20% Probability: Stubborn Inflation
The penultimate scenario is one in which central banks cannot get a handle on inflation and prices continue to rise at, or faster, than the current pace. In this world we would see central banks, the Fed likely leading, chase inflation with a flurry of hikes. Outstripping current expectations of five 25bps hikes and possibly increasing by 50 or 100bps at single meetings. There are many potential sources for this sticky inflation – political tension and spiking demand is maintaining pressure on commodities; a global move toward greener practices is exacerbating price pressures; tight labour markets and increased restriction on movements are pushing wages higher; and many more. Were any of these to persist longer than expected, inflation could be here for many months to come.
- Currency Implications: This scenario would roil global financial markets – leading to a huge increase in volatility in everything from interest rates to equities to commodities. In terms of FX there feels like two directions of travel for USD – if the inflationary conditions are global there will likely be a flight to quality and we could see the USD benefit; if the issues are concentrated (or worst) in the US, we could see an unwind of USD assets leading to a weaker USD. Our current base case within this scenario is for the inflationary issue, should it arise, to be worse in the US than elsewhere – leading to the USD weakening against most peers.
There are plenty of US specific reasons for prolonged inflation – larger, less targeted Covid response creating excess demand; unparalleled size of QE (still ongoing); and accentuated labour shortages to name a few. Those currencies with less structurally embedded inflation, or those perceived to have the easiest path to changing expectations, will likely fair best. The Euro should be well poised in this scenario, against both GBP and USD.
EURUSD 1.15-1.25
GBPUSD 1.35-1.45
GBPEUR 1.05-1.15 USDCAD 1.10-1.20
5% Probability: Flight to Quality
Our final scenario is what we believe to be an outlier scenario but if the last two years are anything to go by, black swans are becoming an increasingly common species. In this “tail” scenario we consider the effects of left field influences damaging the economy or popular confidence. Two obvious candidates would be the arrival of a new Covid variant (would that take us to Pi?) and/or an escalation in political unrest, most likely in Ukraine/Russia.
- Currency Implications: In such a scenario global financial volatility would, once again, spike and Central Banks would at a minimum pause tightening and perhaps cut rates and restart the printing presses in the form of QE. Though rate hike expectations would fall significantly, and currently the US has one of the steepest curves, we believe the Dollar does well in this scenario. A flight to quality would ensue and the usual winner is the USD. Treasuries become the haven for scared money and, a kinder Fed could result in money going back into US stocks after an initial period of volatility.
EURUSD 1.02-1.12
GBPUSD 1.20-1.30
GBPEUR 1.05-1.15 USDCAD 1.35-1.45
Kevin Lester, CEO of Validus Risk Management, said: “At the start of 2021, “transitory inflation” was the phrase on the tip of every central banker’s tongue – the start to 2022 couldn’t be more different. With the term “transitory” all but banned by the Federal Reserve, we have seen a great repricing of market expectations for the path of rates over the coming months.
“Into the end of 2021, and starting 2022, the Fed have pivoted from dovish leaning to assuredly hawkish. In recent comments Chairman Powell has acknowledged the strength of the US labour market and, simultaneously, the continuing and sticky issue of above target inflation. The market has translated recent Fed communication into an aggressive hiking cycle, with five 25bps hikes now expected for 2022, and the start of balance sheet reduction.
“With so many factors driving markets it can be challenging to see the wood for the trees, but we will attempt to lay out Validus’ four most likely scenarios for 2022 and how FX and interest rates may be affected in each.”
