Broadly speaking, investment banks have split into two camps.

One group expects peak US rates to lead to a weaker dollar.

According to HSBC: “The slowdown in the pace of rate rises and the recognition that the Fed is in the late stages of its tightening cycle are part of why we expect the dollar to weaken further in 2023.”

Another group believes that the deterioration in the global economy and the need for the Fed to tighten policy for a longer period of time will hurt the global economy and support the dollar, with the euro to dollar (EUR/USD) exchange rate falling to parity or lower.

According to ING: “Consensus sees the EUR/USD exchange rate near 1.10 at the end of 2023. We believe the exchange rate will be closer to parity in 2023 given the recession and energy concerns.”

Inflationary developments in the US are critical

Inflation trends in the US will be of paramount importance to market dynamics in 2023.

The last two inflation releases were below expectations, with the core rate falling to 7.1% from a peak of 9.1%.

The core rate also fell to 6.0% from a peak of 6.6%, with both core and core inflation retreating from 40-year highs.

A further decline in inflation in early 2023 would bolster confidence in the Federal Reserve’s ability to ease monetary policy.

According to GoldmanSachs, “Most importantly, a pair of lower inflation prints reinforced the assumption that the pace of Fed rate hikes is slowing, which tends to ease financial conditions and weaken the dollar.”

If confidence in lower inflation persists, the dollar will be vulnerable to further selling, but the picture will be markedly different if inflationary pressures prove more persistent than expected.

MUFG summarized the situation as, “We remain confident that the US dollar remains in a weakening trend, although there is now a heightened risk of a corrective rebound in the near term.”

The bank adds: “The higher dot plot makes the US rates market more sensitive to any inflation surprises early next year, even if the underlying inflation trend remains lower. A higher inflation reading could trigger a sharper rebound in the U.S. dollar and increased volatility in the FX market.”

GoldmanSachs notes that the dollar will only sell off if there is confidence in other major currencies, “Essentially, for the dollar to fall significantly would require an improvement in the growth environment for other key cross rates, and so far that has been the case. In our view, the euro has a ‘low ceiling’ as growth is constrained by a scarce supply of commodities.”

Time for the Fed’s monetary policy pivot

The Fed’s latest forecasts suggest there will be no rate cuts until 2024.

HSBC notes that this could be good news for the Fed: “Weakening global demand and easing supply concerns could lead to a faster-than-expected decline in inflation, reducing the need for restrictive monetary policy later in 2023.”

Conversely, tight labor market conditions could contribute to a sustained rise in services inflation, prompting the FOMC to pursue additional rate hikes.

TDSecurities expects the Fed will have to go further: “Given the continued high level of core service inflation and the strength of the labor market, we continue to believe that the Fed needs to raise rates through 2023 Q2 with a pause after the May meeting. The Fed has no choice but to remain in a tightening mode in the near term as the labor market has a long way to go before it turns the corner.”

The bank expects the FedFunds rate to peak at 5.25-5.50%.

 

Recession risks in the US and the world

At its December meeting, the Federal Reserve raised interest rates another 50 basis points to 4.50%. The ECB also announced a rate hike of 50 basis points to 2.50%.

Banks also warned that further rate hikes will be implemented in the short term to curb inflation.

MUFG commented, “The clear message from all central banks was that there is more work to be done in raising rates to contain upward inflation risks.”

ING expects the global economy to have a challenging year, and added: “Currency markets assume that central banks will be able to give an ‘all-clear’ signal on inflation and conduct soft easing cycles to ensure a soft landing in 2023. We suspect that reality will not be so favorable to financial markets. We support dollar strength in early 2023.”

DanskeBank takes a similar view: “It is important to note that a weaker US dollar, rising equities, narrowing credit spreads and lower real rates have led to a significant softening of global financial conditions. In our view, this will be a challenge in central banks’ fight against above-target inflation in 2023.”

TDSecurities added: “The amount of real tightening we expect is likely to push the economy into recession in the second half of 2023.”

ECB gets tough on inflation

Overall, the ECB’s dovish policy has prevailed since 2024, with inflation remaining below target and the bank trying to boost inflation with negative interest rates.

There was a sharp reversal in the second half of 2022, when a surge in inflation triggered a sharp tightening of policy.

At a press conference following the December interest rate decision, Bank President Lagarde delivered a decidedly hawkish rhetoric, warning that a series of more rate hikes would be needed to bring inflation under control.

In particular, the latest staff forecasts put inflation at 3.4% in 2024, well above the 2.0% target.

MUFG believes that markets will have to take the ECB’s message seriously. It notes that there is not much evidence that inflationary pressures in the eurozone are easing to the same extent as in the US.

The ECB also has an opportunity to catch up on rates, while the bank’s president Lagarde has spoken in a hawkish tone.

MUFG adds: “The ECB is now positioning itself as the most aggressive major central bank in terms of raising rates early next year. In itself, the reduced expectation of a divergence in monetary policy between the ECB and the Fed should further support the euro against the US dollar.”

Can the Eurozone economy sustain the strain?

ECB policy tightening will pose serious risks to the economy.

Banks point to the situation in 2011, when the bank’s policy tightening with a weakening economy contributed to the Eurozone debt crisis.

Credit Agricole notes the importance of growth as well as interest rates. Some investment banks have expressed fears that policy tightening will deepen the recession in the Eurozone.

According to the bank, “Overall, we believe that ECB tightening will continue to have a contradictory impact on the euro and could even weigh on EUR/USD if investor concerns about the negative impact of ECB policy on growth cause a further flattening of EGB curves in the coming weeks.”

Eurozone capital account should improve

HSBC is optimistic about capital flows in the Eurozone: “In the Eurozone, we have noted that the backdrop for portfolio inflows has changed quite significantly over the past few months.”

The bank added: “This increase in inflows has been driven by European investors rather than foreign domestic investment. Given the accumulation of around EUR5 trillion of foreign assets since 2010, there is significant potential for repatriation along with higher rates and the lack of ECB QE to ‘crowd out’ investment.”

Risk conditions will play a key role

The dollar will strengthen if equities weaken, while the euro will benefit if stock markets advance.

Regarding the euro, MUFG added: “The upside potential will be reduced if global stock markets continue to correct downwards in response to hawkish policies and increased fears of a hard landing for the global economy, which would generally support the US dollar.”

Nordea believes that the high probability of a stock market rally in the new year (which would support a weaker US dollar), as well as a rate differential that has shifted in the euro’s favor, means that there is a high probability that EURUSD will rise further above the current 1.06 level.

Nordea, however, expects the optimism to fade quickly, “we see equities to fall on the back of higher rates than markets currently expect”.

China abandons zero-covies policy

China’s policy will also have a big impact on euro exchange rates.

For most of 2022, China continued its zero-covidian policy and the economy remained under pressure as closures dampened activity.

However, there was a shift in the fourth quarter, with China adopting a more flexible policy.

At the end of the year, Beijing also announced that travel abroad would resume from January and strict quarantine rules for foreign tourists would be relaxed.

The relaxation in China will help support the eurozone through trade flows, and reduce the scope for defensive demand for the dollar if equity markets go ahead.

Danske Bank notes the importance of China. It notes: “On the positive side, China is likely to ease Covid restrictions during 2023, which would favor the eurozone economy and the euro.”

Goldman, however, is more cautious and also expects the RMB to struggle to advance: ‘Renminbi will also find it difficult to attract significant portfolio inflows given the still challenging process of reopening operations and less attractive yield advantages’.”

Socgen notes the seasonal element: “The pair has weakened every year in January, February and March since 2019.”

The bank adds: “Volatility in peripheral country bonds combined with the resilience of the US labor market could interrupt the upward trajectory.”

Unicredit expects volatility with no clear direction for most of 2023; “major central banks are likely to end tightening by 1Q23 and only start new easing cycles in early 2024, which we have factored into our scenario, implicitly creating a nine-month vacuum in which volatility is likely to dominate trends in major currencies.”

Scotiabank expects optimism to ultimately prevail, “Overall, we believe the dollar has room to strengthen and correct some of the weakness seen in Q4 as the New Year approaches, but short-term gains could still give way to medium-term weakness as markets await peak US inflation/peak Fed.”

Regarding the euro, MUFG added: “The upside potential will be weakened if global equity markets continue to correct downwards in response to hawkish policy and heightened fears of a hard landing for the global economy, which would support the US dollar as a whole.”

Nordea believes that the high probability of a stock market rally in the new year (which will contribute to a weaker US dollar), as well as a rate differential that has shifted in favor of the euro, means that there is a high probability that EURUSD will rise further above the current 1.06 level.

Nordea, however, expects the optimism to fade quickly: “we see equities to fall on the back of higher rates than markets currently expect”.