DM FX Outlook: Slow USD decline to continue but JPY and GBP could be volatile

Figure 1: EUR/USD remains below the level suggested by yield spreads

Source: Datastream

Yield spreads have been the primary driver of FX moves this year

Movements in nominal yields spreads have been the main force behind FX moves in almost all the DM currencies this year, supporting the rise in USD/JPY, the recovery in GBP and the weakness of the scandis, as well as the gradual recovery in EUR/USD. We expect that spreads will remain an important driver, and for EUR/USD that means that we stick with our forecast of modest gains into 2024. By the end of 2024, we expect the 2 year yield spread between the US and Germany to have dropped to 1.35% (from the current 1.5%), and although we don’t see much movement in the 10 year spread, we believe it is already at levels that justify a EUR recovery. 

Figure 2: EUR/USD and 2y US/Germany yield spread

Source: Datastream

However, the rest of this year could prove choppier. While we expect the EUR to make small gains, we may see periods of USD recovery related to the market pricing in a less rapid decline in U.S. rates than is currently foreseen. At the same time, any rises in U.S. yields as a result of this could choke off the gains in equity markets that we have seen of late, and which have been to the benefit of the EUR as well as the other riskier currencies, with the USD still tending to benefit when there are periods of equity weakness. Against this, there is more scope for the U.S. equity market to weaken than the European market, which looks much better value, and outperformance in European equities has been a positive factor for the EUR this year. All in all, this spells a relatively choppy period for EUR/USD, but the underlying point that the EUR is good value at current levels leads us to maintain our expectation of a modest uptrend.

Figure 3: G10 Currency Forecasts 

Source: Continuum Economics 

Figure 4: S&P 500/Eurostoxx ratio and EUR/USD

Source: Datastream

JPY still shows the clearest value, but market needs to recognize inflation as a factor

However, when it comes to value the currency that stands out is the JPY. In the short term, the market has continued to focus on nominal yield spreads (Figure 5) as the primary driver. USD/JPY has stuck close to the short-term correlation with 10 year yield spreads for the last couple of years, so from a short term trading perspective it is hard to avoid focusing on this as the main factor that is likely to impact USD/JPY. On this basis, there isn’t a strong case for expecting USD/JPY to move a great deal. We would expect the short term nominal 10 year spread to remain close to current levels over the next couple of years. But a little more perspective suggests there is still some USD/JPY downside based on longer term historic correlations with nominal spreads. The latest correlation includes a break from history early in the pandemic, and that may be corrected, allowing some JPY recovery.

Figure 5: USD/JPY and 10 year US/Japan yield spread

Source: Datastream

But even this ignores the crucial point that relatively high inflation in the U.S. (and Europe) has created a huge real depreciation in the JPY in recent years. It may be because the market is unused to considering the implications of inflation for FX value in developed markets in recent years, but history (and theory) show that over the long run, higher inflation will lead – with a 1 to 1 correlation – to a weaker currency. Figure 6 showing USD/JPY and USD/JPY purchasing power parity over the last 50 years illustrates this. This creates the risk of a much sharper JPY appreciation, but it is not clear what the trigger might be for such a move. Historically, big real depreciations led to a significant impact on trade performance, but this effect is much reduced in a more globalized world, and financial flows tend to dominate in everything but the very long term. More likely, the JPY would benefit if carry trades that are in place to benefit from the nominal spread in favor of the USD are unwound due to a big decline in risk appetite. This has typically been the trigger for JPY gains in the past (notably in 2008). However, at this stage we don’t see a large enough equity correction emerging to trigger such a move, so for the moment any JPY recovery seems likely to be quite gentle. We see 130 for end 2023 and 120 on USD/JPY by end 2024. 

Figure 6: USD/JPY and USD/JPY PPP

Source: OECD

The currency is currently not a guide to the strength of the economy

One point that is currently very clear is that currency movements are not an indication of the strength of the economy. The market is very focused on nominal yield spreads, and nominal yields are being driven mostly by inflation and inflation expectations, and to some extent by differing policy reactions, much more than by relative growth performance. Theoretically, this doesn’t make much sense if you expect high inflation currencies to depreciate to maintain purchasing power, as the improved return from higher interest rates would then be expected to be offset by losses from a declining currency. But in a market which is ignoring the direct impact of inflation on FX values (as illustrated above with USD/JPY), the attraction of nominal rates is much more significant. 

Figure 7: GDP in the G10 (Q4 2019 =100)

Source: Datastream

One example of this at the moment is GBP, which is benefiting from rising yields related to expectations of relatively high UK inflation and relatively aggressive BoE policy action to deal with it. This is coming against a background of relatively weak UK growth, with the UK still the only one of the G10 countries that has not yet returned to the pre-pandemic level of GDP, but at the moment, the market isn’t seeing this as a concern. Having said this, GBP has not benefited as much from higher nominal yields as might have been expected looking at nominal yields alone, particularly against the USD, but also against the EUR. This may reflect some concerns that the UK will at some point have to pay the price for relatively weak growth and relatively high inflation. There was certainly a confidence issue in GBP last year in the brief period when Truss was Prime Minister, and the underperformance relative to yield spreads this year suggests that has still not been completely eliminated. We expect that high UK yields will prop up the pound short term, but we doubt that the BoE will tighten as much as the market is pricing in, so upside may be less than suggested by current yield spreads. We also expect the poor UK growth/inflation trade-off to undermine longer term confidence in GBP and lead to weakness through 2024 against the EUR.

Figure 8: EUR/GBP and 10 year yields

Source: Datastream

Scandi weakness to reverse

While GBP has benefited from relatively tight BoE policy in spite of weak UK growth, the scandis have suffered from relatively easy central bank policy in spite of relatively strong growth. In Sweden, this relates to the greater sensitivity of the Swedish economy to short term rate moves due to the high proportion of floating rate mortgages, and the vulnerability of the housing market. The latest Swedish growth data has been weak, and this has helped EUR/SEK to hit a new all-time high above 11.80. But from a bigger picture perspective, Swedish GDP performance has been superior to the Eurozone, and the current yield spread picture also suggests downside EUR/SEK risks from here. 

Figure 9: EUR/SEK and 10 year yields 

Source: Datastream

A similar story can be told for the NOK, although the NOK picture is complicated by the historic relationship of the NOK with the oil price, the big NOK sales by the government pension fund and the recent fluctuations in the gas price. Even so, recent price action has been mostly yield spread related. For both the NOK and SEK, we would expect some recovery in real yield spreads relative to the Eurozone (and the UK) to reflect relatively strong growth, and that suggests that the recent period of weakness should be reversed in the next year. 

Figure 10: EUR/NOK and 10 year yields 

Source: Datastream

Commodity currencies still have upside scope

After performing well in the immediate aftermath of the pandemic, the commodity currencies have fallen back in the last couple of years as yield spreads have moved in favour of the USD. However, there has been some recent movement back in favour of the AUD and CAD as markets reassess the policy outlook, and both currencies retain some improvement in their terms of trade as a result of the commodity price moves we have seen in the last few years. There is scope for them to extend the recent recovery in the next year as U.S. yields top out and the China recovery helps to bolster global commodity markets. 

Figure 11: AUD/USD and 10 year yield spread

Source: Datastream