Currency Quarterly Q2 2023 | Insight Investment

Despite surprisingly resilient economic data in Q2, it is increasingly clear that tighter monetary policy is having an impact, and in our view further economic weakness lies ahead. This sets a complex backdrop for global currency markets as US exceptionalism fades, but amidst an environment of broader global economic weakness.

As the world returns to a more normal backdrop for interest rates, we have witnessed a re-emergence of the Momentum and Carry factors as drivers of currency returns. This suggests that the US dollar (USD) may remain expensive for a while yet. However, this is an environment in which idiosyncratic factors could be an important driver of return dispersion. Two currencies are particularly notable in this regard. In the UK, interest rates could reach a level where they shift from being supportive for the British pound (GBP) to a negative. In Japan, and more broadly in Asia, the strength of the US dollar is becoming problematic, and could lead to some pushback from the region’s central banks.

In our educational topic this quarter, we look at the medium-term outlook for inflation. Although we agree that there is significant downward momentum to inflation in the short term, the medium-term picture is less clear. If central banks cut too early, they risk the medium-term outlook and raise the probability that inflation remains stubbornly sticky above central bank targets.

The Alpha view

In our view, a combination of alternative risk premia and macro fundamentals are the key drivers of currencies over short-to-medium-term time horizons. That said, for the moment, we would caution against taking aggressive positions based on macroeconomic fundamentals given the notable crosscurrents. Indeed, we continue to view 2023 as favouring an environment for more tactical and quantitative trading than in 2022. A more definitive turn lower in US core inflation could change this. For the moment, the bulk of our recommended currency exposure for medium-term investors stem from our Alt Risk Premia model. As can be seen in Figure 1, we still hold a long USD bias along with more modest longs in the euro (EUR), GBP, and New Zealand dollar (NZD). Against that, we are short low-yielding currencies such as the Swiss franc (CHF) and Japanese yen (JPY).

Figure 1: Insight Currency Absolute Return Exposure

Source: Insight. Data as at 3rd July 2023. Note: Black dot shows aggregate position.

Longer-term valuation overview

As the investment horizon extends to a multi-year window, valuations are likely to dominate the price action in currency markets. The highlights from our long-term valuation model are:

• The USD remains overvalued, but not against all crosses;
• JPY, EUR, and Swedish Krona (SEK) look very cheap by historical standards;
• Australian dollar (AUD) and NZD look only very moderately cheap;
• GBP, Canadian dollar (CAD), and CHF do not look cheap.

Figure 2: Local currency overvaluation (+) and undervaluation (-) versus USD

Source: Insight. Data as at 30 June 2023.