet …… there are reasons for optimism. Unlikely ones, focused on politics. Plenty has changed in Q4, but arguably a little off the market radar still. There are three potential turning points - the Sunak/Hunt non-nightmare ticket; Scotland and the UK Supreme Court unanimously rejecting an attempt by the Scottish govt to call a second Scottish independence referendum next year and Brexit. On the latter, we see a possible improving relationship with the EU in this post-Johnson era amid encouraging Sunak talks with his Irish counterpart Martin, while The Sunday Times have written senior figures in the UK govt are seeking a closer 'Swiss-style relationship' with the EU'. Latest YouGov polls also show Britons reject Brexit by 57% to 43% and a record high 56% now believe Brexit was wrong and some 19% of Brexiteers now regret their choice. Interesting. At this stage, we think this relatively new UK govt will try and distance itself from such a debate. Business as usual, the theme. However, a warmer relationship with the EU could further stir GBP (particularly EUR/GBP) and perhaps lead to a sustained test of the downside extreme of our well identified long-term approx 0.8500-0.9000 range. We cannot overstate how much the Brexit outlook impacts on GBP. Investment flows have been seriously impacted since that fateful decision of Jun 23 2016 and mere improved relations through to the possible (but highly unlikely) Brexit cancellation would switch politics from the med-to-long term negative column to the neutral-to-(outright) bullish for GBP. Caution - this is a very positive way of looking at things GBP wise. It's not a scenario that can be easily bet on!

CHF - Bias is bullish

Oh what difference a year makes. This time last year the SNB had just left rates unchanged at -0.75%, while reiterating that the Franc was highly valued and it was prepared to intervene in markets if needed. Back then intervention was designed to counter Franc strength. Fast forward twelve months and the SNB have not only been able to exit their negative interest rate policy, which had been in place for over seven years, but they have also raised rates by 1.75% and now they actively seek a stronger Franc, in order to counter imported inflation. President Jordan admitted last week that they have sold foreign currency in recent months.

The Franc has played an important role in making sure Swiss inflation this year has not soared to the eye-watering levels seen elsewhere, but with the headline rate running at 3.0% y/y in December, above the 2% top level of the SNB's target range, Jordan seemed determined to express his displeasure at inflation developments in the Q4 meet. At the moment, it looks like the SNB will deliver another rate hike in March, but there are a lot of inflation updates before then.

As Switzerland is a small, very open economy currency strength is very influential. In real terms SNB policy is now more restrictive than most, so Jordan and co may well make more use of FX intervention in 2023. Remember the SNB holds over Usd 800bln of foreign currency it accumulated in the deflation years, so it certainly has the ammunition to keep the Franc strong in 2023.

The Franc has been the second best G10 FX performer in 2022 and is just 1.50% behind the Usd at the moment. We expect Eur/Chf to remain biased to the downside in 2023. Given the fact that the Swiss economy is much less dependent on fossil fuels than its European neighbours, energy should not be a major issue, although its position means that growth will be heavily influenced by how the Eurozone economy develops. We forecast that Eur/Chf will remain below the parity level, while we suspect that the SNB will not be keen to see much in the way of USD/CHF appreciation.

RISKS As usual with the Franc and its traditional safe haven status, the influences are likely to be of the global variety, with the conflict in Ukraine and if/how it is finally resolved likely to be a major issue.

CAD - Bias is neutral-to-bearish

The Loonie was the G10's star performer in 2021 and for the first seven months of 2022 it was only slightly behind the all-conquering USD. Then the mood changed sharply and since the start of August it has been the bloc's worst performer. It is hard to put a finger on why really, for sure oil and wider energy prices have weakened, but the Bank of Canada have delivered 400bps of tightening and according to Macklem last week are more inclined to err on the side of delivering too much tightening rather than risk too little. Maybe that is the problem as the Canadian economy is historically much more sensitive to interest rate hikes, than its counterpart south of the border. Equity market weakness is always a factor that correlates strongly with Loonie performance, but US equity losses have been a year long issue. Another factor often cited is the reversal in the Dollar.

Heading into 2023 the Bank of Canada look to be very close to the peak in rates, but inflation remains elevated, particularly on the core front. We suspect that the Loonie's outlook next year depends on how the Canadian economy responds to the tightening cycle and also how activity in the US fares in the face of its own round of rate hikes. There are quite a few factors that the Loonie has going for it, the positive energy situation, yield differentials and its AAA status. We expect Usd/Cad to meander down to the 1.3000 area if the Canadian economy manages to escape too much damage from the rate hike cycle.

RISKS – A quick resolution to the conflict in the Ukraine and a delay in the reopening of China could propel oil prices significantly lower.

AUD - Bias is bullish

AUD/USD has endured a tough year as the Fed's aggressive tightening mission and geopolitical events sapped demand, with 2022 lows of 0.6170 reached mid-Oct – some 20% off its 0.7661 early-April peak.

Much of AUD's fortunes for 2023 will remain tied to market sentiment around China developments, while the ongoing war in Ukraine again poses underlying risks for the outlook. Nonetheless, the tide is increasingly turning against Putin, and we expect commodity currencies to endure a somewhat bumpy but modest recovery path in 2023 - particularly as the Fed's hiking cycle comes to an end.

To the latter, strong signs of “peak inflation" in the US have spurred suggestions that the USD has also, in fact, reached its peak, and while the US currency will certainly continue to draw appeal as a haven asset during bouts of uncertainty next year, we nonetheless suspect the overall trend of AUD/USD should be a positive one.

The RBA last hiked rates by 25bps in December 2022 which pushed its OCR out to 3.10%. The central bank reiterated its forward guidance that the Board expects to increase interest rates further over the period ahead. Expectations that the RBA would signal a pause were thus not met, and so the decision was viewed as somewhat more hawkish than expected.

The clear source of uncertainty for the RBA comes from the strong labour market and the upside risk to inflation it poses to its 2023 forecasts. The Bank has repeatedly pointed out that Australian wages' growth remains lower than in many other advanced economies.

Headline inflation stands at 6.9% y/y - still well above the RBA's 2-3% target range. The board has said it is “resolute in its determination to return inflation to target and will do what is necessary to achieve that." A continuation of hikes early next year is therefore necessary, though the size and timing of hikes during 2023 will be determined by data and the outlook for inflation and the labour market.

The median expectation is for a 3.60% terminal OCR rate, suggesting 25bps hikes at both the February and March RBA policy meetings, ahead of a possible “pause".

Australian assets – including the AUD - should also benefit from the country's strong terms of trade. At the same time, the labour market remains tight, while the Australian economy continues to grow solidly.

Indeed, the Australian economy retains strong momentum and has shown resilience in the face of global rate hikes, which argues against any pause by the RBA in February.

RISK - The RBA may well be discouraged from hiking rates again next year amid falling inflation, higher unemployment and a global economic recession. The effects of the RBA's 2022 tightening mission have already started to be felt as retail spending stalls and building approvals trend lower. Demand for labour is in the early stages of easing, house prices are falling, and inflation pressures are topping out. The RBA forecasts inflation to remain a little above 3% in late 2023 and into 2024, but if inflation tracks towards 2% by the end of 2023, not only will interest rates be on hold in the first half of 2023, they will need to be cut to tackle the problem of inflation being too low. Also, externally, China's uncertain post-pandemic path and the war in the Ukraine. We are tentatively optimistic on both, but after China's government ended its strict zero-Covid policy in early December, local health authorities have warned it is now “impossible" to track the spread of Covid as the virus surges, while data revealed economic activity worsened in China in November amid widespread Covid outbreaks.

NZD - Bias is neutral

Similar to our view of the broader Dollar. NZD/USD is unlikely to make new range lows beyond 0.5512 in 2023 (though it cannot be ruled out).

We also think a sustained 0.7000-plus charge will prove difficult and overdone 0.72/0.73 highs could be about it.

Even after (at times Kiwi supportive) 350BPs of hikes in 2022, we think the RBNZ will be hiking some more next year. In fact, from a current OCR of 4.25%, the OIS market is pricing near 70BPs in Feb currently and a terminal rate above 5.00% as CPI hovers 7.2% y/y. Positive carry will prove attractive at various times.

The problem is Orr and co will likely be hiking in a recession, with ANZ seeing four quarters of the latter.

Also, we see a very uncertain external backdrop. Yes, the AUD is more exposed to China, as ever, but NZ's key dairy exports to Beijing will depend to an extent on the success of Beijing's reopening. Also, Kiwi will stay exposed to broader market sentiment given its market size and traditional reduced liquidity.

RISK – NZ is not alone, but housing. Thanks to ANZ who remark while upside interest rate risks remain a key downside risk for the housing outlook, household income and housing confidence risks are both intensifying. The investment bank think we're about halfway through the house price correction and have downgraded their forecast from a decline of 18% (peak to trough) to 22%.

NOK - Bias is neutral-to-bearish

Having started their rate hike cycle all the way back in September 2021, the Norges Bank have given industry and the consumer time to adapt to the round of rate hikes. After delivering a further 25bps rate hike to 2.75% last week, it still looks like Wolden-Bache and Co are not finished yet. The Norges Bank seem to be edging to a further rate hike in Q1 2023, but have also clearly sent the message that they are more data dependent going forward.

The last two disappointing Norges Bank regional network surveys remain lurking the background, but they are normally a very good growth indicator and the current reading is consistent with a quarterly growth rate of minus 0.3% over the next six months.

The Krone has performed poorly in 2022 and remains susceptible to bouts of risk aversion. Unless we see a marked improvement in risk sentiment in 2023, we expect Eur/Nok to keep an underlying bid tone, but we suspect that only another major risk off event will send the pair into the 11.0000 area.

Whether the pair can make another run at the 10.0000 level will probably depend on energy price developments and if the Norwegian economy can avoid the downturn that the network survey suggests.

RISKS – As ever with the Krone, risks are closely tied to oil prices, so obviously issues in regard to supply (the Ukraine conflict) and demand (Chinese COVID) reopening will prove crucial.

SEK - Bias is bullish

EUR/SEK started 2022 just above 10.00 before enduring a choppy 10-month rally, peaking at just below 11.10 in October. Consolidation near the 10.90 handle has since been witnessed.

Krona losses during the first three quarters of 2022 were largely caused by risk aversion in the broader space as global recession fears knocked the high-beta SEK lower, while aggressive FOMC hikes and subsequent USD/SEK strength proved a key driver of trade.

The implementation of Riksbank policy tightening as local inflation soared to record highs prompted bouts of SEK buying, but such demand proved short-lived as broader Dollar dynamics again took the reins.

But as the Fed looks set to ease the pace of tightening, pause or even “pivot" on rates in 2023, the risk is for a fresh USD/SEK, and subsequent EUR/SEK downturn – the latter back to 10.00, perhaps beyond. The fact that global central banks are pausing their hikes after the historic rate hiking cycle in 2022 should be supportive for SEK (and perhaps NOK).

Indeed, many banks now say the Krona's fair value sits well above current levels, with a buoyant 2023 potentially on the cards for the Swedish currency given all the “bad news" may well be in the price. Improved global growth prospects from China's recent reopening should also help cushion any further SEK losses.

In terms of local monetary policy, the repo rate currently stands at 2.50% and the Riksbank has signalled it will probably raise rates again early next year to bring the repo rate to just below 3.0%, reasoning that inflation is still “far too high".

Indeed, Swedish CPIF rose again in Nov from 9.3% y/y to 9.5% (back towards September's 9.7% peak, while CPIF ex-energy hit new highs of 8.0% y/y. The need for more aggressive tightening is clear.

Markets see Sweden's policy rate hitting around 3.25% in the second half of 2023, though we see upside risks to that pricing, and suggest a terminal rate closer to 3.50-3.75% is more likely.

Note, Governor Ingves (broadly a hawk) will leave the Riksbank at the end of 2022. Current FSA head Erik Thedeen, who takes over in January, has not indicated where he stands on policy. The February meeting will also be the first at which new deputy Governor Aino Bunge votes.

RISK: The Riksbank has recently warned that it will most likely report a large financial loss for 2022 due to its asset purchases. The Bank may have to request capital injections from Sweden's parliament next year, which could in turn threaten the central bank's independence. The bond buying, expected to be wound down at the start of 2023, may have reduced government borrowing costs by 15bln kronor in 2015-2022, but the purchases have also been criticised as one of the main reasons for the poor functioning of the bond market.

Summary

Who'd be in this business?

So much for any forms of forward guidance and the capacity for shocking markets as the BOJ just confirmed remains.

It feels like there will be more in store in 2023 and heightened uncertainty over potential impacters such as recession; interest rate hikes-to-a period of stability-to cuts unless inflation stays high; migration; politics including Brexit as ever; COVID and healthcare/welfare systems across the world unable to cope; a possible global house prices crisis, wars and geopolitics.

What if some central banks shift their inflation targets amid increased realism in a changing world?

No wonder the digitals/crypto industry was in crisis in 2022! (Another uncertainty hitting risk!) Hedge funds, real money investors et al didn't need their volatility. They had it here in G10 land.

We see the likes of EUR and AUD as relatively/potentially attractive in 2023. However, we suspect investors/traders might have to be imaginative with their 'sells', ie vs some EMs such as the Asians. The USD could be in relative demand, as there is still a lot to like in the big Dollar in an uncertain world.