Inflation and the future of the G10 FX space

The key driver of financial markets this week was economic data. Benign inflation in the US and the UK sent bonds surging (and yields falling), stocks had a stellar week, the S&P 500 is up more than 3% so far this week. On Tuesday, the dollar had its biggest daily loss of the year so far, and the dollar index is down 1.66% so far this week and is lower by nearly 2% on the month. Interest rate differentials have been key to currency movements so far this year, and with the prospect of the major central banks cutting interest rates, the future direction of FX in the G10 space could get interesting in the coming weeks. The euro has been a big winner from the dollar’s demise, and is higher by 2% this week, the yen is also up by 0.5%, but are these moves sustainable in the long term?  

Inflation pulse firmly to the downside

Last week was all about Treasury auctions driving the bond market and having a ripple effect across other asset classes, but this week the focus is on economic data. The two lower than expected inflation reports for the UK and the US along with a higher claimant count rate in the UK and lower US retail sales for October has unleashed animal spirits in financial markets, with stocks receiving a major boost and the dollar on a dive lower. We have mentioned before our concern about the market becoming too reliant on single monthly data points as they can be extremely volatile. However, while we think that a future upside surprise in inflation could knock the current risk rally on its head, there is no denying that the trend for inflation in the West is lower. In the US, super core inflation continues to trend lower, led by housing. The high cost of car loans is also weighing on car purchases and there are signs that rental costs in the US could fall further in the coming months. The Fed looks closely at super core inflation trends, so this data supports lower Treasury yields and a weaker dollar in the medium term. The UK had been a major outlier when it comes to inflation, but with headline prices now at a 2-year low, even the UK is looking like it has returned to the pack with other G7 economies. The UK’s headline inflation rate is now 4.6%, this compares with a 4.5% annual rate in France and a 3.2% rate in the US. The UK and the US also reported lower than expected core inflation for October, with a notable drop-in service price inflation, which is one of the reasons price growth has remained elevated in 2023. In Italy, inflation has fallen below the ECB’s target rate of 2%, and it is now 1.7% on an annualised basis. With momentum on the downside, and no sign yet that an energy crisis will hit western economies this winter, this central bank remaining on hold and investors are looking ahead to interest rate cuts.

Why the euro, GBP and the yen may not benefit from a weakening dollar

In the US, the market has increased its expectation of a rate cut from the Federal Reserve to as early as March, there is now a 35% chance of a rate cut to 5-5.25%, up from a 12% chance a week ago. The interest rate futures market is now expecting the Bank of England to cut rates in June 2024, although analysts at Goldman Sachs expect interest rates to fall from February next year. This is a shift from last month, when higher than expected inflation for September pushed out expectations of Bank of England rate cuts to 2025. Where the market thinks interest rates will go next are a key driver of the FX market. With the US economy likely to weaken this quarter, after an extremely strong rate of growth in Q3, and falling price pressure then we believe the key FX story for 2023 will be a weaker dollar, but where will the challenge to the dollar come from? Upside in the euro and the pound could be limited if the BOE and the ECB start cutting interest rates at the same time as the Fed, and there is a chance they start to cut rates before the Fed due to their economies weakening at a faster pace than the US. The outlook for the yen will be fully dependent on what the Bank of Japan does next. While the BOJ has dangled the prospect of ending yield curve control and raising interest rates at times during 2023, they have yet to pull the trigger and instead stress that they need to follow a cautious path in the future, which is why USD/JPY remains above 150.00 at the time of writing.

Where G10 FX goes next

The outlook for USD/JPY is unclear at this stage. We believe that the BOJ will have to raise interest rates in the first half of next year, and they are likely to do so in a cautious manner and signal their intentions to the market. Once this signal comes, we could see a mass purchase of the yen, sending USD/JPY back down to the 140.00 level, and helping Japanese stocks to surge. If the Fed does cut interest rates in the first half of 2024, then a bullish steepening of the US yield curve, when short term rates fall and longer-term rates rise, can favour commodity currencies like the Scandi currencies, the Aussie dollar, and the Kiwi dollar. These currencies can benefit from a reflation trade triggered by the steepening of the US yield curve. The Aussie and Kiwi dollars could also benefit from a brighter economic outlook for China from next year. As mentioned, the EUR, GBP and yen could all rise if the dollar embarks on a prolonged downtrend, but they may lag the commodity currencies in the medium term and their upside could be limited due to deteriorating interest rate differentials.

As we move to the end of the year, the focus will be on how quickly the major economies can get back to 2% inflation. Bar any outside shocks to the commodity market, the US is projected to see inflation return to the Fed’s target by mid-2024, which is just in time for next November’s US Presidential election!