Understanding the direction of foreign exchange (FX) markets often hinges on the analysis of actual economic outcomes and the extent to which these outcomes were anticipated by the markets. However, equally crucial is the concept of the "counterfactual"—analyzing how FX markets react to events that were widely expected but did not occur.
Traders and investors in global currency markets frequently build positions (either long or short) based on projections of future economic events. When these anticipated events fail to materialize, significant shifts in currency values can occur as speculative positions are unwound.
This dynamic underscores the importance of understanding not just economic outcomes, but also the shifting sentiments and expectations that drive FX market behavior.
USD strengthening on expected recession
A prime example of the counterfactual in action can be seen with the US dollar (USD) and the global recession that was widely anticipated 18 months ago.
As central banks worldwide increased interest rates sharply to combat high inflation, there was a prevailing expectation that the global economy would enter a recession. Historically, such a scenario would lead to an appreciation of the USD.
Large-scale long positions in the USD were established based on this expectation. However, the global recession did not materialize.
Major economies like the US, China, and Australia maintained positive GDP growth, while economic downturns in the UK and Europe, exacerbated by the Ukraine war's energy crisis, were less severe than anticipated.
Despite US interest rates remaining high relative to other countries, the USD has not seen aggressive selling off of these long positions from 2022 and 2023. It appears only a matter of time before these positions are adjusted downward.
Oil prices and market speculation
The volatility in oil prices provides another example. In October 2023, crude oil prices surged from $80 to $95 per barrel following the Hamas attack on Israel, with investment banks forecasting prices to exceed $100 per barrel due to ongoing Middle East tensions and OPEC supply cuts.
Oil prices are extremely volatile as the market is regularily manipulated by speculation and influence traders. For instance we observe WTI drop from near $90 to mid $70's in a week.
— Rick Nash (@RickNas95547619) June 8, 2024
Contrary to these forecasts, oil prices fell to nearly $70 per barrel by the end of 2023. Although prices briefly rose to $87 per barrel in early 2024, they have since declined to around $74 per barrel.
The primary reason for this decline is the unwinding of speculative long positions in oil futures markets, which were based on the high price forecasts that did not materialize. Lower oil prices are now providing central bankers with confidence that they can reduce interest rates, as the risk of an inflation resurgence diminishes.
In the US, lower gasoline and energy prices are expected to drive headline CPI inflation lower for the remainder of 2024.
US 10-year bond yields and FX market expectations
From June to November 2023, US 10-year bond yields rose from 3.6% to 5.0%, driven by forecasts of prolonged high interest rates needed to curb inflation amid a strong labor market. Increased bond supply from the US Federal Government also contributed to a bearish outlook for bonds.
However, in December, the Fed pivoted on its monetary policy, leading to a drop in bond yields to 4.0%. Despite a brief rise to 4.75% in April 2024, weaker employment and inflation data have caused yields to decline again.
BREAKING: The US Treasury yield curve has been inverted for 702 days, the longest streak in bond market history.
— The Kobeissi Letter (@KobeissiLetter) June 9, 2024
The difference between 10-year and 2-year Treasuries has turned negative on July 6, 2022, 22 months ago.
The previous record was made in the late 1970s and lasted… pic.twitter.com/xQi7joCTl5
This fluctuation highlights how FX markets can be influenced by changing expectations. Many bond fund managers are now extending the duration of their portfolios, anticipating lower yields in the coming months.
Despite a strong May jobs report, which temporarily boosted the USD, lower oil prices and bond yields suggest the USD Index may decline below 104.00. The NZD/USD exchange rate, which fell from 0.6200 to 0.6100 following the jobs report, is expected to recover as the USD weakens.
The New Zealand dollar has potential to rise to 0.6400 in the coming weeks, driven by a weaker USD.
NZ's credit rating and economic resilience
Speculation about a potential downgrade of New Zealand's sovereign credit rating has emerged due to the government’s deteriorating fiscal position. However, no downgrade has occurred yet. The latest warning from Fitch highlights increased negative rating sensitivity if New Zealand fails to return to fiscal surplus.
Credit rating agency shot across the bow a danger to New Zealanders’ living standards
— New Zealand Taxpayers' Union (@TaxpayersUnion) June 6, 2024
The Taxpayers’ Union says that the comments from credit ratings agency Fitch overnight represents a major threat to New Zealand’s public finances and New Zealanders’ living standards should the…
Despite these concerns, New Zealand's Terms of Trade Index rose in the March 2024 quarter, indicating resilience in the export-dependent economy. Finance Minister Nicola Willis remains hopeful that the economic downturn will be less severe than projected, aided by expected global interest rate cuts.
Overall, the risk of a significant depreciation of the NZ dollar due to a credit rating downgrade remains small. Lower global interest rates are likely to boost international investment and trade, supporting New Zealand’s economic recovery.
In conclusion, understanding the counterfactual—how FX markets react to unfulfilled expectations—is as crucial as analyzing actual economic results. This dual approach provides deeper insights into market dynamics and helps anticipate future currency movements.