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Outlook for 2022: Currencies

Where does the interest-rate advantage lead to?

The prospect of higher interest rates in the future strengthened the US dollar this year, but lots of advance praise is already priced into the greenback today. In order for the dollar to climb higher, the US Federal Reserve now has to deliver on rate hikes.

 

From the lower left to the upper right – whoever studies the US dollar index chart for 2021 will see a continually rising greenback. Inversely, the trajectory of the euro against the US dollar – the world’s most traded currency pair – descended continually from 1.23 at the start of January to intermittently below 1.13. Anyone looking for the cause of those currency movements ultimately ends up at the keywords “inflation” and “interest rates.” Unlike in recent prior years, those were the pivotal drivers on the world currency market in 2021. Inflation this year surged much higher than expected in all industrialized countries (except Japan). But while core inflation and inflation expectations in the Eurozone just barely reached the European Central Bank’s 2% target despite the surge, the US Federal Reserve had to contend with a massive overshooting of its target inflation rate. Voices among Fed officials that had characterized the elevated inflation as being only “temporary” thus grew ever quieter since summer if not before while calls for an end to the glut of money grew louder. Finally, in November, Fed Chairman Jerome Powell announced an imminent start to overdue tapering. Securities purchases by the Fed will be reduced to zero by mid-2022. Judging by current market expectations, one can then expect to see a rapid series of interest-rate hikes afterwards. Meanwhile, various ECB officials in recent weeks have repeatedly stressed that the (inflation) situation in the Eurozone is different than in the USA. The vast majority of analysts therefore don’t expect ECB officials to implement an initial rate hike until 2024 at the earliest.

It’s precisely this widening monetary policy divergence that has strengthened the US dollar and weakened the euro in recent months. But what’s next for the currency pair? We wouldn’t simply project a linear continuation of this year’s trend because, on one hand, the market’s expectations appear to be a bit overhawkish with regard to Fed rate hikes. And on the other hand, although the lofty inflation in the USA and the resulting interest-rate speculation have a buoyant effect on the US dollar in the near term, over the longer-term the currency’s “fair” value is falling. In fact, the greenback now is actually on the expensive side against the euro from the perspective of purchasing power parity. Furthermore, speculators on futures markets have already substantially dialed back their heavily pro-euro positions and are now positioned neutrally, which constrains the euro’s further downside potential from a sentiment standpoint. Against this backdrop, the psychologically important 1.10 mark could act as both a magnet and a springboard (to a rally) for the EUR/USD exchange rate in the first half of 2022. The absolute worst case would be a drop to the 1.04–1.06 level, which consistently has been a solid support zone over the last seven years and is likely to hold up once more. In any case, the euro’s potential for surprises next year lies on the upside. A very dovish Fed and/or a much stronger-than-anticipated rebound in Eurozone economic activity from the current slowdown in growth would trigger an unexpected strengthening of the single currency.

 

One-way street
The greenback continually appreciated in 2021

EUR/USD exchange rate

Sources: Bloomberg, Kaiser Partner Privatbank

 

The British pound and the Canadian dollar also ranked among the stronger currencies in 2021. That’s hardly surprising since the prospect of a more restrictive monetary policy had an uplifting impact on them as well. The Bank of England and the Bank of Canada look set to tighten the interest-rate screw even before the Fed does. So, their respective currencies will arguably tend to strengthen in the near future. The same, in the end, also goes for the Swiss franc, at least against its main reference currency, the euro – and all without any interest-rate speculation because in recent weeks it has become increasingly evident that the Swiss National Bank is no longer fighting against CHF appreciation as vehemently as in earlier episodes. This easing off was long overdue because the “fair” value of the EUR/CHF exchange rate has continually fallen further in recent years. We no longer consider the franc overvalued (nor, apparently, do most Swiss entrepreneurs). So, based on the fundamentals, a rendezvous with parity in the next two to three years wouldn’t be unjustified, but it would nonetheless be a pretty astonishing surprise, likely one that hardly anyone is bargaining on at the moment.

 

Oliver Hackel, CFA Senior Investment Strategist

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