The Federal Reserve is fine-tuning its policy, and if economic data is soft in the next several months, as we expect, there may be no real need to lift rates materially higher. By contrast, the European Central Bank and the Bank of England, among other European central banks, have indicated they still have more work to do to fight inflation pressures.
Diverging performance versus the USD was a major theme in foreign exchange markets during the first half of 2023. The stronger currencies were backed by central banks with a strong hawkish tilt and improving terms of trade—like the UK, Eurozone, and Switzerland. On the opposite end of the spectrum, currencies that either struggled with a lack of economic growth—like in Scandinavia—or monetary policy that was not hawkish enough lagged.
But in some currency crosses, we have already seen a lot of strength (for the GBP) or weakness (for the JPY and NOK), likely leaving little room to keep running from here. For these currencies, the narrative for 2H could well be a reversal of recent trends. This opens opportunities for FX positions that are less correlated with equity markets. It also leaves room for select volatility-selling chances, despite the steady decline in option volatility of late.
We expect the market’s focus on yield to continue in the early part of the second half. But as growth slows further and central banks remain hawkish, the risk of mounting financial stress could increase as 2H progresses. With interest rates still on the rise and inflation falling globally, real rates should climb sharply. We think that concerns about economic growth will play an increasingly important role for FX markets from here.
The ECB still has work to do as mentioned above, despite recent soft PMI readings, fueling our broadly positive view on European currencies. Since the Swiss National Bank (SNB) will likely will not need to be more hawkish thanthe ECB, we think the CHF should trade mostly sideways in the crosses.
Beyond calling for a weaker USD, we expect laggards that should benefit from more rate hikes, like the NOK and AUD, to outperform other pro-growth currencies like the GBP that have done well so far and have high rate expectations already priced in. We also believe the JPY, which has struggled materially but tends to perform well in risk-off conditions, has room to stage a comeback toward yearend.
Meanwhile, the opportunity set when engaging in volatility-selling strategies is narrowing further. A steady decline in option volatility amid greater uncertainty ahead calls for a highly selective investment approach, in our view.
From a volatility perspective, we only see value in the NOK and JPY, and to some degree in AUD-linked exchange rates. Here, historical volatility percentiles over the last 5–10 years stand at reasonable levels for the NOK and JPY, while somewhat below 50% for the AUD. We believe volatility in EURUSD, USDCAD, and USDCHF should be bought.
So how should investors navigate the macro cross-currents that are likely to shape markets besides country-specific factors?
Here are our monthly FX ideas for EUR-based investors:
Hedge USD longs
EURUSD has been trading in well-established ranges lately despite disappointing PMI readings out of the Eurozone. We still think the ECB has more ground to cover in order to rein in inflation versus the US. Narrowing yield differentials between the two regions should bring EURUSD closer to fair value. Moreover, Europe’s external balances have improved materially on the back of lower natural gas prices. Both factors combined still set the tone to push EURUSD to 1.14 by year-end and to 1.16 in early 2024.
Yield pickup in EURJPY
Diverging monetary policies between Europe and Japan have pushed EURJPY to a 15-year-high. Considering the BoJ is likely to normalize monetary policy toward September 2023, while the ECB would likely be done with rate hikes by then, we expect EURJPY to top out and roll over in the coming months. As yield differentials reverse and investors look for deep value, we expect EURJPY to trend lower again. Our forecast points to EURJPY around 146 by year-end, and we favor selling the upside risk in EURJPY for yield pickup.
Yield pickup in EURNOK
EURNOK is showing signs of a top at pandemic highs. A hawkish Norges bank supports our narrative that NOK weaknesses has reached uncomfortable levels for policymakers. Moreover, as current low energy prices translate into lower FX purchases by the Norges Bank, we expect this key krone headwind to ease as well. Combining these factors and an attractive volatility backdrop in EURNOK, we recommend selling the upside risks in EURNOK above 12 over the next 1–3 months.
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