Output gaps have closed/are closing
If equity markets embody some sense of confidence in the global economy, then this year’s stellar returns suggest policymakers have achieved their goals in preventing the Covid-19 pandemic from turning into a multi-year recession. G10 economies are bouncing back and concerns about the strength of the recovery are shifting towards unease over the path of inflation.
Output gaps – or how economies are growing compared to potential – can provide some sense on whether central bankers can take their time in normalising loose monetary policy or need to act faster in response to the inflation threat. While output gaps are notoriously hard to forecast, the IMF believes 2022 will see positive gaps in the US (+3.3%) and Canada (+0.8%). In theory, the Fed and the Bank of Canada should be at the front of the queue when it comes to tightening.
Both the Euro area and Japan have seen negative output gaps since 2008 and probably again in 2022 – justifying the more entrenched dovish positions of those central banks.
Though it seems a very much consensus view, we do favour dollar strength during the Fed lift-off – and largely against those currencies which will be more tolerant of higher inflation. This should mean the EUR, JPY and CHF will be the stand-out under-performers in 2022, while the SEK may lag too.
We do not think a stronger dollar against the low-yielders needs to upset the risk environment yet. After all, it is probably best to characterise the global economy as being in mid-cycle right now – growing confidence in the recovery, inflation picking up and central banks starting up tightening cycles. That should mean most commodity currencies can continue to perform well as their economies realise, through stronger business investment, the benefits of recent terms of trade gains.
GBP probably falls between the three stools of the: i) stronger dollar, ii) weaker low yielders and iii) steady commodity currencies. We think GBP can hold onto its 2021 gains unlike a market generally more pessimistic on the pound.
One final point. We do like to drop anchor on some kind of medium-term fair value for currencies against the dollar, using our Behavioural Equilibrium Exchange Rate (BEER) model. Recent terms of trade changes have depressed EUR/USD fair value to around 1.10. That is our year-end 2022 forecast which is well below the consensus of 1.18. Of the under-valued currencies in our BEER model, we would favour NOK and NZD playing catch-up. We are bearish on the JPY in 2022 and whilst the AUD may benefit from being undervalued and over-sold, positioning for recovery here remains a high-risk proposition.
Please see all our regular currency sections below.
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