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FX volatility ahead as central banks walk tightrope

July 2022

The tightrope central banks are walking is starting to sway ominously. 

They are trying to pull off a soft landing, hiking interest rates to slow inflation without tipping their economies into recession. It’s a near impossible task, according to former US Treasury Secretary Larry Summers, who found that since 1955 in the US, there has never been a quarter with price inflation above 4% and unemployment below 5% that was not followed by a US recession within the next two years.1 

Six months ago, commentators were calling on US Federal Reserve Chairman Jerome Powell to stave off surging inflation with interest rate rises. Back then, he, and other central bank policymakers, asserted that inflation was a transitory phenomenon caused by COVID-19 lockdowns, and a release of pent up consumer demand. But inflation readings remained stubborn and with other factors like the war in Ukraine driving up food and fuel prices, central banks have had to jack up interest rates hard and fast to prevent prices from spiralling out of control.2

The 1.5% rise in US interest rates so far this year seems to be biting much harder than many had predicted, with the Atlanta branch of the US Federal Reserve forecasting a 2.1% drop in GDP for the second quarter. That would be on top of the 1.6% contraction in the first three months of 2022.

That’s a forecast, rather than official data, but if accurate it would meet one criteria for calling a recession – two consecutive quarters of negative growth. 

As seen in 2008, if the US does start to tip into a recession, it is likely that other countries may follow and effectively managing currency risk in this environment would be increasingly important.

Fears grow on the state of the global economy

In June, the World Bank issued its 176 page economic analysis — Global Economic Prospects. It made for ugly reading. The bank slashed its forecast for global growth from 5.7% in 2021 to 2.9% this year, the sharpest deceleration in a post-recession recovery in 80 years. And there wasn’t any sugar coating about the future in the report’s second paragraph;

“Amid the war in Ukraine, surging inflation, and rising interest rates, global economic growth is expected to slump in 2022. Several years of above-average inflation and below-average growth are now likely, with potentially destabilizing consequences for low- and middle-income economies. It’s a phenomenon—stagflation—that the world has not seen since the 1970s.”

There’s been no shortage of data supporting that thesis. Indicators in many nations are pointing in the wrong direction.


  • US consumer confidence fell in June for the second month in a row and the expectation index – that is confidence about the short-term future fell to its lowest level since 2013.3
  • US factory activity fell to a two-year low, with new orders dropping into contraction territory, while employment expectations in the sector also fell.4
  • Conversely, employment continues to gain, with 270,000 jobs likely created in June. That follows the record number of job openings in March, and while the pace of new jobs has slowed, the unemployment rate is a minuscule 3.6%. 

Inflation and interest rate concerns are clearly hitting the US economy, but with job vacancies so high, that means higher wages, which filters into higher inflation, which will require further tightening (interest rate hikes) by the Fed.5

Europe and UK

  • The European Central Bank (ECB) announced it will be raising interest rates for the first time in 11 years to stave off inflation and in early June forecast that GDP would come in at 2.8% this year. Economists, however, are starting to talk about the prospect of a recession toward year-end as consumers are smashed by a 41.9% increase in household energy prices and an 8.9% rise in food prices due to the war.6
  • The Bank of England already forecast in May that its economy would likely slide into recession and the data is starting to confirm that view. British manufacturing contracted at the fastest rate in two years in June, and Bank of England Governor Andrew Bailey told an ECB conference in late June that it was “very clear” that Britain’s economy was starting to slow.7


  • Manufacturing output is down across the region. South Korea’s export growth slowed sharply in June; Vietnam technology exports fell in June for the second consecutive month and Taiwan’s export orders recorded their steepest drop in two years.8
  • After being one of the most sought after pieces of infrastructure during the pandemic, the cost of shipping a 40-foot container from China to the U.S. west coast is now 14% lower than a year earlier, another sign of slowing demand.
  • China, by contrast, actually saw factory output expand following a lifting of Covid lockdowns, but opened to headwinds rather than tailwinds — almost half of manufacturers said orders were “insufficient”.9 In May a major Chinese chipmaker warned that demand for consumer electronics and home appliances had dropped “like a rock.”10
  • Iron ore prices also fell by 7% a tonne as traders anticipated slowing global demand would reduce the need for steel.11

With the three major drivers of the global economy all showing signs of slowing, the global outlook is becoming more uncertain. In a switch to risk-off sentiment, financial markets are on high alert. US equities, sold off in times of economic shock and uncertainty, had their worst start to a year since 1962 with the Dow Jones down by 21%, S&P 500 down 20.6% by June end. The Nasdaq’s fall of 29% year to date is its worst ever.

US government bond yields are another sign of a spooked market. Bond yields move in inverse relation to prices. The benchmark US 10-year Treasury yield dropped to its lowest level since May as investors sought the safety of US government bonds, driving up bond prices.12

What that means for currencies

The US dollar has already been rallying thanks to the more hawkish (aggressive) tone set by the US Federal Reserve on interest rates. Now global slowdown fears are adding momentum to the dollar’s upward trajectory as investors look to the US dollar as a safe haven currency in the event of a slowdown. So far the dollar has had its best start to the year since 2010 according to the Wall Street Journal’s Dollar Index, increasing 8.7% against a basket of 16 currencies.13

Other currencies, like the euro, are struggling. The war in Ukraine has meant the prospects for the eurozone are less certain. Interest rate hikes, while coming, have not yet eventuated, muting demand for the currency as investors look to higher-yielding currencies for better returns. The euro is down 7.5% against the dollar so far this year.

The Japanese yen is another safe haven currency in times of stress but here particularly the ultra-accommodative monetary policy is having a strong impact. While the Fed has been steadily raising rates, the Bank of Japan has been opting to wait and see. The width of that interest rate differential has helped the US dollar soar 18% against the yen this year.

Slow or backward global growth is bad news for commodity currencies such as the Australian dollar and New Zealand dollar, which are closely linked to demand for key exports. These currencies are already being sold off based on the fear of global recession, both hitting 2-year lows in July.

What to look out for

The tightrope is wobbling. A hard landing is looming but it’s possible the negative sentiment is already starting to have an impact on economic output, and therefore inflationary pressures. 

As noted above, heat is already coming out of commodities (apart from fuels) and shipping costs. Slower factory demand will reduce employment expectations, making it harder for employees to secure wage rises, and slowing consumer demand — as disposable income is eaten up by high energy and food costs — should also slow down prices.

Financial markets will be looking for any signs that inflation could be slowing to alleviate their recession fears. But, if inflation can’t be tamed, then the only lever central banks can really pull is higher interest rates. If rates keep going up, it could compound economic slowdown — then the global outlook will look very grim.


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