As we enter 2023 and reflect on 2022, it is clear last year was not for the faint hearted when it comes to market 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 an upcoming recession. So, as we launch into this next year, it is important to think about the key themes that will influence the macro economy as well as how they will impact the FX market.
1) Inflation – Living with it?
Inflation was arguably one of the biggest challenges faced last year and does not look to be going away in the early part of 2023, but it looks likely to slow as the year goes on. Commodity prices, such as oil and gas, have fallen and 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 down trend. 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. CME Group FX futures and options, which saw record volumes and OI in 2022, can provide a variety of ways to manage FX risk, from hedging exposure to seeking profits on changes in exchange rates. The product suite can be found here.
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 (Fed), Bank of England (BoE), and the European Central Bank (ECB) 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. Watching what these policy makers do next is likely to be key in 2023. Maintaining higher rates for longer means and the Fed’s balance sheet tightening could have a larger impact on its policy stance. The Bank of England has estimated that the UK economy has already entered a protracted recession, which would 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. CME Group offers central bank watch tools, and they can be found here, and here.
3) ESG Practises – Increasing in FX?
The UN COP27 conference of 2022 restated the global commitment to tackling climate change, particularly in the face of the current energy crisis. However, going into 2023, global emissions remain at record highs and the world is on track to warming more than the 2°C target with increasing climate damages. FX hedging strategies linked to sustainability targets are one to watch this year, although still an unfamiliar concept to many, popularity 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 of ESG, with trading desks ensuring they are trading with counterparties that have strong ESG practises in place. The Global FX Code (GFXC) has also shifted focus for the buy-side to pivot into ESG related trading practices, with even a focus on currencies of countries with high ESG investment, such as Sweden. CME Group offers a variety of ESG solutions across a range of products, which can be found here.
4) FX Market Shifts – Changing behavior?
The latest BIS Triennial FX survey, which was 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 towards 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 record volumes on CME Group’s FX Link platform where volumes increased 90% YoY, which is the only cleared electronic marketplace for FX swaps. It is not only regulatory related reasons for the increase in these products, but also because they often offer tighter pricing, transparency in the marketplace, credit efficiencies, and flexibility in execution. More information about CME Group’s FX futures product offering can be found here and the FX Link platform here.
5) Emerging Markets – More vulnerable in 2023?
The Russia and Ukraine war and the energy crisis, the reopening of China’s economy, trade wars and supply chains are all areas to keep eyes on going into this new year. 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, geographical, 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 back of lower yielding currencies like the euro becoming more insulated once the central banks begin to pause hikes at some point. CME Group offers a variety of currency products across emerging markets, from the Renminbi to the Rand, delivering greater certainty in trading emerging markets in all market conditions. The products can be found here.
Entering a new year always brings a plethora of uncertainties and for 2023 around geopolitical risks, economic policies, recessions, the climate crisis, central bank activity, and volatility. These issues impact the FX market and paying close attention to them throughout the year will be especially beneficial for risk management.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.