ING Economic and Financial Analysis | Nov 18, 2021 12:07AM ET
Pandemics and financial crises aside, exchange rates typically can be seen as an extension of monetary policy. They reflect whether central bankers want to hit the accelerator or the brakes. In 2022 it seems clear that the Fed will have the strongest cause to apply some monetary restraint and that the dollar should perform well.h2 Output gaps have closed/are closing/h2
If equity markets embody some sense of confidence in the global economy, then this year’s stellar returns suggest policymakers have achieved their goals in preventing the COVID-19 pandemic from turning into a multi-year recession. G10 economies are bouncing back and concerns about the strength of the recovery are shifting towards unease over the path of inflation.
Output gaps—or how economies are growing compared to potential—can provide some sense on whether central bankers can take their time in normalizing loose monetary policy or need to act faster in response to the inflation threat. While output gaps are notoriously hard to forecast, the IMF believes 2022 will see positive gaps in the US (+3.3%) and Canada (+0.8%). In theory, the Fed and the Bank of Canada should be at the front of the queue when it comes to tightening.
Both the Euro area and Japan have seen negative output gaps since 2008 and probably again in 2022—justifying the more entrenched dovish positions of those central banks.
Though it seems a very much consensus view, we do favor dollar strength during the Fed lift-off—and largely against those currencies which will be more tolerant of higher inflation. This should mean the EUR, JPY and CHF will be the stand-out under-performers in 2022, while the SEK may lag too.
We do not think a stronger dollar against the low-yielders needs to upset the risk environment yet. After all, it is probably best to characterize the global economy as being in mid-cycle right now—growing confidence in the recovery, inflation picking up and central banks starting up tightening cycles. That should mean most commodity currencies can continue to perform well as their economies realize, through stronger business investment, the benefits of recent terms of trade gains.
GBP probably falls between the three stools of the: i) stronger dollar, ii) weaker low yielders, and iii) steady commodity currencies. We think GBP can hold onto its 2021 gains unlike a market generally more pessimistic on the pound.
One final point. We do like to drop anchor on some kind of medium-term fair value for currencies against the dollar, using our Behavioral Equilibrium Exchange Rate (BEER) model. Recent terms of trade changes have depressed EUR/USD fair value to around 1.10. That is our year-end 2022 forecast which is well below the consensus of 1.18.
Of the under-valued currencies in our BEER model, we would favor NOK and NZD playing catch-up. We are bearish on the JPY in 2022 and while the AUD may benefit from being undervalued and over-sold, positioning for recovery here remains a high-risk proposition.
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Good growth momentum going into 2022 (we forecast GDP at 5%) backed by strong corporate and consumer balance sheets should mean that pricing power holds and inflation stays above 3% all year. A stronger dollar can play a role in tightening monetary conditions.
The eurozone is still expected to run a 0.5% of GDP negative output gap in 2022 and the ECB has made it pretty clear it does not want to repeat the mistakes that Trichet made by tightening policy in July 2008.
Perhaps the only scenario for a much stronger EUR/USD in 2022 would be a strong global recovery, a eurozone renaissance (as in 2017), and a Fed turning dovish. With supply chain disruptions expected to weigh on growth in manufacturing-heavy Europe next year, such a scenario seems unlikely.
This should keep USD/JPY supported near 115.00, with scope for a break towards 120 as the Fed embarks on its tightening cycle— potentially next summer.
Targeted Japanese CPI is not expected to rise up to 1% until FY23, keeping the BoJ tightly holding its convoluted policy setting of QQE with yield curve control.
We suspect Japanese officials will not want to see USD/JPY trading sharply through 115 for the time being, but the combination of a turn in energy lower next spring and the Fed preparing for lift-off suggests 2Q22 could be the topside break-out period for USD/JPY.
The difference is that there are no clear signals of a UK recession in 2022. Our economist sees a reasonably healthy UK growth profile next year, initially running at 1% QoQ. That should allow the BoE to hike 15bp this December and a further 50bp in 2022.
Additionally, as negotiations have shown, there is plenty of scope for last-minute position adjustment from both sides and we doubt 2022 becomes characterized as a year of looming Brexit deadlines.
In a year when the external environment could become tougher (higher US rates, later in the economic cycle), the UK does not look as vulnerable as some might think. The UK current account deficit has narrowed to a manageable 2% of GDP and the budget deficit is forecast to shrink to just 0.6% of GDP in FY22-23. The UK’s 5-year CDS now trades inside of the US too.
This should be a gently positive environment for EUR/JPY and keep it supported within a 130-134 range.
While the ECB will have a challenging meeting on Dec. 16 with regard to how to end the Pandemic Emergency Purchase Program, we expect a new hybrid scheme to be introduced to smooth the PEPP exit. Like the JPY, we expect the EUR to remain a popular funding currency through 2022.
Invariably at some point, there will be risk-off events that trigger sharp rallies in funding currencies such as JPY and EUR. History would probably suggest that the JPY still outperforms when these risks hit.
Based on how GBP has traded so far this year, we believe Brexit fatigue can keep the risk premium more to the 1-2% region. 0.8650/8700 could then remain at the top of the EUR/GBP trading range.
In the UK, we are faced with the intriguing prospect of the BoE allowing its Gilt holdings to roll off once the policy rate hits 0.50%. The improvement in relative government bond yields should favor GBP.
French elections certainly weighed on the euro in early 2017. In the UK, the Johnson government seems to survive most missteps and the opposition Labor party are yet to mount a serious challenge. And we suspect Chancellor Rishi Sunak is keeping his powder dry for a pre-election tax give-away potentially in early 2023. Arguably, therefore, political risks are greater for the eurozone in 2022.
We think there are probably other factors at work here too. Switzerland’s trade balance remains strong (surpluses in excess of CHF4bn per month since May) and continued ECB money printing is keeping EUR/CHF subdued. EUR excess reserves parked at the ECB are now EUR3.6trn!
As above, we very much doubt the SNB does a U-turn in policy in 2022 and would expect a slowing in ECB balance sheet expansion to start providing EUR/CHF with support as 2022 progresses.
We must remember that, unlike other exporters, Norway’s low hydro reserves makes it prone to a sharp rise in domestic energy costs. There is a non-negligible risk that the country may face a situation where higher costs of living may coincide with wider room for wage increases as investments rise and the job market tightens; the result could be a considerable heat-up of the economy and inflation.
We think the risks are skewed towards the central bank overdelivering (four hikes in 2022); as highlighted in the point above, we see some risk that the economy may heat up excessively in early 2022, which could lead the NB to accelerate its tightening plans. Still, even with three hikes next year, a policy rate at 1.0% means that NOK will be at the forefront of benefitting from any revamp of carry trade interest in G10.
Still, tightening plans elsewhere and a robust domestic story should force a hawkish shift in communication by 2H22, which should take the form of signals about balance sheet reduction and/or some 2023/24 hikes being added in the rate projections. Still, lower rate attractiveness suggests SEK will struggle to outperform higher-yielding currencies like NOK in periods of supported risk sentiment.
We expect a YoY increase in global trade by 2.9% in 2022. More than half of Swedish exports are intra-EU and while we don’t see eurozone growth exceeding expectations, we still forecast a decent 3.9% YoY for 2022, which should keep supporting the Swedish export industry.
Back then, an aggressive Riksbank tightening cycle gave an extra boost to SEK. As this is unlikely to happen this time around, we expect SEK gains to prove more moderate. We target 9.65 in EUR/SEK for the end of 2022.
This may signal how the wider EUR/DKK rate differential may be a necessary, but not sufficient, driver for consistent re-appreciation in the pair, given current market conditions. At the same time, the differential should be able to provide a floor that is solid enough to let the DN manage the peg only with FX interventions and not with another rate cut in 2022.
A potential shift to a more hawkish tone by the ECB in the second half of 2022 may also provide some support to the pair, but we may have to wait until late 2022 or even 2023 to see the pair stabilise in the 7.4500/7.4600 region.
Being a very open economy, Canada is also set to benefit from the further recovery in global trade, which could accelerate in 2H22 as supply strains ease. As 70% of Canada’s exports head to the US, long-CAD should continue to be a proxy trade for the strong US growth story.
When adding that demand from the neighboring US for Canadian exports is likely to keep rising, and Trudeau’s government pledged to keep fiscal policy loose for longer, the domestic economic story is set to remain a positive for CAD, and partly shield it from any risk-off waves or USD appreciation.
Having the lowest volatility among G10 commodity currencies, CAD may emerge as a popular carry bet against low-yielders next year. We think CAD has the lowest downside risk in the commodity FX space and expect USD/CAD to stay closer to 1.20 rather than to 1.25 in 2022.
The growth outlook is blurrier as many headwinds may come from China. We think the RBA will taper asset purchases and end QE before the end of 2022. The first hike may only come in early 2023, although risks are skewed towards an earlier move. Still, the market pricing (75bp of tightening in the next 12 months) is too hawkish in our view.
Iron ore (Australia’s primary export), whose prices have approximately halved since mid-2021, should be able to hold around the current $100 levels on average next year, although a return to the 1H21 levels appears off the cards given China’s new restrictions on steel production. All in all, we expect a moderate net-negative impact of commodities on AUD in 2022.
Still, AUD is arguably facing the biggest deal of downside risks among G10 commodity currencies given its huge exposure to China-related sentiment and a potential commodities downturn. Even assuming only very few of those risks materialize, a return to the 2021 0.80 highs in AUD/USD seems quite unlikely in the next year.
We think markets will have to scale down tightening expectations for 2022, but signs of persistent inflation throughout the year should fuel speculation that the tightening cycle will have to continue in 2023-24, and put a floor below NZD. The currency should have the most attractive carry in G10 in the year ahead and should therefore benefit more than others from periods of low volatility a supported risk sentiment.
A big downside risk for NZD in 2022 is, however, China-related sentiment, which remains quite uncertain amid government crackdowns on some sectors and a potential economic slowdown. While being modestly undervalued vs USD in the medium term (3% according to our BEER model), NZD is the most overbought currency in G10 and is facing some position-squaring-related downside risk in the near term. We expect NZD/USD to rise gradually to 0.74 in 2022.
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