2023 FX Market Preview: Every Country And Economic Area In The G10 Will Continue To Experience An Inflation Overshoot Through The End Of 2023

But what can we expect in the FX market in the next twelve months? Below, we outline our main calls for the coming year, providing an overview of the factors that we believe could have the most significant impact on currencies in 2023.

Inflation rates to ease from highs - for now

We have finally begun to see signs of an easing in price pressures in the past few months, suggesting that we may have seen the peak in inflation, at least in the short- and medium-term. Recent inflation prints have started to come in below both economists’ expectations, as represented by a sharp drop in Citigroups’s Inflation Surprise indices, and their respective peaks. This has been particularly evident in the US, where the CPI reports for both October and November came in well below projections.

Much of these softer inflation prints can be attributed to the recent drop in energy prices. Core inflation rates, which strip out volatile components such as food and energy, remain elevated and have not yet shown any real signs of trending downwards in most cases. This will be key for central bank policy in 2023.

Figure 1: Citigroup Inflation Surprise Indices (2012 - 2022)

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Source: Refinitiv Datastream Date: 04/01/2023

If peaks in inflation rates haven’t already materialised, we believe that these will emerge in early-2023, in large part due to the below:

1. Energy prices have fallen sharply, particularly natural gas. Since peaking in late-August EU natural gas prices have dropped by approximately 75%, while in the US prices have declined by around 50%. A complete cutoff in Russian energy supply to Europe remains a risk factor. Energy shortages and rationing, however, appear highly unlikely this winter in light of high gas storage (still above 80% in EU at the time of writing), an oversupply of liquefied natural gas and rather mild winter weather in Europe thus far.
2. Supply chains are improving. The main driver of the initial spike in prices in 2021 was the mismatch between the supply of goods and booming demand following the lifting of pandemic restrictions. These supply constraints have eased in recent months, and we believe will continue to do so in 2023. This is represented by a sharp drop in freight rates, which represent the cost of transporting goods from one place to another, an increase in port volumes and shorter shipping times.
3. Economic activity globally is softening, in part due to tighter monetary policy. While economic slowdowns and recessions are an unfortunate byproduct of higher interest rates, they may be a prerequisite to bring down rates of inflation in a sustainable manner. The IMF expects global growth to slow to 2.7% this year, from 3.2% in 2022, with growth in advanced economies projected to drop to a mere 1.1%, less than half the expected pace for 2022 (2.4%).
4. Inflation expectations have eased. For the most part, both the market’s and consumers' expectations for future inflation rates have either eased or stabilised in recent months. In the US, the two-, five- and ten-year breakeven inflation rates have all fallen to the 2.25-2.30% range, just above the Fed’s 2% target, from 4.9%, 3.6% and 2.9% respectively in March.

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We believe that a normalisation in inflationary pressures will likely be a gradual process, and the return to central bank targets remains some way off. According to the IMF’s most recent projections, every country and economic area in the G10, with the exception of Japan (-0.6%), will continue to experience an inflation overshoot through the end of 2023. In some instances, most notably the UK (+7.0%) and Sweden (+6.4%), this gap is expected to remain significant, though we believe that these estimates may soon be revised downwards. We suspect that China's reopening will be an important factor for inflation rates this year, as an increase in activity in the world's second-largest economy would likely present an upside risk to prices.

 

Written by: Enrique Diaz-Alvarez, Matthew Ryan (CFA), Roman Ziruk, Itsaso Apezteguia, Eduardo Moutinho, Michal Jozwiak – Ebury’s Market Analysts

Source: 2023 FX Market Preview: Is a global recession on the way? (ebury.com)