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After dodging a series of major shocks and overestimating the speed and impact of monetary policy transmission in the first half of the year, financial markets seemed to capitulate in the last few weeks, with volatility measures falling and the dollar coming under pressure as risk-sensitive currencies and asset prices climbed.

We think this “melt up” could continue, with emerging markets and high-risk currencies outperforming their safe haven and low-yielding counterparts for a few months yet. But we also expect deeper global imbalances to begin reasserting themselves in the autumn months, helping the dollar defy overly-bearish consensus forecasts by early 2024.

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Economies are proving remarkably resilient.

The last year and a half should have been disastrous for the global economy. Russia’s invasion of Ukraine upended supply chains and sent energy prices soaring. Chinese authorities forced hundreds of millions into lockdown. High and persistent inflation forced central banks to raise interest rates at a pace unequalled since the 1980s. Housing markets tumbled. Bank failures triggered unease at the very core of the financial system. Political brinkmanship brought the US to the edge of default.

Yet, over and over, worst-case fears in markets and boardrooms have gone unrealized. European economies retooled at lightning speed and a warm winter helped bring energy prices back to earth. China lifted pandemic restrictions without suffering mass casualties. Solid balance sheets, a wave of post-pandemic refinancing activity, and immigration flows helped insulate homeowners against brutal rate increases. Swift regulatory intervention prevented a systemic meltdown in the banking system. And lawmakers managed to strike a last-minute debt ceiling deal without forcing the government to delay its payments.

Unemployment is near historic lows in most developed economies, consumers are still spending, businesses are investing, and asset prices are nearing post-pandemic highs. Forecasters have steadily revised 2023 growth estimates up since the beginning of the year.

Bloomberg consensus growth forecasts for 2023, %, median

Disinflationary forces are growing more powerful.

The “transitory” supply-side forces that lifted inflation through much of the post-pandemic period are retreating. With supply chains almost fully healed, global shipping costs have plunged, agricultural price indices are down more than 20 percent from their highs, and in most industrialized countries, grocery costs are softening in month-over-month terms. Energy prices remain elevated relative to historical averages, but are down dramatically from last year. And consumer expectations are coming down in most regions.

On the demand side, a powerful feedback loop remains in play, with aggregate nominal household incomes rising as persistent labour market imbalances put upward pressure on wages, adding to excess savings and positive wealth effects in keeping consumer spending aloft, and in turn, raising incomes even more. Economists and policymakers expect this “sticky” core inflation cycle to continue for many months yet. But even here, there are signs of an easing in price pressures ahead: Measures of underlying inflation are subsiding, breakevens suggest markets are convinced price growth will slow dramatically by the end of the year, and producer price indices – which typically foreshadow changes in core inflation – have been falling in most major economies over the last nine months.

Producer Price Indices, annual % change

The pace of monetary tightening from major central banks is clearly decelerating, and rate hikes look likely to peter out almost completely by the early autumn, helping reduce overall policy uncertainty. Following a pause in June, the Federal Reserve looks likely move to the sidelines after delivering a final quarter-point increase at its July meeting, bringing rates to a 5.50-percent terminal level. The European Central Bank looks likely to follow a similar (but lagged) trajectory, with two half-point moves in July and September, followed by a shift onto a data-contingent footing. Investors currently have the Bank of England priced to push its base rate all the way to 6 percent by late autumn, but we think this belief looks overegged, and suspect the rate will top out closer to the 5.5-percent mark. And – although rate cuts could come in several emerging markets before the end of the year – markets don’t see any major industrialized economy following suit until early in 2024.

Reflecting this backdrop – and notwithstanding a short-lived surge around June’s US labour market releases – trading ranges in interest-rate futures have tumbled sharply from their peaks. Implied volatility has fallen dramatically across financial markets, with the closely-watched VIX index plumbing levels last seen before the pandemic hit in 2020.

Volatility indices, z-scores, January 2000 – July 2023

After a long series of shockingly-positive data releases out of the United States, investors are suddenly more convinced that policymakers will succeed in pulling off an “immaculate disinflation” – in which price growth comes back to target without triggering a big rise in unemployment. Equity valuations, long-term yields, financial conditions, and consensus economic forecasts are all pointing to stronger conviction in a “soft landing” scenario, and a growing number of previously-bearish market pundits have pivoted, pushing recession forecasts into late 2024 and beyond.

Currency markets have realigned, with the greenback following archetypal “smile” dynamics in falling against its counterparts in the rest of the world. Powerful momentum factors are driving other majors – including the pound, euro, and yen – higher, snapping resistance levels that had remained in place for months. If major shocks can be avoided and underlying price pressures keep cooling through the summer months, this risk-taking mechanism in financial markets might accelerate, lifting asset prices higher, generating self-reinforcing dynamics in consumer spending and labour markets, and weighing on the dollar.

Equity market capitalisation by country, billions USD

The laws of economic gravity have not been repealed.

Growth through much of the post-pandemic period has defied traditional business-cycle analysis, and the noise-to-signal ratio in economic data remains extraordinarily high. Yet the sheer breadth and diversity of recession indicators that are currently flashing red in developed economies – inverted yield curves, tighter bank lending standards, weak manufacturing activity and depressed consumer confidence – would suggest that a deepening slowdown is underway.

We think global growth rates will slow sequentially in the third and fourth quarters as the lagging impact of higher rates hits home and household demand continues to normalise relative to pre-pandemic levels. Corporate labour hoarding and a slow wind-down in excess savings could push the bottoming-out point into early 2024, but the downturn – and eventual recovery – could be prolonged if inflation-fearing central banks keep policy settings in restrictive territory.

Spread between 2- and 10-year government bonds, %

The factors pushing volatility lower through the first half of the year are beginning to lose traction, and the list of outcomes that could topple prevailing market assumptions is multiplying: Long-term interest rates could yet revert higher if inflation rates remain elevated. A policy mistake could trigger a financial crisis or drive economies into recession more quickly than currently expected. A ceasefire in Ukraine could drive a reappraisal in global energy markets and lift the euro out of its malaise. An aggressive stimulus push from Chinese authorities might send commodity prices soaring. The artificial intelligence mania could reach new heights – or implode.

The current lack of clear directional narratives is also vulnerable to change. We think the monolithic “higher for longer” message from central banks will become more nuanced and variegated as time progresses. In the US, expectations for rate hikes are now relatively well aligned with projections from policymakers themselves – most importantly, the Fed’s dot plot – but these could shift as signs of softness emerge in the economy. The European Central Bank might change its views even more quickly as growth flatlines and inflation subsides. And doves at the Bank of England could reassert themselves if labour markets begin deteriorating – with the Australian and Canadian central banks following suit at a lag.

Ultimately, we suspect traders will soon become more willing to build high-conviction positions in individual currencies – which should lead to an increase in speculative flows.

Net Long (+) or Short (-) US Dollar Futures Position Held by Large Speculators, Billions USD

The dollar could emerge as the “cleanest dirty shirt” yet again.

The dollar’s decline from its September highs could continue for several months yet, with depressed volatility supporting outward capital flows and limiting the currency’s safe-haven appeal. But the key conditions for a decisive move lower – a clear peak in US interest rates and a period of economic underperformance relative to the rest of the world – have yet to play out, and in the longer term, we think the risk outlook for other major trading blocs looks asymmetric, with structural vulnerabilities often outweighing the potential for sustained gains.

The euro is, perhaps, the currency best positioned for outpeformance against the dollar in the second half. It is deeply undervalued on most metrics, and typically exhibits greater resilience in the early stages of a global downturn. But bank lending volumes are worsening across the bloc, higher borrowing costs are damaging consumer confidence, and the European Central Bank looks likely to tighten into a slowdown.The UK is facing stagflationary risks, with persistent inflation and ever-tighter financial conditions threatening to push the economy into recession. Recent price action would suggest growth fears are beginning to trump policy rate increases in influencing the pound’s direction.

In China, where an early-year rebound is fading, the central bank and other parts of the policy apparatus seem poised to ramp up stimulus efforts after the July politburo. Targeted fiscal spending, relaxation of property sector restrictions, and monetary loosening are all on the menu, with rate differentials unlikely to tilt dramatically in the renminbi’s favour.

Even if adjusted, the Bank of Japan’s yield-suppression efforts should leave the yen with an important role in funding global carry trades – and half-hearted intervention efforts aren’t likely to decisively pull the currency out of its slump.

Although evidence of weakness has been slow to appear, we worry that both Australia and Canada could suffer outsized declines in household consumption – along with currency weakness – as borrowing costs build over time.

Taken in sum, this adds up to a scenario in which the greenback weakens through the early part of the third quarter, but slows its decline toward the end of the year – and one in which another round of financial turbulence could easily topple current market assumptions, with low-carry and growth-sensitive currencies in the line of fire if a classic flight-to-safety response unfolds.

Nominal forecast currency returns by quarter, relative to current levels, %

To review our forecasts for specific currency pairs in greater detail, please see the regional outlooks linked below: