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Currency Volatility: Will US Dollar Strength Last?

After the U.S. dollar surged to record highs in 2022, J.P. Morgan Research examines the greenback’s outlook for 2023. What will a strong dollar mean for currency markets around the world?

December 23, 2022

2022 was a historic year. The U.S. dollar strengthened against nearly every other major currency to levels not seen in decades, as the Federal Reserve (Fed) aggressively hiked interest rates in a bid to combat inflation. On the whole, the nominal broad dollar index — which is used to measure the value of the dollar against a basket of currencies widely used in international trade — appreciated over 12% in 2022.

In response, central banks and governments around the world conducted rate hikes and foreign exchange interventions to increase the value of their own currencies relative to the dollar. Against this backdrop of heightened forex volatility, what’s the outlook for the U.S. dollar, British pound, euro and Japanese yen in 2023?

The 2023 Outlook for Major Currency Pairs

Source: J.P. Morgan

GBP/USD is forecast to fall to 1.14 in March 2023 and to 1.08 in September 2023, holding at 1.08 in December 2023. EUR/USD is predicted to plunge to 0.95 in March 2023, before rising to 1.00 in September 2023 and holding at 1.00 in December 2023. USD/JPY is expected to hit 140 in March 2023, before strengthening to 133 in December 2023.

Has the US Dollar Peaked?

Probably not just yet. Heading into 2023, the baseline outlook still calls for dollar strength, but of a lower magnitude and different composition than in 2022.

After a year of aggressive hiking and with another increase due in January 2023, the Fed will likely hold its policy rate and monitor the economy to see the full effect of its tightening so far. This pause should give the dollar’s rise a breather. Additionally, unlike in 2022, lower-yielding currencies like the euro are expected to be more insulated as central banks pause hikes and the focus shifts to addressing slowing growth — but this in turn makes high-beta, emerging market currencies more vulnerable.

“Ultimately, a Fed pause is not a sufficient condition for dollar weakness. USD performance around the last four Fed pauses was not consistent and depended on the macro context at the time,” said Meera Chandan, Global FX Strategist at J.P. Morgan. For instance, when inflation was rampant in the 1970s, the dollar weakened in the months prior to the Fed pause and then strengthened again when inflation persisted. “What’s more, U.S. recession risks are high, and this is USD-supportive,” added Chandan.

The dollar already yields more than 56% of currencies globally —
and the Fed isn’t done hiking yet

Source: J.P. Morgan

While the dollar’s carry prospects have fluctuated over the past two decades, it now yields more than 56% of currencies in the global universe as of 2022.

Weak growth outside the U.S. will also remain a pillar of USD strength in 2023. “Some growth signals suggest an improvement outside the U.S., but we are skeptical of the longevity of this theme,” said Chandan. In the Euro area, the primary vulnerability remains energy dependence. For China, the hope is that 2023 will be a year of normalization as the country finally moves away from zero-Covid and as pragmatic policy support fosters some stabilization in the bruised real estate sector — but the road ahead is challenging.

In addition, the carry trade landscape will continue to favor the dollar. Simply put, a carry trade involves borrowing a low-yield currency to buy a higher-yield currency in order to profit from the difference in interest rates. In 2022, the Fed’s aggressive stance dramatically transformed USD’s carry status, with 56% of global currencies now yielding less than the dollar — and the Fed has not yet finished its hiking cycle. This offers investors an incentive to own dollars in 2023, particularly versus low-yielding, high-beta currencies.

Overall, while there are several possible pushbacks to USD strength from outside the U.S. — including negative growth surprises, the policy response to Europe’s energy crisis and currency interventions — the outlook for the dollar remains bullish into 2023. “We forecast a relatively modest 2% strengthening of the broad dollar index from current levels,” said Chandan.

Will the Euro Keep Falling?

In 2022, the euro weakened as much as 17% versus the dollar intra-year, plunging below parity for the first time in two decades in July. This was largely due to the dollar’s historic rise and the ongoing Russia-Ukraine conflict, which will continue undermining the euro’s prospects in 2023.

“Our outlook for 2023 envisions ongoing malaise rather than recovery, with the euro/dollar pair expected to languish in the mid-0.90s in the first half of the year,” said Chandan. The primary vulnerability remains energy dependence — while Title Transfer Facility (TTF) gas prices, the key benchmark for gas prices in Europe, have declined about two-thirds from their peak, the eventual depletion of gas supplies will remain a pressing issue beyond winter. Additionally, poor carry is likely to weigh on the euro, with policy rates in euro versus the dollar set to worsen further. What’s more, a recession in the U.S. would have a spillover effect on the rest of the world, including Europe.

“Overall, the Fed pause is not a sufficient condition for a rebound in the euro relative to the dollar. Our bearish outlook is motivated by the persistence of energy dependence vulnerabilities on the other side of winter, a weakening global growth picture and highly negative carry versus USD,” noted Chandan. As such, J.P. Morgan Research expects euro/dollar to approach 0.95 in March 2023, before rising to 1.00 in September 2023.

“The biggest game-changer for the euro would be a de-escalation with Russia. If realized, this could be worth at least 6-7% in euro strength against the dollar, perhaps even 9-10% as it could enable the European Central Bank to hike further,” added Chandan.

What’s the Outlook for the British Pound?

Similar to other major currencies against the U.S. dollar, the sterling is being battered, tumbling to record lows in September 2022 after the Truss administration announced a series of tax cuts. While a new prime minister has since taken over, J.P. Morgan Research remains bearish on the pound.

“2022 was a dismal year for the U.K. and the sterling, and we do not expect much relief next year. Post-Brexit adjustments in areas such as trade relations and labor supply will continue to exacerbate U.K. stagflation, while the fiscal crisis will leave a lasting impact on growth,” said Patrick Locke, Global FX Strategist at J.P. Morgan.

The U.K. government aims to tighten public finances by £55 billion (around $65.9 billion) by 2027/2028, which raises uncertainty about the country’s prospects and poses cyclical headwinds for the sterling. “All this is in the context of exceptionally high tax burdens and still-elevated mortgage rates, which altogether paint a bleak medium-term outlook for the U.K.,” added Locke.

Looking ahead, J.P. Morgan Research projects broad underperformance for the pound in 2023. “We are underweight on the British pound and look for cable to break back below 1.10 next year, reaching 1.08 in September 2023,” said Locke.

What About Japanese Yen Weakness?

The dollar/yen pair breached 150 in October 2022, marking a 32-year low. This was largely due to Japan’s yawning trade deficit and the Bank of Japan’s (BoJ) dovish stance. While the Japanese yen is closing out 2022 almost 18% down versus the dollar, J.P. Morgan Research expects it to inflect stronger in 2023.

“The expectation for a decline in long-end U.S. yields and a peaking out in terminal rate expectations into 2023, alongside a U.S. recession, should clear the runway for a lower repricing of the dollar/yen pair in 2023,” said Benjamin Shatil, Head of Japan FX Research at J.P. Morgan. In addition, the BoJ shocked markets in December by relaxing its yield curve control (YCC) policy of pinning yields close to zero. The central bank announced it would allow 10-year Japanese yields to climb as high as 0.5 percent, compared with 0.25 percent previously, in order to achieve a 2% inflation target. The yen strengthened against the dollar after the news, breaching the long-term fair value level of around 130. J.P. Morgan Research expects the dollar/yen pair to reach 133 by December 2023.

Throughout 2022, the BoJ staged several yen-buying interventions in an attempt to defend its currency — and there could be a renewed spate of official purchase operations in 2023 to combat any idiosyncratic weakening in the yen. “In the near term, the lingering threat of intervention should keep the price action relatively bounded to the upside — assuming, of course, that U.S. yields do not again lurch higher,” said Shatil.

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