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Currency Market Analysis

May 19, 2022 | Currency Market Analysis

Global Themes

  • Stocks suffer sharpest fall since pandemic
  • What’s to like about sterling?
  • EUR/USD slips back under $1.05

EUR

Eurozone stagflation risks are a major concern as inflation in the Eurozone is at 7.4% , revised a tick lower from 7.5%, but still near record highs, whilst growth forecasts have been downgraded. The risk of EUR/USD sliding to parity this year is still on the cards.

Even if stagflation is avoided, global recession risks are growing, driven by new emerging macro shocks from China and the war in Ukraine this year and this should fuel further dollar demand. Despite the ever-increasing hawkishness of European Central Bank policymakers signalling an end to negative rates this year, the euro’s potential to fall to 1.0 against the dollar was highlighted by a recent survey of more than 400 FX traders in which a majority (60%) of the respondents think EUR/USD will fall to parity for the first time in nearly two decades.

GBP/EUR is about 1% lower year-to-date but has only traded in a 5% range in 2022 compared to the 13% range witnessed in GBP/USD. A substantially weaker euro will likely limit the downside potential for GBP/EUR. 

GBP

Not a lot. Sterling’s valuation is the subject of many debates in the currency market. Is it over or undervalued at its current $1.23 level against the US dollar? The circa 9% sell off this year and the fact it’s 12% below its 10-year average suggests there’s more room for upside than downside, but as it stands, the UK currency just doesn’t have much going for it at the moment and a further depreciation cannot be ruled out.

Selling the British pound is a common strategy in volatile markets awash with risk aversion. Since the Brexit vote in June 2016, it has often traded like an emerging market currency in that respect. The pound is not emerging market currency of course, but it has the weakest outlook amongst the major currencies. UK recession risks are higher compared to other G7 nations. Inflation is at 9% - a 40-year high – and showing no signs of peaking. Real wages are at their lowest since 2013 and consumer morale is worse than during the 2008 financial crisis and the height of the Covid pandemic. The Bank of England has shown reluctance to raise interest as fast as markets first thought. Money markets now expect only 120 basis points of cumulative rate hikes by the end of the year compared to the Fed's nearly two full percentage points.

Volatility is clouding near-term direction and GBP/USD may indeed test $1.25, even $1.26, but a deeper drop to and below $1.20 remains a significant possibility especially given a few unique factors also weighing on sterling. For example, Brexit uncertainty and the risk of a trade war with the EU. 

USD

After a cheerful Tuesday came a woeful Wednesday for global risk sentiment. Investors dumped stocks and riskier currencies amidst a raft of lacklustre corporate earnings reports. The US benchmark S&P 500 sunk 4% - its sharpest fall since June 2020, whilst GBP/USD surrendered nearly all its 1.4% gains from Tuesday.

Market sentiment continues to flip flop, but the overriding mood is pessimistic about future economic growth. US retailer, Target, warned high inflation is weighing on margins and consumer spending as its stock plunged 25% - the most since Black Monday in 1987. Monetary tightening has largely been driving stocks lower of late, but this next phase of weak global economic growth is becoming more evident, prompting the extended flight from risky assets like equities into safe havens like government bonds, the US dollar and the Japanese yen.

Asian shares followed suit overnight, with Hong Kong’s Hang Seng index falling 3.6%. There are signs of stability this morning across European and US equity markets, but realistically the market turmoil is far from over and further volatility should be anticipated as central banks battle inflation whilst recession fears mount.


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