FX Viewpoint: Various Landing Scenarios & the USD

Key takeaways

• Debate over landing scenarios (hard, soft, no) continues; which one is realized will determine the USD's direction this year.
• I see 2 of the 3 scenarios (hard and no landing) as constructive for the USD, posing upside risks to my USD forecasts.
• A soft landing should see the USD's depreciation trend resume, as policy rates decline amid constructive risk appetite.How will we land?

Challenging inflation and growth dynamics point to rising policy uncertainty as the global monetary tightening cycle matures. As the data has evolved, so too has the debate over which landing scenario will ultimately come to fruition later this year: “hard landing,” “soft landing,” or “no landing.” Each one presents notably distinct economic conditions, with differing implications for the dollar. I see two of these three scenarios as constructive for the dollar, posing upside risks to my USD forecasts.

Soft landing: Does not bode well for the USD

In essence, a "soft landing" refers to a gradual decrease in inflation that aligns with the existing monetary tightening in the system. This approach would aim to avoid a broad recession. Although payroll growth may decrease, it would still maintain a positive trajectory, and a wage-price spiral is unlikely to occur. In such a scenario, the USD would likely continue its decline observed in Q4 2022 and January 2023.

Hard landing: USD to be supported as risk assets decline

When discussing the concept of a "hard landing," it generally refers to the occurrence of a recession, which may even be severe in nature. In such a scenario, inflation could either decline alongside economic activity, or remain stubbornly high due to structural or supply-related factors. The precise economic conditions at the time, as well as the Federal Reserve's response to the situation, will be crucial in determining the severity and duration of the recession. Nevertheless, it is likely that the USD would find support during heightened market volatility and risk aversion.

No landing: Here but for how long?

US data releases in February have been clear – the labour market is still tight, and disinflation is not a straight line. Fed expectations have re-priced higher, and the USD has rallied accordingly. While this “no landing” scenario likely implies either a hard or soft landing down the road, the longer it persists, the better the dollar should do.

Various landing scenarios and the USD

As I analyse the current economic landscape, it's clear that the USD has taken a sharp turn at the start of the year. The influx of positive US data has created uncertainty around which path of inflation and growth will manifest and how the Federal Reserve will react.

The challenging inflation and growth dynamics have led to increased policy uncertainty, especially as the global monetary tightening cycle matures. As the data has evolved, so too has the debate over which landing scenario will eventually come to fruition later this year. I've observed that these scenarios can generally be grouped into three categories: A) "hard landing," B) "soft landing," and C) the emerging "no landing" scenario. Each of these scenarios presents unique economic conditions, which would have different implications for the USD.

Although market consensus and my own forecasts predict that the USD will depreciate later this year and next, the current economic landscape suggests there could be more upside risks to our forecasts heading into the second half of 2023. This is because two out of the three landing scenarios would likely be beneficial for the USD.

How we got here

I've been analyzing the reasons behind the USD's decline from its cyclical highs in the fall of 2022, and they seem to be reasonable. Passing peak inflation in the US, combined with China reopening and improved economic and energy prospects in Europe, have significantly reduced the risk premium that supported the USD in 2022. Global energy prices have also fallen, and supply chains have thawed. Furthermore, volatility in financial markets across FX, rates, and equities has declined. However, as we move further into 2023, these factors will likely have less impact on price action in currency markets, especially as new risks emerge.

One of the most significant factors influencing the USD has been the evolution of inflation and the accompanying assessment and impact of Fed policy. Passing peak inflation led to a market narrative shift from the Fed "pivoting" to a smaller magnitude of hikes, to "pivoting" to a potentially lower terminal rate, to "pivoting" to expected rate cuts in the second half of 2023. As the magnitude of Fed hikes declined from 75 to 50 to 25 basis point increments, so did the USD.

The USD hit a recent low after the February Federal Open Market Committee (FOMC) press conference, during which markets focused on Chair Powell's lack of pushback on market pricing, his recognition of deflationary forces, and his step back from rigid "higher-for-longer" forward guidance. However, since that time, top-tier US data surprises have reminded the market that passing peak inflation does not necessarily lead to a straight-line move to the 2% target. As a result, both pricing and the USD have adjusted higher accordingly.

A closer look at the landing scenarios

As noted, the three broad scenarios of “hard,” “soft,” or “no” landing pose different paths for the dollar. While stopping short of taking on the fool’s errand of prescribing hard probabilities to each one, looking at them in turn can nonetheless be helpful in framing possible outcomes for the dollar later in the year. The following table (FIG 1) summarizes the general characterization of these scenarios and their possible implications for the Fed, risk assets, and the dollar.

FIG 1: “Soft,” “hard,” and “no landing

Hard and no landing should be constructive for the USD

 A soft landing:

Bodes well for risk assets, not so much the USD

In the current economic environment, a soft landing scenario would likely be the most favourable for risk assets but less favourable for the dollar, as gradual disinflation occurs in conjunction with existing monetary tightening, preventing a widespread recession. Although payroll growth may decrease, it will still remain positive and prevent any wage-price spiral. This scenario was initially the consensus among market participants at the beginning of the year, before the recent surge in US data. During this time, equities rose by around 9%, Treasury yields remained within a narrow range, and the dollar (as measured by DXY) dropped to cyclical lows.

BBG’s “Goldilocks” story count & USD

Dollar depreciates amid January soft-landing narrative

 S&P 500 & 2Y USTSteady rates and rising equities in Q4 2022 and early 2023

 Assumes steady disinflation…

If a true soft landing scenario were to materialize, the expected inflation trend would be downwards towards the 2-3% range by the end of this year. Using the current market-implied Fed Funds effective rate for the December 2023 FOMC meeting date, which is at 5.27%, would produce a real effective Fed Funds rate of around 2-3%. However, some may argue that this rate is still restrictive, given that the Fed views the long-run nominal Fed Funds rate at 2.5%, suggesting a real neutral rate of 0.5%. The market's expectation of a soft landing was one of the reasons for the decline in the dollar since October, and the market was also pricing in rate cuts from the terminal rate in H2 2023. However, as shown in Exhibit 5, these cuts have been pushed further out, and terminal rate has repriced higher, indicating a reduced expectation for steady disinflation.

CPI & DXYSteady inflation decline likely to correspond with dollar depreciation

 Fed Funds futures curveRapid Fed cuts from terminal priced to start the year; gradually pushed out since

…And low but non-recessionary growth

A soft landing is seen as the most constructive outcome for risk assets, while being least constructive for the US dollar. The realization of a true soft landing would correspond with inflation trending down towards the 2-3% range by the end of 2023. From a growth perspective, soft landing scenarios continue to be reflected in economic forecasts for many G10 countries, with greater proximity to China being a notable factor, for example Australia, Japan, New Zealand). However, unemployment forecasts are mixed, with the US standing out as having a higher forecasted rate in 2024 than the current reading. Overall, a soft landing scenario is likely supportive for the US dollar due to its inverse relationship with risk.

Consensus growth projectionsModest but positive growth projections for most countries in 2023 & 2024

 Current unemployment versus consensus projections

US unemployment expected to rise in 2024

 Risks to a soft landing are… a hard landing, of course

One way that a soft landing can turn into a hard one is through the financial conditions virtual circle, as I have learned. Fed officials have emphasized the importance of monitoring financial conditions as overly loose conditions, such as strong equities, easy credit, and a weak dollar, can lead to inflationary pressure. While Chair Powell has acknowledged the net tightening in financial conditions over the past year to curb inflation, the recent trend of looser conditions may indicate an even tighter policy stance as inflation expectations rise, all else being equal. I have observed that market-based measures of inflation expectations remain relatively stable, but implied rates based on US inflation swaps have been increasing recently, which can be attributed to unexpected positive US data. The minutes from the February FOMC meeting also suggest that some participants recognized the easing of financial conditions in recent months, which could necessitate a tighter monetary policy stance.

US financial conditions

Financial conditions starting to ease, following notable tightening over past

 CPI & inflation swap pricing Market-implied inflation expectations contained yet creeping higher

 A hard landing:

Could see differing inflation paths…

If we experience a hard landing, there are a couple of potential outcomes for inflation. In one scenario, the Fed follows through with its stated guidance and hikes rates in line with market expectations. This would result in a concurrent downturn in inflation and aggregate demand. Monthly payrolls would trend downwards and growth data would reflect further contraction. Deeper rate cuts would be needed in this environment, but they may not be enough to offset cuts in other countries or widespread risk aversion, which could partially weigh on the dollar.

In the second scenario, which is even more concerning, inflation remains stubbornly high due to structural or supply-side factors. This would pose significant policy challenges for central banks. To bring inflation down, the Fed would need to maintain restrictive interest rates, which could be even higher than what is currently priced in. This would likely result in a more concerted effort to balance the labor market, potentially leading to an even deeper recession.

…As growth contracts

I believe that global Purchasing Manager Index (PMI) data suggests that we may be facing some recessionary forces. The manufacturing PMIs for all G10 economies, except Canada and New Zealand, indicate contractionary conditions with a downward trend over the past six months However, services PMIs suggest expansion in each economy, except Australia and the UK. This presents a difficult tradeoff for central banks as tighter monetary policy responses to inflation in the services sector could further tighten manufacturing activity, all else being equal.

When we look at a broader set of economic indicators, the view supports this perspective. Leading indicators have turned negative for the first time since COVID. Historically, this has led to negative QoQ GDP 90% of the time, along with a clear dollar uptrend over the ensuing 12-month horizon.

G10 Manufacturing PMIs PMI Manufacturing readings sub-50 and trending lower in most G10 economies

 G10 Services PMIPMI Services readings above 50 in most G10 economies

 With the USD supported regardless

Indeed, irrespective of the inflation path, flight to safety and liquidity would be a sizable tailwind for the dollar on net, despite the potential for a drop in interest rates. This assumes that such a state of the US would be felt similarly, if not more severely elsewhere (i.e., no “decoupling”). As forecasts for future US unemployment have risen, so too has the dollar. Policy uncertainty and presumable financial market volatility would clearly correspond to dollar strength.

DXY & US Unemployment Forecasts As unemployment forecasts rise, so too does the dollar

 DXY and MOVE Index

Policy uncertainty, as measured by rate volatility, benefits the dollar

 Hard landing could bring back “Fed put” and/or further fiscal support

If a hard landing scenario were to occur, the Fed would likely respond by cutting rates significantly in an effort to steer the economy towards a soft-landing outcome. However, the more significant risk factors in this scenario would likely be more long term and structural in nature. Depending on the state of inflation, the credibility of the Fed (and other central banks) could be called into question if they are seen as choosing to set policy more in line with the "Fed put." To preserve inflation-fighting credibility, relatively tighter policy would be necessary, potentially risking an even deeper recession down the road. Additionally, a hard landing could lead to more fiscal stimulus on top of what is already viewed as a relatively loose stance, which could be detrimental to the dollar, all else equal.

No landing:

Here but for how long?

I'll give it a shot:

I've noticed that there is a scenario that's been gaining a lot of attention lately, which some are calling the "no landing" scenario. This is mainly due to recent signs of economic resilience in the US, where inflation stays high or declines only slightly, and employment and activity data remain strong despite more aggressive Fed policy. However, the term "no landing" can be somewhat misleading compared to the "soft" and "hard" landing scenarios, as it refers to the journey rather than the destination. I believe it's only a matter of time before inflation is forced lower or a policy-induced recession occurs, or possibly both.

While headline and core inflation have declined somewhat, they have been uneven and stubbornly persistent. Going from, say, 6% to 4% is easier than going from 4% to 2%, particularly when energy prices have already fallen significantly, and the impulse from thawing supply chains has already occurred. Dallas Fed President Logan recently remarked that "supply chains can't recover twice, so I don't see 3 percent deflation in core goods as sustainable." We've also been noticing sticky services inflation, which is persisting despite some indications of topping out in the Atlanta Fed series. Year-ahead expectations, which are a key watchpoint for the Fed, have not de-anchored but are still well above 2%, according to both the Federal Reserve Bank of New York and University of Michigan surveys.

Headline CPI & sticky inflation Inflation has peaked but remains sticky

 Inflation expectationsInflation expectations are not unanchored but still above 2%

 Has been dollar supportive

As for the dollar, its recent (albeit nascent) appreciation could be viewed through the “no landing” lens, with equities and credit losing momentum but not collapsing, as higher terminal and less short-end curve inversion support the dollar.Indeed, as US data surprises have both materialized and surpassed those of other G10 economies, interest rates have adjusted accordingly, with the DXY-weighted 1y1y overnight index swap (OIS) rate differentials rising back to levels last observed in December 2022 This suggests some two-way risk for the USD in this scenario, partly as “data dependence” can impact markets in either direction, partly as “no landing” can keep some investors in a “risk-on” mentality.

Economic surprises & the DXY

 Dollar supported by recent US growth outperformance

 Interest rate differentials & the DXYDollar rising with rate differentials

 I am aware that there are inherent risks to the “no landing” scenario. Eventually, a soft or hard landing is likely to occur. According to few economists, is expected a recession to begin in mid-2023. While I have recently revised my Fed terminal rate call upward by 25 basis points to a target range of 5.50-5.75%, I expect the “no landing” scenario to continue until H1, before transitioning to a “hard landing” in H2.

Looking ahead

Real rate support should continue

As I contemplate the potential scenarios above and how global policymakers might react, I see a potentially narrowing path towards dollar depreciation and hence upside risks. In my opinion, currencies should do well where monetary policy is seen as committed to staying the course on inflation fighting. If current and projected policy stances are any indication, I can make some inferences about where the market sees vulnerabilities. In this regard, Fed credibility does not appear to be in question at present. Within the G-10, Fed policy is among the tightest relative to current inflation readings. Consensus projections for both monetary policy and inflation imply expectations for the US and Canada to be the only economies with positive real policy rates in 2023 and 2024, and the Fed to be the highest this year.

In my view, shorting the dollar (versus G-10) is a negative carry proposition and risks exposure to risk-off moves. Also, it would be likely be associated with an investment thesis predicated on other central banks (CBs) bringing real policy rates notably closer in line with the Fed, amid challenging economic conditions. Absent clear signs on which landing we will get, the choppiness that we have seen thus far in the currency markets is likely to continue, and upside dollar risks should persist.

G10 real effective policy rates Real fed funds among tightest in G10; still negative

 2023 & 2024 real policy rate forecastsForecasts imply positive real Fed Funds in 2023 & 2024

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