FX Talking: No margin for error

One of the most important market developments over the last month has been the Bank of England intervening in the UK Gilt market on grounds of financial stability. That Gilts and sterling had to fall so far on UK fiscal concerns owed in part to the restrictive Federal Reserve conditions and the strong dollar. The hawkish Fed will increase pressure in the system still further into year-end – a move that will undoubtedly punish any poor policy choices.

The Fed’s relentless and most aggressive tightening cycle since the early 1980s is starting to create a few casualties. Though the wounds in UK asset markets were self-inflicted, the occasion did show that the tighter liquidity conditions being created by the Fed are leaving no margin for error. There are still few signs of any ‘pivot’ in Fed policy coming through this year and we do not see that until 1Q23 at the earliest.

As the Fed tightens into a recession and yield curves invert further, expect the dollar to stay bid. We could easily see further gains of 5-7% across the board. With the eurozone likely entering three quarters of negative growth, dollar strength can probably see EUR/USD building a new 0.90-0.95 trading range. Again, we would say the euro is not especially undervalued – having been damaged by the negative terms of trade adjustment.

In Europe, heightened scrutiny on policy choices can see GBP/USD nearing parity later this year. The high beta Scandinavian currencies also look vulnerable as do some of those in Central and Eastern Europe (including the Polish zloty) where hiking cycles have been curtailed. In Asia, we think USD/CNY can rally further to 7.40, taking most of the region with it. And the commodity-centric Latam currencies also remain vulnerable as investors shun Emerging Market asset markets.