FX markets are starting to wake up from a sleepy period as central banks signal they are prepared to change interest rate policy. The phase of central bank convergence towards low interest rates since the start of the pandemic is over.
Monetary policymakers are, increasingly, less in tune with one another. Central banks, which have not had to assess the trade-offs between growth and inflation previously, now have to do so as rising inflation challenges the transitory inflation narrative. Measures of expected volatility in currency markets have started to edge back up to reflect a more divergent world.
Source: Bloomberg, Bank of Singapore
We believe the USD’s resilience should continue into 2022 as central bank policies diverge. Stronger growth and higher inflation in the US compared to the Euro area or Japan are likely to increase pressure on the Fed to take a gradual but divergent path towards eventual rate hikes.
Following higher-than-expected inflation in the October US CPI report, recent comments from FOMC participants suggest a lower bar for accelerating the pace of QE tapering. We expect further gentle USD strength against low yielders like the EUR, CHF and JPY through 2022, where the European Central Bank (ECB), Swiss National Bank (SNB) and the Bank of Japan (BoJ) have a much stronger case to keep policy loose.
President Biden will re-nominate Jerome Powell for Chair of the Federal Reserve and will nominate current Governor Lael Brainard for the Vice Chair seat. Both Powell and Brainard’s nominations signal continuity in Fed leadership and represent a likely more hawkish Fed than if Powell had been replaced.
The next FOMC meeting is on 15 December, while the next ECB meeting is on 16 December. Given how recent data and the Covid situation are evolving, it is possible that we see divergence in monetary policy trends between the Fed and the ECB in mid-December.
The more hawkish Fed should help the USD, but against some more than others. A few countries are tightening or set to tighten faster than the Fed. These countries include Canada, New Zealand, Norway and the United Kingdom. Currencies of these early hikers are likely to hold up better against the generally more robust USD.
We expect another 25bps rate hike in the policy rate by the Reserve Bank of New Zealand (RBNZ) this week, although there are clear risks of 50bps. We also would not rule out a hawkish shift in guidance by the RBNZ following recent inflation and activity data that could benefit the NZD.
The CAD and NOK are also commodity currencies that should continue to benefit from elevated energy prices into early 2022. With global economic recovery set to continue, compressed risk premiums in many parts of the financial markets need not upset the risk environment just yet. A still-benign risk environment in 2022 could continue to lend support to G10 commodity currencies. But G10 commodity currency gains are likely more limited given the backdrop of slowing growth outlook in China, as the shift toward common prosperity implies a tolerance for lower growth.
Stagflation concerns and Brexit uncertainties will likely limit scope for the GBP to rally strongly. But GBP policy error risk looks overdone. The UK's hiker status and long-term currency undervaluation should support the GBP in 2022.
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