Currencies in a Rising Rate Environment

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Michael Sager

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Michael Sager, Executive Director of Multi-Asset and Currency at CIBC Asset Management

Inflation has definitely been entrenched at a higher rate than previously expected by markets throughout 2022. This has led to more central bank tightening. And that tightening process is expected to continue for a number of months yet, across many regions of the world. Higher inflation and higher interest rates have definitely impacted the outlook for global currencies.

The main beneficiary has been the U.S. dollar. The U.S. dollar started 2022 relatively strong, but also relatively overvalued versus long term valuation metrics. However, in the context of a relatively aggressive Federal Reserve and heightened market uncertainty and stress, these are typically conditions that are supportive of the U.S. dollar. And that’s what we’ve seen so far in 2022 and we are likely to see for the next few months on balance yet. So the U.S. dollar has certainly been a primary beneficiary of the outlook for inflation and interest rates that we’re currently seeing.

In terms of other top picks for the currency markets, I think we have to look at currencies of countries with relatively attractive long term fundamentals. That means good growth prospects. It means relatively low debt levels at a country level, things like that, countries which are not significantly positively correlated to a slowing global economy. So currencies that come top to mind include the Mexican peso, very attractive interest rate carry, very attractive valuations and improving fundamentals. The Indian rupee also falls into that bucket. And we tend to express these long fundamentally attractive currency positions against short, in currencies that are much more procyclical. Currencies like the Canadian dollar, currencies like the New Zealand dollar, that rise when the global economy is strong and tend to depreciate when it’s weaker. So those would be some of the currency ideas that we’re currently looking to exploit in portfolios.

Which currencies are riskier? At the moment, we really think that currencies in core Europe are looking quite vulnerable to further weakness. Across the global economy, it’s clear that growth is slowing and that the risk of a recession is relatively elevated, but that risk is particularly prominent in Europe, partly as a result of the energy crisis, partly because central banks like the European Central Bank and the Bank of England are being particularly aggressive in tightening interest rate policy. So the risk of recession in core Europe looked particularly acute and that’s a negative for currencies like the Euro, like the Pound, like the Swedish krona. So those currencies that we particularly think will be challenged over the next several months.