2023 FX Outlook

What’s your view on USD?

• We do believe that the USD is peaking and indeed that it may already have peaked. Cyclically, we think that the USD is now significantly overvalued.
  
• On yield differentials, despite the hawkish inflation-focused messages from the Fed, the market sees data –dependence and the risk of recession as driving Fed policy, and is pricing in terminal rates at 5%, in line with our view. This now stands in sharp contrast with some other Central Banks (ECB, BoJ and even SNB, all of which delivered hawkish surprises in the end of 2022).
• We also expect China’s re-opening to ultimately weigh on the Dollar, once Covid-related concerns stabilise.

As the USD peaks, who will be the beneficiaries?

As recession risks rise, risk-off safe havens: the EUR, the JPY and also CHF.

• While near-term growth concerns may cap the EUR, the gradual fall in USD bond yields relative to the EZ should be supportive for the Euro. Also, with the ECB ending its QE purchases, the supply of European sovereign bonds available to domestic investors will begin to increase again. For both these reasons, we expect a slower pace in EZ investors buying foreign bonds. Since, eurozone investors currently account for 61% of inflows into the US (about $1 Trn), the impact of even a small shift here this could be sizeable. We also expect the EUR to be supported by China’s re-opening.
• We remain moderately bullish JPY in coming months even after the recent major appreciation, given the possibility of further interest rate increases down the line, and any potential widening of YCC target band by the BOJ longer term.
• We expect gold and precious metals to continue to remain well supported both in an inflationary and in a recessionary environment. Lower interest rates and a weakening USD will also be supportive of gold.
• Lastly as China re-opens, the commodity currencies (AUD, CAD) should benefit. These economies and currencies are likely to get a boost from improving terms of trade, and strong fundamentals.

What do you think of Gold?

• A weakening USD and lower bond yields are positive drivers for gold, and we are bullish Gold in the current environment.
  
• The supply and demand dynamic have become more favorable for Gold of late. Throughout 2022 we saw ETFs selling gold and this was balanced by demand from central banks and Asian retail. We now see the ETF holdings rise as well, resulting in buying on all these fronts. This should continue to support Gold prices
• Lastly, post the Russia-Ukraine war and the resulting sanctions, central banks and others have increasingly realized the need for a politically neutral alternative to the Dollar. This need has become even more apparent with Cryptocurrencies being eliminated as investment alternatives.
• Gold remains our preferred hedge against tail risks, and it deserves an allocation in all investment portfolios.

How do investors position their FX portfolios to benefit?

Indeed, there are potentially some big changes in direction in FX underway.

• The USD is peaking, as the Fed comes close to the end of its rate hiking cycle, as yield differentials narrow, and a recession looms.
• These changes have led to a big rise in FX implied volatility. It is this, that constitutes the biggest opportunity in FX right now.
• What that means is that, there’s currently an opportunity to generate extremely attractive yields by entering into structures, for those who are familiar with these. These allow you to buy your favoured currencies at a big discount to the market, or to play the range.
• A very effective way to position is to look for innovations in structures which have an additional way to terminate early. This allows you to re-position your portfolio as the market evolves. Even for those who haven’t been active in FX, this is a good time to have a source of uncorrelated risk; and earn attractive yields, while still staying liquid.