Production gaps have been closed / are being closed

If the stock markets embody a certain sense of confidence in the global economy, then this year’s stellar returns suggest policymakers have met their goals in preventing the Covid-19 pandemic from turning into a multi-year recession. The G10 economies are rebounding and concerns about the strength of the recovery turn to unease about the path of inflation.

Output gaps – or the growth of economies relative to potential – may give some idea of ​​whether central bankers can take their time to normalize loose monetary policy or need to act faster in response to the inflationary threat. While output gaps are notoriously difficult to predict, the IMF estimates that 2022 will see positive gaps in the United States (+ 3.3%) and Canada (+ 0.8%). In theory, the Fed and the Bank of Canada should be leading the way when it comes to tightening.

Fed and Bank of Canada should lead the way when it comes to tightening

Both the Eurozone and Japan have experienced negative output spreads since 2008 and likely again in 2022, justifying the more accommodating positions of these central banks.

While this seems like a very consensus view, we favor the strength of the dollar during the Fed’s take-off – and largely against currencies that will be more tolerant of higher inflation. This should mean that the EUR, JPY and CHF will be the worst performers in 2022, while the SEK could also lag behind.

We do not believe that a stronger dollar relative to low yielding countries should further upset the risk environment. After all, it’s probably best to characterize the global economy as being in the mid-cycle right now – growing confidence in the recovery, resuming inflation, and central banks entering tightening cycles. This should mean that most commodity-linked currencies can continue to perform well as their economies realize, through larger trade investments, the benefits of recent terms-of-trade gains.

The British pound probably sits between the following three stools: i) a stronger dollar, ii) weaker low-yielding currencies, and iii) stable commodity currencies. We believe the British Pound can hold onto its 2021 gains unlike a generally more pessimistic market in the British Pound.

One last point. We like to anchor on some sort of medium-term fair value for currencies against the dollar, using our behavioral equilibrium exchange rate (BEER) model. Recent changes in the terms of trade have lowered the fair value of EUR / USD to around 1.10. This is our end-of-year 2022 forecast, which is well below the consensus of 1.18. Among the currencies undervalued in our BEER model, we favor the catching up of the NOK and the NZD. We are bearish on the JPY in 2022 and while the AUD may benefit from being undervalued and oversold, positioning for the recovery remains a high risk proposition here.

Please see all of our Common Currencies sections below.