Fixed Income Outlook  |  Q4 2022

Currency views

Fixed Income team

Currency views

Dollar outlook is data dependent

The Federal Reserve raised short-term interest rates by 75 basis points for the third meeting in a row in September and coupled the move with resolutely hawkish language and forecasts. The Fed will remain highly data dependent and the pace of hikes will only slow once it has seen considerable progress in core inflation coming down and tightness in the labor market starting to dissipate. The U.S. dollar direction remains reliant on inflation and labor market data as well as safe-haven flows driven by prospects for global growth and the global risk appetite. Considerable bad news is currently priced and positioned, so tactical squeezes in U.S. dollar longs are highly probable.

Euro softens on weakness

The European Central Bank (ECB) made aggressive rate hikes in July and September. It also announced its transmission protection instrument (TPI) for bond markets would have unlimited size, but deploying it comes with a rather high hurdle. The implications and risks for energy prices, along with the consumption hit from the Russian invasion of Ukraine, are likely to keep the single currency soft. If these risks abate or signs emerge that they could, there will be considerable upside risks to the euro.

British pound steadies after collapse

The Bank of England (BoE) is set to see a level of inflation higher than many other G10 countries and seems ready to respond with more rate hikes. A recession in 2023 is almost inevitable — the question will be the depth. The fall of the Truss government after six weeks suggests a step back from expansionary fiscal policy. As such, it is likely that downside tail risk from fiscal policy is now much lower. This could keep the pound rangebound over the coming quarter as much damage has already been done and risks of more are hard to envision.

Japanese yen supported by intervention

The Ministry of Finance surprised the market by conducting FX market intervention operations while the Bank of Japan decided to keep its policies unchanged. In the near term, the dollar-yen pair will be driven primarily by external factors as global central banks lift short-term rates to counter rising inflation, increasing hedging costs for Japanese investors, and further adjustment of hedge ratios. This puts downward pressure on the yen in the short run, but with Ministry of Finance intervention a reality, the risk-reward of medium-term short yen positions is far less compelling. The currency is only likely to stabilize and begin strengthening when the Fed’s hawkishness has peaked, the BoJ pivots from its ultra-easy stance, or late-cycle dynamics come to fruition and recession risk becomes reality.

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Fixed income markets experienced widespread declines in the U.S. and globally in the third quarter of 2022, as inflation remained high and became more broad-based.