Capital IdeasTM
Investment insights from Capital Group
Currencies
Jens Søndergaard
A rapid shift in the outlook for the global economy — punctuated by soaring inflation, Europe’s deepening woes and increasing fears of a worldwide recession — is having an enormous impact on currency markets.
The US dollar has continued to climb higher, building on its impressive rally during the first half of the year. Both the euro and Japanese yen are trading at multi-decade lows, and the euro recently touched parity with the dollar with a 1-to-1 exchange rate for the first time since 2002.
With global foreign exchange markets changing rapidly, Capital Group currencies analyst Jens Søndergaard shares his outlook on a strong US dollar, a weak euro and a Japanese yen that appears to be running away from its reputation as a safe-haven asset.
What’s driving these recent moves?
Global growth is slowing faster than expected and the inflation picture is a lot worse. Central banks in both developed and developing markets are hiking interest rates aggressively, with the European Central Bank (ECB) surprising markets with its recent 50 basis point hike. Currencies are just reacting to the shift in relative macro fundamentals we are now seeing.
US dollar has outpaced currencies of major trading partners
.png)
As at 27 July 2022. All data indexed to 100 as at 30 December 2011. Source: Bloomberg
How much longer can the US dollar gain on other currencies?
I believe the dollar can continue its ascent for at least another six months. The dollar is rallying for good reasons. The US economy is stronger than that of other major economies, and the US Federal Reserve (Fed) is aggressively tightening to blunt the impact of inflationary pressures. In most other parts of the world, it’s a very different story. We have lacklustre growth, inflation that’s mostly driven by energy prices, severe compression of real wages and central banks that are being forced into what I could characterise as “bad” rate hikes.
It’s this contrast between the United States and the rest of the world that’s been driving these currency moves.
I expect the next six months will be very bumpy in terms of market volatility, mainly driven by recession fears. While the dollar is overvalued by various metrics I track, I don’t see a catalyst for a near-term drop. In a recession, the dollar has been the preferred safe haven for investors. So, I anticipate the dollar will stay strong until we see signs that global growth is stabilising, along with indications that inflation has peaked around the world.
US dollar remains overvalued
.png)
As at 26 July 2022. Note: Chart displays the percentage by which the US dollar’s trade-weighted nominal exchange rate is greater than or less than its trade-weighted nominal fair value. Trade-weighted nominal exchange rate and fair value are metrics designed to measure the strength of a country’s currency compared to other currencies weighted by the amount of trade that a country has with other countries. Sources: Capital Group, JPMorgan
What’s your outlook for the euro and the British pound?
My biggest conviction is a bearish view on the euro. The euro area needs a very cheap exchange rate to offset the macro headwinds from the Russia-Ukraine conflict. In my view, even with the euro and dollar close to parity, it’s not clear the euro is cheap enough.
The euro’s recent depreciation reflects concerns about the euro area macro-outlook. We’re seeing a cost-of-living crisis starting to show up in the data: consumer confidence is weakening and Europe’s manufacturing sector — an important growth engine — is slowing. This comes after a post-COVID-19 rebound for the eurozone that wasn’t as strong as in the US.
Euro area inflation hit a record high of 8.6% in June. There’s also the lingering risk that Europe won’t get the natural gas supplies it needs from Russia for the next heating season. That would raise the prospect of widespread rationing, which would likely shut down large parts of the European manufacturing sector, and is likely to hit Germany and Italy the hardest.
I am also bearish on the pound. The euro and the pound tend to move in tandem. The United Kingdom is also facing escalating living costs, and political uncertainty is heightened with the recent resignation of British Prime Minister Boris Johnson.
Risk factors you should consider before investing:
- This material is not intended to provide investment advice or be considered a personal recommendation.
- The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
- Past results are not a guide to future results.
- If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
- Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.
Our latest insights
RELATED INSIGHTS
Past results are not predictive of results in future periods. It is not possible to invest directly in an index, which is unmanaged. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.
Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.
Capital Group manages equity assets through three investment groups. These groups make investment and proxy voting decisions independently. Fixed income investment professionals provide fixed income research and investment management across the Capital organization; however, for securities with equity characteristics, they act solely on behalf of one of the three equity investment groups.