DM FX Outlook: USD strength to fade into 2024

• Bottom Line: The resilience of the U.S. economy and consequent risk of further Fed tightening is keeping the USD well supported near term despite its overvaluation. A likely Eurozone recession in H2 2023 suggests near term downside risks for the EUR.
• Forecast changes:We have revised up our USD forecasts to reflect the relative outperformance of the U.S. economy and the increasing risk of recession in Europe. But we still anticipate the USD declining through 2024. AUD forecasts have been revised lower to reflect the lower growth picture in China.
• Risks to our views: There are significant USD upside risks if the U.S. labour market remains tight and continues to limit the prospects for Fed easing in 2024. Uncertainties around China represent major two way risks, particularly for the AUD, but if weaker risk sentiment undermines global equities. China weakness could also be a trigger for a JPY recovery.

Figure 1: EUR/USD has declined as U.S. 2 year yields have risen

Source: Continuum Economics/Datastream

Rising U.S. yields and rising spreads in favour of the USD have been the prime driver of USD strength

The USD has strengthened through the summer as the market has priced in a less dovish view of the likely path of Fed policy. While there has also been a rise in European (and Japanese) yields, the relative strength of the U.S. economy has ensured that yield spreads have moved in the USD’s favour. Going into 2024, there is a risk of one more rate hike in the U.S. this year, but thereafter we should start to see U.S. yields come down. We don’t see the U.S. economy retaining sufficient strength to prevent the Fed easing through 2024, with inflation already back close to target on a m/m basis. The lagged effect of monetary policy tightening can be expected to slow the economy in the coming months. While this is just as true of Europe – indeed, probably more true – the bigger picture story is still favourable for the EUR on a yield spread basis, with 10 year yield spreads still suggesting scope to 1.15 by the end of 2024 if the current USD support from the perception of a strong U.S. economy fades. 

Figure 2: EUR/USD and 10y US/Germany yield spread

Source: Continuum Economics/Datastream

But this will depend on the Eurozone managing a recovery in 2024 after what looks likely to be a recession in H2 this year. The fact that the ECB remain reluctant to ease policy until there is clear evidence that inflation is returning to target both limits the EUR downside short term and is likely to prevent a strong EUR recovery longer term. Weak money and credit growth in Europe suggests a very sluggish picture is likely in 2024, keeping longer term yields subdued. But yield spreads between the U.S. and Europe are still likely to be dominated by developments in the U.S., and a slower U.S. growth picture should see Fed easing from the spring and declining U.S. yields bring the USD down.

Nominal yield spreads aren’t everything

Anyone watching the developed FX market in the last year or two would be forgiven for thinking that nominal yield spreads were the only significant driving force behind FX movements. Clearly, they are a significant force, but in the longer run there are also value considerations. If nominal yields were all that mattered, everyone would be buying Turkish lira and Argentinian pesos, but they don’t because of the high level of inflation in those countries. In the long run, there is a 1 to 1 relationship between relative price levels and currencies, both theoretically and empirically. In other words, if your relative price level rises (due to a relatively high level of inflation) your currency should, in the long run, depreciate in proportion to the rise in your relative price level to maintain the same level of purchasing power relative to other countries. This is most revenant on the current FX market in relation to the JPY. Japan has seen a much lower level of inflation than the rest of the G10 n the last few years, and there has consequently been a real depreciation in the JPY over and above the nominal depreciation. While there may be some reasons for a JPY depreciation related to the rise in energy prices and a consequent deterioration in the Japanese current account position, the decline seen in recent years is excessive. Eventually, this will be corrected, and when it is the recent close relationship between nominal yield spreads and USD/JPY, is likely to break. 

Figure 3: Nominal yields spreads have dominated the move in USD/JPY

Source: Continuum Economics/Datastream

The precise timing of any shift in FX market behavior is always difficult to assess, but we suspect that once nominal yield spreads between the U.S. and Japan start to narrow, we will see a much sharper move lower in USD/JPY than is suggested by the current relationship between the currency and nominal yield spreads. USD/JPY has appreciated more than 20% in real terms over and above the nominal appreciation seen in recent years, and a return to the real long term average level of USD/JPY would require a move to around 100 in nominal terms. We don’t anticipate a move that sharp in the next year or so, because U.S. yields are likely to remain at relatively high levels. But towards the end of 2023 and through 2024, we are likely to see a narrowing of U.S./Japan yield spreads, as the Fed eases and the BoJ tightens, or at least allows JGB yields to rise to the 1% YCC ceiling. This narrowing is likely to be a trigger for a sharper USD/JPY decline than is suggested by nominal spreads alone. While we have slightly revised up our USD/JPY forecasts due to the strength of the U.S. economy, we still see 125 by the end of 2024.

Figure 4: Real USD/JPY close to 50% above long term average

Source: Continuum Economics/Datastream

China uncertainty weighing on risk sentiment in general and AUD in particular

An increasing concern in recent months has been the debt problems in the Chinese property sector (here), and the associated slowing in the Chinese economy. We don’t anticipate a major financial crisis, with the Chinese authorities likely to step in when required to prevent any major disruptions, but the weakness of the property sector will help to restrain growth. To the extent that this also restricts demand for raw materials it might be seen as directly negative for the AUD, but the AUD is likely to remain more sensitive to the implications for global, and particularly for regional risk appetite. Regional equity markets have already suffered, and this has undermined the AUD, but while we do anticipate weaker Chinese growth going forward, we suspect this has now been largely priced into equity markets, so the worst of the regional risk fallout has probably been seen. This should mean that the AUD can continue to find support in the low 0.60s, and over the course of 2024 we would expect the AUD to gain some ground, with the fundamental positive of the improvement in Australian terms of trade in recent years and the consequent improvement in the current account justifying gains above 0.70. 

Figure 5: AUD subdued by recent weakness in Chinese equities

Source: Continuum Economics/Datastream

Scandis have potential for recovery

Along with the weakness of the JPY, the weakness of the Scandinavian currencies has been one of the more notable features of the FX market in 2023. The SEK in particular has been under a lot of pressure, hitting new all time lows against the EUR, with EUR/SEK trading close to 12. Weakness was initially related to the Riksbank lagging the monetary policy tightening seen elsewhere in Europe, resulting in significant yield spread widening in favour of the EUR. But the Riksbank has been playing catch-up through the summer, and spreads have moved substantially in the SEK’s favour in recent months. Nevertheless, the SEK has remained close to all time lows, in part because of the perception that the Riksbank’s slow response and subsequent sharp tightening has been a policy mistake that has led to a severe economic downturn. There has certainly been a marked downturn in the Swedish economy in recent months, with the housing market leading the way. The preponderance of floating rate mortgages in Sweden means there is a more rapid reaction to monetary tightening than elsewhere. Even so, from a bigger picture perspective the Swedish economy has outperformed the Eurozone through the pandemic, and we doubt that the current weakness will persist for much longer. While the SEK also tends to suffer in periods of weaker European risk sentiment, and this may prevent much recovery through the rest of 2023 with the Eurozone likely to be in recession, there is scope for a substantial recovery through 2024 as markets readjust to the current level of yield spreads. 

Figure 6: Yield spreads suggest EUR/SEK has scope to decline 

Source: Continuum Economics/Datastream

GBP may have potential for recovery through 2024, particularly against the USD

While we are not particularly positive about the UK economy, GBP has shown significant weakness in the last couple of years over and above that suggested by UK underperformance, and currently carries something of a risk premium relative to the levels suggested by the usual metrics. This was most clear in 2022 when he pound fell back even as yields rose under the short-lived Truss administration, but GBP also underperformed rising UK yields for much of 2023. Part of this perhaps reflected a skepticism in the FX markets that the UK money markets were correctly pricing the likely path of UK rates. However, it may also have reflected doubts about the prospects for the UK economy given relatively high UK inflation and growth underperformance related to Brexit. But although GBP has weakened after the latest BoE MPC decision to leave rates unchanged, the decline has been relatively modest compared to the decline in UK yields, and suggests some of the risk premium is starting to dissipate. We still see some GBP downside against the EUR over the coming year, partly for long term valuation reasons, but GBP may get some support from politics by H2 2024 as the market starts to look towards a change in government which could reduce the concerns around Brexit.

Figure 7: GBP starting to look more resilient

Source: Continuum Economics/Datastream