Without doubt, 2022 was a difficult year. Markets wrestled with geopolitical risks and surging inflation, leading almost all central banks to hike interest rates at the fastest pace in decades.
As we look into 2023, the drivers that have underpinned risk sentiment are still in place. Inflation remains stubbornly high, the Ukraine conflict shows no signs of abating and China’s relaxing of Covid-19 rules has had many false starts.
Furthermore, the cost-of-living crisis continues to put pressure on households. With such a list of challenges it is no wonder that recession is the focus for many.
Ultimately, inflation is the most important macro variable that will dominate asset classes, including foreign exchange activity, in 2023. This is how we see these factors affecting major global currencies this year.
Sterling well positioned
It is likely sterling will weaken into the first half of 2023 as the domestic situation remains challenging. The outlook should depend on fundamental drivers in 2023, given the political tail-risk has been removed as the government attempts to regain credibility.
UK real rates remain negative with further downside risks. UK households’ real disposable incomes will decline thanks to higher energy and food costs, plus higher rates will become a reality for mortgages and other lines of credit. There is still an idiosyncratic risk of Brexit’s labour and trade balance frictions.
Despite this bearish outlook, sterling would participate in any broad risk rally, particularly if there is sustained weakness in the US dollar. In addition, if the energy shock diminishes, this would likely improve the terms of trade, which would improve sterling sentiment.
Don’t write off the US dollar
While the US dollar has performed well over 18 months, several positive catalysts are waning. The Fed’s tightening cycle is probably in its final stages. If interest rate volatility has peaked, the dollar can weaken.
Much will be predicated on inflation. The Fed will be reluctant to cut rates even in a US slowdown as it will want to ensure inflation remains on a downward trajectory. Any premature loosening of policy may cause inflation to rise.
If the Fed is successful in lowering inflation, it will cause a sustained weaker dollar. A bottoming in global growth dynamics alongside a yield stabilisation would also weigh on it. But the dollar remains a haven and investors will continue to seek refuge there during volatility.
A further reason challenging any sustained dollar downside is the currency still retains a yield advantage against most G10 currencies. A US investor will soon be able to earn 4.5% by simply investing in cash.
Euro looks for upside surprises
For the euro to rebound there needs to be a reversal of factors that weakened the currency in 2022. Energy is key, storage levels remain high and gas prices have fallen sharply. If this continues, the 2023 outlook improves.
The growth outlook is challenging, but any signs of faster euro-area growth would be positive. Economic surprises have been improving since the summer and have moved into positive territory.
Another positive case for the euro comes from capital flows. Since the euro-area adopted negative interest rates, there has been significant outflows. The euro can benefit from repatriation of European savings held abroad to take advantage of higher yields. The currency will also benefit from a rotational move into cyclical assets.
Yen to return to safe-haven status
The yen had a difficult 2022 and was under pressure from a stronger dollar, a dovish Bank of Japan and higher energy costs. But fortunes will change in 2023.
Japan’s balance of payments is likely to improve with the lagged effects of declines in commodity prices and reopening of its borders. In the short term, given the light positioning by investors, the yen will continue to strengthen.
At the end of December, the Bank of Japan (BoJ) kept policy rates unchanged but unexpectedly widened the 10-year bond yield curve control from 0% +/- 25bp to 0% +/- 50bp, in a response to rising global yields.
The energy situation that has weighed on the currency should not have the same impact, particularly with a shift to nuclear, with a quarter of the country’s energy expected to come from nuclear by the end of 2023 – which will be good for external balances and positive for the yen.
Ultimately the change in yield curve control and a potential end to their ultra-loose monetary policy, along with lower US yields and a global recession, will see the Japanese yen regain its safe-haven status.
Chinese yuan reliant on Covid-19 restriction changes
The outlook for the yuan will depend on Covid-19 restrictions. There have been some signs of restrictions easing in China but given the cautious nature of the government this is likely to be a slow process.
If China can successfully exit its strict Covid-19 policy, it is likely to be the only major economy to grow faster in 2023. In addition, the currency can benefit from less dovish monetary policy as growth bottoms and from a bottoming-out of real estate.
There are several downside risks for the yuan. These include Covid-19 outbreaks that stop re-opening, the continued decline in exports dependent on the severity of a global recession, a slower recovery in real estate and any deterioration in relations with the US.
Gareth Gettinby is a multi-asset investment manager at Aegon Asset Management. The views expressed above should not be taken as investment advice.