Validus Risk Management, the leading independent financial risk advisory and technology firm, today published its annual analysis of the top macro risks for the coming year. This year, the prospect of Fed rate rises – whether they meet market expectations (40% probability) or not (35% probability) – registered as the most likely macro risks, followed by stubborn inflation (20% probability) and a flight to quality (5% probability), all with significant currency implications.
Validus publishes it analysis of most likely market risks every year, in which the firm’s analysts and economists highlight the most pertinent macro risks, the likelihood of them occurring, possible scenarios and currency implications.
40% Probability: The Fed manage to deliver on market expectation
In this scenario, the Fed lives up to market expectations and delivers on its duty of five hikes and a commencement of QT. We have assigned this scenario as one of our two most likely outcomes, and with good reason. The US economy is undoubtedly doing well, unemployment rates are rapidly falling back toward 4% – a level which, historically, represents a labour market about as tight as it can be. Add to this that GDP growth has remained robust, printing higher than average figures for the last several quarters.
In such a setting there is scope for higher rates, should there be a cause, and there certainly is. Inflation in the US, and around the globe, shot higher in 2021 – though, there was hope it would pass, it hasn’t. US CPI now sits at levels not seen since the early 80’s and many commentators are saying the Fed is behind the curve and this problem is already embedded. In such a setting it is not hard to imagine the Fed hiking five times and beginning an unwind of its balance sheet.
- Currency implications: Unlike last year, the consensus for the USD coming into 2022 has been for strength. And much of this expectation is unpinned by the hikes carried out in this scenario. We have some issue with this conclusion. As the number of expected hikes rose from 2 in late Nov to 4 at the start of 2022, the Dollar saw almost no gains, in fact it lost value against several peers. We have seen strength in the last week or so, but non-hedging positioning (speculative positions) is still very long Dollars, as long as it has been since mid-2019. From here we think it will be difficult for marginal buyers to take the USD higher and as such we remain neutral USD in this scenario
EURUSD has already had a difficult 2020 and so a lot of the rate differential is already baked in, but it certainly will be the most fragile pair in this scenario. If the Fed manage five hikes it feels reasonable to assume UK and Canada won’t be fair behind, keeping these pairs fairly flat.
EUR/USD 1.05-1.15
GBP/USD 1.32-1.42
GBP/EUR 1.20 – 1.30 USDC/AD 1.20-1.30
35% Probability: The Fed under deliver on market expectations
Our other most probable scenario is a disappointing Fed – here we envisage the Fed manage to hike 1-3 times but no more. There are three drivers which could push the markets down this route, firstly – a move lower in inflation. As YoY effects begin to drop out and (dare we say it) the worst of Covid lockdowns are behind us, we could see inflation numbers move lower in the second half of the year. Energy is a large driver of current inflation figures and tensions in Russia are exacerbating things but historically speaking such tensions, often, don’t last forever or result in military action. Secondly, equity markets will cause concern for the Fed. Recent changes in rate expectations have seen equities (led by growth stocks) lurch lower – the S&P500 is currently about 10%, if it were to fall another 10% there is an argument that the Fed would step in to support and in this case that means fewer hikes. And finally, if the economic robustness we mentioned earlier was to wobble. It is always difficult to know how an economy will handle tighter monetary conditions, and it would be hard to blame the Fed for getting cold feet ahead of hike number 4 if the preceding NFP, for example, was a large negative.
- Currency Implications: This scenario would be difficult for the USD – with positioning so skewed in favour of USD as mentioned earlier, such a move could spark a domino effect of unwinds. It would be difficult to see the USD strengthening against any pair were this to happen, with the Euro having the most to gain. With a completely flat curve for 2022, market expectations are widest for EURUSD – a disappointing Fed could therefore push EURUSD higher. Sterling, however, could see an initial bump from this action but we think that a slower Fed could allow the BoE some breathing room to take their foot of the pedal, resulting in GBPUSD levels which are volatile but arguably not very directional.
EURUSD 1.20-1.30
GBPUSD 1.35-1.45
GBPEUR 1.05 – 1.15 USDCAD 1.20-1.30
