FX Weekly: Experiencing 2008 – Like Economic Conditions Minus Lehman Crisis

Discover the striking similarities between the current economic climate and the tumultuous year of 2008, while exploring how this time around we can navigate the challenges without the catastrophic Lehman Brothers collapse. Gain valuable insights into the present financial landscape and learn how to prepare yourself for potential market fluctuations.

The current foreign exchange (FX) market environment exhibits certain resemblances to the period preceding the Lehman Brothers collapse in September 2008. During that time, concerns regarding the US economic outlook and banking sector, coupled with the political impasse surrounding the debt ceiling in the US Congress, manifested as a weakening of the US dollar (USD) across various currencies. Notably, the 'divergence FX trade' reached its pinnacle on July 3, 2008, when the European Central Bank (ECB) raised interest rates in stark contrast to the recent rate cuts by the Federal Reserve (Fed), resulting in the EUR/USD pair reaching an all-time high shortly after. Nevertheless, the USD sell-off proved to be short-lived, as the currency regained strength following the resolution of the US debt ceiling on July 30, 2008, fuelled by increasing market risk aversion and growing fears of a global recession.

There are several notable distinctions between the current financial landscape and the year 2008. Primarily, I anticipate a more hawkish policy stance from the Federal Reserve (Fed) owing to the persistence of inflationary pressures in the United States, the resilience observed in labour markets, and less severe issues plaguing the US banking sector. Furthermore, it is my expectation that the US debt ceiling issue will be effectively resolved. This prognosis aligns with recent communication from the Fed and may find further validation through the release of last Friday's Non-Farm Payrolls (NFP) data and this week's Consumer Price Index (CPI) data.

However, it is important to note that the prospects of the US dollar (USD) may not witness a significant consolidation unless there is a sustained alleviation of apprehensions surrounding regional banks in the United States. Moreover, persistent concerns regarding the potential economic ramifications of the ongoing debt ceiling impasse within the US Congress may further diminish the attractiveness of USD-denominated assets in the immediate term. Consequently, the USD is expected to remain under pressure, particularly when compared to safe-haven currencies within the G10 like the Swiss franc (CHF) and the Euro (EUR), both of which are supported by hawkish central bank policies. Additionally, the Japanese yen (JPY) stands to benefit from the unwinding of short positions within the foreign exchange (FX) market.

In the upcoming week, market attention will be directed towards the May meeting of the Bank of England (BoE) and the release of the latest UK Gross Domestic Product (GDP) data. Economists specializing in the UK anticipate a 25-basis point (bp) interest rate increase by the BoE's Monetary Policy Committee (MPC). However, it is expected that the central bank will maintain a cautious approach regarding future monetary tightening, despite persistent inflationary pressures and recent improvements in UK economic indicators. Consequently, it is my belief that the UK rates markets have once again become overly optimistic, pricing in overly aggressive BoE tightening in the coming months. A re-evaluation of these market expectations could pose additional challenges for the British pound (GBP), thus limiting its potential for near-term gains.

Five-Day Performance (vs USD)

Source: Prime Market Terminal

US rate expectations driven by the outlook for US banks.

Source: Bloomberg, CIB

FX and Gold outlook

While I acknowledge that the recent gains in EUR/USD have been exaggerated and may experience a near-term correction, I maintain a predominantly positive outlook for the currency pair, expecting it to regain further ground over the next 6-12 months. Several factors contribute to this optimistic stance. Firstly, I anticipate continued repatriation flows from USD to EUR driven by higher yields on European Government Bonds (EGB) and limited sovereign credit risks. Additionally, stable global energy prices and the reopening of the Chinese economy are expected to mitigate the deterioration of Eurozone external imbalances. However, it is important to note the negative impact of the Eurozone energy crisis, which remains a significant drag on the region's outlook. The anticipated energy demand in the Eurozone prior to the next winter could lead to fresh spikes in gas and oil prices in the latter half of 2023 (H2 2023), undermining international competitiveness and external imbalances. Consequently, these factors are likely to contribute to renewed weakness in EUR/USD in 2024.

The USD is expected to face downward pressure in the next three to six months due to factors such as the Federal Reserve nearing the end of its tightening cycle, the possibility of a US recession, and concerns surrounding the US debt ceiling. This underperformance is anticipated to be more pronounced against safe-haven currencies like the Japanese yen (JPY), Swiss franc (CHF), Euro (EUR), and Gold. However, the USD may hold its ground against commodity and risk-correlated currencies given the prevailing market uncertainty. Looking ahead, the USD could reach a bottom in early 2024, benefiting from improving financial conditions, economic recovery in the US, and more favourable asset valuations. Conversely, the European G10 currencies and energy importers like the JPY may face challenges due to the persistent energy crisis.

Despite Japan's inflation surpassing the Bank of Japan's (BoJ) target, the combination of sluggish wage growth and a deceleration in global economic growth will hinder the central bank from implementing further adjustments to its Yield Curve Control (YCC) policy in the next year. However, as the Federal Reserve's tightening cycle begins to impact the US economy and potentially leads to a recession, short-term yields in the US are expected to compress closer to short-term Japanese Government Bond (JGB) yields. This compression, coupled with a greater inversion of the US Treasury (UST) yield curve, will contribute to a narrower spread between 2-year and 10-year yields, resulting in a weaker USD/JPY exchange rate.

Furthermore, China's gradual reopening throughout the upcoming year will provide a boost to Japan's economy, enhance its current account balance, and consequently strengthen the Japanese yen (JPY).

The recent outperformance of the GBP is in stark contrast to its position as the weakest G10 currency based on my FX scorecard analysis. I remain of the opinion that FX investors will continue to perceive the GBP as a valuable hedge against both risk aversion and stagflation. However, I have doubts regarding the currency's ability to achieve further recovery without the support of real UK rates and yields. Additionally, I express concerns that the negative aspects associated with the UK's economic slowdown will be exacerbated by the fresh fiscal austerity measures implemented by the Sunak government. Furthermore, the deteriorating external imbalances of the UK, coupled with concerns that the Bank of England (BoE) is falling behind the curve, could prove detrimental to the GBP in the upcoming months. Consequently, I maintain a cautious stance on the GBP for the next three to six months and anticipate a potential recovery only in late 2023.

Given the anticipation of potentially challenging times ahead for the global markets and economy, the demand for the CHF is expected to persist as it retains its status as a safe-haven currency. Despite the recent banking reforms in Switzerland, the CHF's appeal as a safe-haven asset remains intact, while domestic fundamentals continue to demonstrate strength. Notably, the Swiss National Bank (SNB) is regarded as one of the most hawkish central banks among the G10 nations, maintaining a firm control over the CHF to prevent any unwarranted weakness.

Throughout the current year, the CAD has exhibited a behaviour closely aligned with that of the USD, rather than reflecting its usual status as a commodity-related currency. In the absence of any significant deterioration in the global landscape, the CAD has the potential to perform favourably. This is due to the Bank of Canada (BoC) not likely maintaining a distinct position for an extended period, coupled with the possibility of substantial short positions being unwound.

The reopening of China's economy is expected to have a positive impact on the Australian dollar (AUD), albeit with a modest economic recovery that is driven primarily by consumption rather than investment. As a result, there will be a moderate boost to prices of metallurgical coal and iron ore, which are key commodities for Australia. Additionally, the AUD will continue to benefit from elevated energy prices stemming from the conflict in Ukraine, as well as increased demand from China for air travel and electricity.

In terms of monetary policy, the Reserve Bank of Australia (RBA) is projected to pursue less aggressive interest rate hikes compared to the Federal Reserve (Fed), Bank of Canada (BoC), and Reserve Bank of New Zealand (RBNZ). This is because Australia does not face a wage-price spiral, which acts as a constraint on the AUD's appreciation.

The Reserve Bank of New Zealand (RBNZ) is currently implementing an assertive tightening cycle, with the expectation that its Official Cash Rate (OCR) will reach the highest level among the G10 countries. However, this trajectory coincides with the occurrence of a cyclone and flood, which is anticipated to result in a recession. Therefore, the upside potential of the New Zealand dollar (NZD) will be constrained despite the combined factors of a weaker USD and China's reopening.

While China's reopening is set to bolster New Zealand's agricultural exports, the NZD's terms of trade will be curtailed by persistent firm energy prices. On a positive note, the return of Chinese tourists to New Zealand's shores is projected to provide an additional boost to the economy in 2023.

The anticipated depreciation of the USD throughout 2023 is likely to contribute to a resurgence in the appeal of Gold, particularly if there is continued support from central bank purchases on a structural level. Gold (XAU) is expected to regain its position as an attractive hedge against inflation and risk aversion, outperforming G10 currencies that continue to grapple with negative real rates and yields.

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