FX Talk - an Ebury podcast

In this episode, we discuss the recent banking turmoil, specifically the failure of SVB and its impact on the market. SVB's sensitivity to interest rate risk and its investment in long-duration bonds led to a significant mark-to-market hole in its balance sheet, causing depositors and investors to withdraw their funds en masse. This panic has contributed to the troubles faced by Credit Suisse, but we believe these failures are one-offs rather than systemic issues. While the market has stabilized, we must closely monitor the situation. In terms of central bank rate hikes, there is a delicate balancing act between banking uncertainty and inflation. Markets are only pricing in one more 25bp move from the Fed, but we believe the ECB and BoE still have room to go.

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Today's focus is on the major data that has reshaped expectations for central bank interest rates. Generally, we're observing two things: the activity data is holding up better than expected, and inflation is proving more persistent than hoped. As a consequence, markets are bracing for higher rates for a longer period.

Let's start with the US. We have seen a string of positive surprises in recent macroeconomic data. The latest reports on GDP, retail sales, non-farm payrolls, and inflation have all exceeded expectations in the past month. Even the latest services PMI from the Institute for Supply Management beat consensus and was comfortably above 50. Initial jobless claims and new claims for unemployment benefits have fallen again, with no significant uptick in layoffs, despite ongoing recession concerns.

What does this mean for the markets? Investors have gone from pricing in one to two additional Fed hikes to now expecting three to four. Even FOMC Chair Powell has opened up the possibility of a 50bp return in March.

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Since the last episode, the markets have experienced a relatively quiet period, with most major currencies trading within narrow ranges. There were, however, some exceptions in Scandinavia, where certain currencies rallied sharply. For instance, the Swedish krona jumped following a hawkish announcement from Riksbank. On the other end of the scale, the euro underperformed and was the only G10 currency that failed to rally against the US dollar.

That being said, there has been a noticeable increase in volatility around this week's main event, the US inflation report for January, which is due to be released on Tuesday. 

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The current trading environment is marked by volatility and choppiness, with most currencies trading within tight ranges throughout January. This can be attributed to a combination of the absence of major news events and anticipation surrounding announcements from central banks such as the Fed, ECB, and BoE.

Starting with the Fed, their latest move was in line with expectations - a smaller 25bp hike was announced on Wednesday, following a 50bp hike in December. This move was heavily telegraphed and already priced in, with no updated projections or dot plot released. The focus was instead on the Fed's communications.

The Fed's statement remained largely unchanged, and speculation surrounding a tweak to the language regarding "ongoing rate increases" proved to be unfounded. Powell's comments were considered dovish, with a focus on the Fed's "no desire to overtighten" and acknowledgement that a "disinflationary process" had begun in the US.

The market reaction was swift, with a selling of the USD across the board. The USD Index saw a drop of nearly 1% on Wednesday, and the EUR/USD broke above the $1.10 level for the first time since April. However, the dollar has since recovered sharply and we will discuss the reasons for this shortly.

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At the moment, the key theme in currencies is an improvement in risk sentiment and an appreciation in high-risk currencies, at the expense of lower-risk ones, such as the US dollar. The USD index has hit a June 2022 low and has fallen more than 10% since October, as the Federal Reserve slows its hiking cycle and global recession fears abate. Among the better performers, currencies closely linked to China have been doing well. In the G10, the Australian dollar has been doing particularly well. Among emerging market currencies, some Asian currencies, notably the Thai baht, have seen a strong performance. The Brazilian real and Chilean peso in Latin America, which rely heavily on China's demand, are also outperforming. Later in this podcast, we will delve into China's reopening and examine the winners and losers of that development.

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What can we expect this year? The narrative in 2022 was much about central bank responses to rising inflation rates. Will that remain the case this year? Or will these central banks begin calling time on their tightening cycles. And what about the global economy? Are recession indeed on the way? Or will we just see modest downturns in growth? 

In summary: what are the main themes to look out for in currencies in 2023? Our Market Analysts will tell you everything about it. 

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China finally signs of an easing in its zero-Covid policy. It boosted the CNY and risk currencies against the USD. We see an improvement in risk sentiment and also signs of a downtrend of US inflation. We also are noticing growing expectation among investors for a dovish pivot during the Fed meeting next week. 

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If you’re following financial markets at the moment, there really is very little chance to catch your breath. Since our last episode, the market sentiment has improved and investors dialed back expectations for US rate hikes, weighed significantly on the dollar. 

Meanwhile, the October US inflation report is much softer than expected. The big question is: What does that mean for the US dollar?

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According to the BoE, further increases in interest rates may be required to bring inflation back down to target, but the bank stated that the peak in rates would be '‘lower than priced into financial markets''.

On the UK economy, the BoE once again struck a sombre note. In its statement, the MPC spoke of a ‘very challenging’ outlook for the UK economy, mentioning the tightening in financial conditions since August. The committee also warned that the economy may already be in recession, and that this could last until the middle of 2024, which would be the longest recession since records began.

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Last time we spoke about the reaction in the pound to the budget and the potential impact of the tax cuts on the economy. Since then, we have seen one of the most dramatic U-turns in British political history. Most of the tax cuts (around 80%) that were announced have now been reversed. 

How have markets reacted? Sterling posted decent gains and UK bond yields have stabilized. Big question for us: What’s next for the pound? Is this U-turn a green light to a sterling rally, or do downside risks remain? 

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