Fed can no longer turn the blind eye to inflation

The most important factor for FX across the board will be how whether the US Federal Reserve is able to get ahead of the curve and whether the enormous gap from “fiscal cliff” of reduced government spending after the blowout response to the pandemic outbreak will be filled and then some by consumer spending and a new credit cycle in 2022 and beyond. The end of 2021 saw the market recovering from the omicron variant wobbles, and consensus expectations are that the Fed will hike about three times in 2022, even as longer term predictions for the Fed into 2024 and beyond are actually below the Fed’s own forecast. Ironically, the market is predicting that the Fed will never be able to get to where it says itself that it is going after at least a year of indicating the Fed was forecasting the policy rate too low.

For monetary policy next year, there is a Fed policy risk premium that can go in either direction. As noted, current pricing suggests that the market is leaning more on the risk that the Fed will fail to get anywhere near the “terminal” policy rate it has forecasted that it will reach in the coming few years even as it kicks off a hiking cycle. This market conviction could stem from a belief that the halt of Fed balance sheet expansion by mid-March and a mere few hikes will bring an over-tightening of financial conditions and trigger a massive market deleveraging that will feed back into the real economy/inflation and therefore into the Fed’s rate decisions. In such an event, the USD could remain firm even as the Fed fails to hike nearly as much as the market currently anticipates, only weakening again when the pain becomes sufficiently large to trigger a new Fed easing and new fiscal money printing.

On the other hand, if the credit cycle does kick in and growth outlook remains strong, Fed rate expectations could head higher but the Fed could soft-pedal its tightening relative to other central banks as it is concerned about spiking market volatility, leading to a weaker US dollar, one that is compounded by strong US consumer demand driving worsening trade imbalances. Either way, a smooth hiking cycle is unlikely as the Fed’s QE tapering and the fiscal cliff either short-circuit markets or the Fed remains far behind the curve.

Elsewhere, other currencies will certainly be buffeted by the above either/or setup for the US economy and financial markets, as an extension of the commodities inflation cycle further supporting the likes of CAD, NOK, and AUD in particular within G-10 currencies.

But as we survey the major currencies, there are two that really stick out for their relative moves during 2021 and that will likely demand our attention further in 2022: the Chinese renminbi and the Japanese yen. China kept a very strong renminbi policy in late 2021 even as it cracked down on property developers and major companies in the tech industry. With the Chinese economy clearly limping as we head into the New Year, the government has signaled the intention to ease, with the easing likely more forceful if the demand look is weak elsewhere and less so if commodity prices remain high and demand is strong for Chinese exports. On the flip-side, the Japanese yen suffered a huge mark-down in 2021 and could prove the single currency with the most volatility in 2022, with a very different return profile in the two scenarios we outline. If the fiscal cliff weighs and disinflation sets in, pushing yields back lower for safe haven countries, the JPY could rebound very smartly, especially if this brings a strong reversal in the Chinese renminbi, which is more likely as long as

commodity price pressures are relatively benign. The relative pricing of CNY (the CNH is the offshore version of the renminbi/yuan that is tradable outside mainland China) and the JPY is the most stretched pairing among major exchange rates.

Any way you look at it, the question marks hanging over the year to come are significant, with a huge dispersion of views among clever market observers, so the year ahead is likely bring many surprises and plenty of market volatility.