Fixed Income Outlook  |  Q2 2022

Currency views

Putnam Investments

Currency views

Dollar move hinges on growth and risk sentiment

The Ukraine conflict has taken center stage in global markets, with rising energy prices further bifurcating the reactions from global central banks. The Fed made a hawkish pivot in December, but the war seems to have had very limited impact on the Fed's expected actions in the coming months. Since the March FOMC meeting, hawkish commentary has picked up, making rate hikes of 50 basis points (bps) very likely in May and June. Room for more hawkish expectations relative to the market has declined and is much more symmetric, as the market now prices in a policy mistake with rate hikes this year, followed by rate cuts less than two years from now. From here, the performance of the dollar will depend on prospects for global growth and risk appetite, where there are considerable risks for investor sentiment, as well as idiosyncratic stories driven by the reaction functions from other central banks.

A neutral exposure to the euro

The ECB continued its gradual move in a more hawkish direction, with significant division among the hawks and the doves given the current inflation profile and the ongoing Russia-Ukraine conflict. At its March meeting, the ECB said it plans to end bond buying under its asset purchase program in the third quarter. It further stated rate hikes would be gradual and take place sometime after the end of quantitative easing. If sanctions on oil and gas are avoided, there will be upside risks to the euro. Still, if sanctions are enacted and energy prices surge higher, the single currency could move significantly lower. As such, it is recommended that euro exposure be kept neutral.

Rate hikes and balance sheet normalization likely to lift pound

In terms of the BoE rate hike in March, there were no calls from the nine Monetary Policy Committee members for a 50-basis-point hike, and one member voted to keep rates on hold. In the short term, the Russia-Ukraine War continues to temper any expectations of 50-bp rate hikes. We still expect the BoE to increase interest rates a few more times over the coming months. If the central bank follows its previous guidance, a hike in May would also coincide with the start of active selling of securities and balance sheet normalization. This should be supportive of the currency, especially relative to the euro over the next few months.

Japan yen's valuation likely to be a headwind

The Bank of Japan (BoJ) continues to diverge from other global central banks. Inflation is viewed to be a one-off, wages will remain weak, and overall, a weak yen is considered a positive. These ideas allow the BoJ and Governor Kuroda to suggest it's too early to even discuss an end to ultra-easy monetary policy. So, in the near term, the dollar-yen pair will be driven primarily by external factors. As the Fed starts its rate-hiking cycle, the cost of purchasing longer-dated hedges of U.S. assets has risen. Hedge ratios are likely being adjusted, putting downward pressure on the yen. The yen has broken the range to the weak side. From here, prospects of higher rates to counter inflation by global central banks will likely keep the yen weaker, but valuation is likely to be more of a headwind. The currency will likely stabilize when the Fed's hawkishness has peaked and when the BoJ pivots from its ultra-easy stance.

More from Fixed Income Outlook

The first quarter was a challenging time for global financial markets.