By Hannah Baldwin, CME Group
AT A GLANCE
- As the Fed accelerates the end of its quantitative easing program – and looks to raise rates – all eyes will be on the FOMC for how these moves impact the FX market
- Regulation is likely to be a hot topic this year, as U.S. banks implement SA-CCR and the final Phase 6 of UMR
As we begin 2022, several influential macro themes will be impacting the FX market. The Fed lift-off should help the dollar, but not across the board. Historically in conditions like these, commodity currencies have performed well, but some more than others. Some local markets also look more interesting than others for a year of higher interest rates. If volatility continues to pick up and the pandemic continues to unfold, we’ll be watching six areas over the next year.
1) Central Bank Activity
The January FOMC minutes reiterated that Fed officials plan to accelerate the end of the quantitative easing program adopted at the onset of the pandemic. Further, several FOMC members have suggested that the Fed might begin raising rates as soon as March. How quickly the Fed moves might still depend on economic data over the next few months. European Central Bank President Christine Lagarde has made it clear that conditions to raise rates are very unlikely to be satisfied this year. She warned that the ECB must not rush into a premature tightening of monetary policy. Inflation is the one to watch, as Lagarde has argued that the drivers of these pricing pressures were likely to fade over the medium term, which is the horizon that matters for monetary policy.
On Dec. 16, 2021,the Bank of England surprised investors by raising rates after all, despite the most obvious change in the economic outlook being a worsening of the pandemic. The bank's monetary policy committee voted by a margin of eight to one to raise interest rates from 0.1% to 0.25%.
2) Increase in FX Volatility
Volatility rose slightly at the end of 2021 in the FX market as opposing positions have been taken on how aggressively central banks will tighten monetary policy in the face of surging inflation-exacerbated swings in global currencies. Though volatility is still low compared to historical levels, some investors believe the elevated levels of volatility are unlikely to subside anytime soon, making it a hot topic to watch in 2022 – could it be the year volatility returns to currency markets?
Source: JPMorgan FX volatility index, Bloomberg
3) Metals’ Correlation with Inflation
Gold and silver are typically negatively sensitive to changes in investor expectations regarding Fed rates. Most often, shifts in investor expectations toward tighter monetary policy put gold and silver prices under downward pressure. 2021 was no exception. As investors moved toward anticipating as many as seven or eight Fed rate hikes over the course of 2022 and 2023, gold and silver prices moved sideways despite U.S. inflation rates rising toward 7%. Now that expectations for Fed rate hikes are reflected in the forward curve, however, this might give precious metals further room on the upside should inflation continue to surprise on the high side or should the Fed tighten policy more slowly than investors currently anticipate.
A firmer dollar could make commodities more expensive for buyers using other currencies, and China’s role in the future of the metals market should not be underestimated. China is expected to continue to take around 45-55% of global consumption in base metals and continue to be the world's biggest refiner of metals, accounting for between 35% and 55% of total global production. There has been some evidence that China’s economy is slowing under the strain of high debt burdens and a possibly overextended real estate sector.
4) Market-Moving Political Events
The French presidential election in April and legislative elections in June might generate a choppy response from the euro. Macron’s impressive pandemic handling put him in a strong position for reelection; however, left-wing voters are irked by his business-friendly politics and the country’s highest inflation in a decade.
The U.S. midterm elections in November are also likely to generate significant market responses, in particular from the U.S. dollar. Tensions between Russia and Ukraine, as well as tension in the Middle East and in Asia, could also potentially impact markets, especially with a potential weakening for the ruble.
5) Local Markets
Slower growth in China and the Fed taper have contributed to a relatively downbeat outlook for emerging markets, but could the mood be set to change in 2022? Emerging markets are far better equipped to deal with the COVID-19 pandemic than they were a year ago. The threat of new variants presents an ongoing risk to be aware of, but the vast majority of local and emerging markets are on track to inoculate large proportions of their population in the coming months, and this highlights positivity with respect to ongoing recovery in economic activity. China stands out as a market to watch in 2022, where the reduced availability of credit was certainly felt during 2021. However, the yuan is likely to be supported by the sizeable current account surplus which could provide a sufficient buffer against any U.S. dollar strength. The downside risks for the yuan, however, will likely be led by rising regulatory uncertainty, a slowing growth outlook, and monetary policy divergence between the Fed and the People’s Bank of China.
Regulation is likely to be a hot topic for 2022 with a few changes on the horizon: the final Phase 6 of Uncleared Margin Rules (UMR) and standardized approach to counterparty credit risk (SA-CCR) implemented for U.S. banks being two of the main challenges. Of all the market participants, real money accounts may face the greatest challenges in the face of UMR. This could encourage increased use of listed FX futures, and the use of Exchange for Related Position (EFRP) and blocks will be a logical part of any growth trend, given their effective substitution for the OTC market. U.S. banks will also be intensifying their efforts to optimize FX swaps and forwards portfolios affected by the new capital regime for the standardized approach to counterparty credit risk (SA-CCR). The FX market in particular is highly affected by these two pieces of regulation, as well as the market embracing new last look guidance and TCA requirements under the FX Global Code.
Though we can depend on some events in 2022 – like the implementation of new regulation – there remain a number of unknowns around geopolitical risks, economic policies, the pandemic and more. However, the question is likely not will these issues affect the FX market, but rather how. We’ll certainly be paying close attention to each of these macro themes and their potential impacts as the year progresses.