Hannah Baldwin, CME Group
AT A GLANCE
- Central bank activity, ESG practices and emerging markets are among the macro themes that could impact the FX market this year
- Inflation and the Fed’s response will continue to remain in focus in 2023
As we move further into 2023, yet continue to reflect on 2022, it is clear last year was not for the fainthearted when it came to market-moving events.There was an easing of pandemic restrictions globally (mostly), but the world was hit by Russia’s invasion of Ukraine, climbing inflation, increasing repercussions of climate change, central bank activity, and the looming threat of recession. Looking at the year ahead, what key market themes should we consider, both in terms of how they might influence the macro economy and additionally impact the FX market?
1. Inflation – Living with it?
Inflation was arguably one of the biggest challenges faced in 2022. Although it doesn’t look to be going away in the early part of 2023, it does seem likely to slow as the year goes on. Commodity prices, such as oil and gas, have fallen, as inventories of all sorts of goods are beginning to build up again, which are often substantial indicators that price pressures could fall. High inflation left a lot of major currencies on the back foot against the U.S. dollar. Going forward, it will be important to watch how positioning in the U.S. dollar holds up and whether conditions are in place for a major dollar downtrend. It may be the case that FX markets continue to react to levels of inflation but could be distinguished less by trend and more by volatility in 2023.
2. Central Bank Activity – What next?
The December 2022 meetings by three of the most major central banks concluded a year of chasing inflation across developed economies. The Federal Reserve, Bank of England, and the European Central Bank all aggressively hiked rates throughout the year, but the lower inflation readings in November allowed them to step down the 75bps hikes to 50bps hikes. (And on Feb. 1, 2023, the Fed raised rates at its lowest level – 25bps – since the previous March.) Watching what these policymakers do next is likely to be key in 2023. The Bank of England has estimated that the UK economy has already entered a protracted recession, which is expected to continue until the end of 2023. The eurozone also entered recession territory at the end of 2022, and persistent risks in the euro area complicate what the ECB will do in 2023.
3. ESG Practices – Increasing in FX?
COP27 restated the United Nations’ global commitment to tackling climate change, particularly in the face of the current energy crisis. However, global emissions remain at record highs, and the world is on track to warm more than the 2 degrees Celsius (35.6 degrees Fahrenheit) target with increasing potential for climate damage. Although still an unfamiliar concept to many, the popularity of FX hedging strategies linked to sustainability targets is increasing. The general mechanism works like sustainability-linked bonds; the costs of these derivatives are tied to a company’s ESG goals. ESG-linked hedging programs allow companies to showcase their sustainability journey. For FX trading, smooth execution is critical, and “best execution” prescribed under the MiFID II regulation is a continued area of focus. It particularly points to the G (or governance) of ESG, with trading desks ensuring they are trading with counterparties that have strong ESG practices in place. The FX Global Code (GFXC) has also shifted focus for the buy-side to pivot into ESG-related trading practices, with a focus on currencies of countries with high ESG investment, such as Sweden.
4. FX Market Shifts – Changing behavior?
The 2022 Triennial Survey, which the Bank for International Settlements published in October 2022, showed that overall trading volumes in OTC FX markets was up from $6.6 trillion three years ago to $7.5 trillion per day as of April 2022. The FX market also saw a large shift toward listed products, such as FX futures in 2021 and 2022, noticeably via the CME Group Central Limit Order Book, and looks set to continue into 2023 and beyond. Firms faced the UMR Phase 6 AANA calculations and the increasing impact of SA-CCR on bank capital calculations. There were also records set on CME Group’s FX Link platform (the only cleared electronic marketplace for FX swaps), where volumes increased 90% year-over-year. Regulatory-related reasons are not the only ones behind the increased use of these products; it’s also because they often offer tighter pricing, transparency in the marketplace, credit efficiencies, and flexibility in execution.
5. Emerging Markets – More vulnerable in 2023?
The Russia-Ukraine war, energy crisis, reopening of China’s economy, trade wars and supply chains are all areas to keep an eye on in 2023. It’s likely that the market will remain very sensitive to COVID-19 developments in China where the worst of zero COVID-19 restrictions are hopefully over. The challenges and complexities involved in the reopening are ones to watch. Concerns persist about the political, geographic and regulatory associations after the cabinet reshuffle by President Xi at the end of 2022. Emerging market currencies could potentially become more vulnerable in 2023, on the backs of lower-yielding currencies like the euro becoming more insulated once the central banks begin to pause hikes at some point.
Entering a new year always brings an abundance of uncertainties. For 2023, that includes questions around geopolitics, economic policies, recessions, the climate crisis, central bank activity, and volatility. Each of these issues can impact the FX market, and paying close attention to them throughout the year will be especially beneficial for risk management.