The Two Thousand and 22 Outlook for Rates in Currency Markets

With recent central bank action raising questions on monetary policy, Global Head of Macro Strategy Matthew Hornbach takes us through the implications for the trajectory of rates and currency markets in the year ahead.

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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the 2022 outlook for rates and currency markets. It's Friday, December 10th at 10:00 a.m. in New York.

Every November my colleagues within research come together to discuss the year ahead outlook. And almost every year something happens in the month after we publish our forecast that changes one or more of our views. This year, several Morgan Stanley economists have changed their calls on central bank policies given higher than expected inflation and shifting central bank reaction functions.

Our monetary policy projections have become more hawkish for central banks in emerging markets, mostly. But earlier this week, our projection for Federal Reserve policy became more hawkish as well. Our economists now see the Fed raising rates twice next year, whereas before they didn't see the Fed raising rates at all.

Does this change alter our view on how macro markets will move next year?

Well, it doesn't change our view on the direction of markets. We still think U.S. Treasury yields will rise and the U.S. dollar will strengthen in the first half of the year. But now we see a flatter U.S. yield curve and the U.S. dollar performing better than before.

What hasn't changed in our outlook? We still see macro markets dealing with variable central bank policies in 2022. Some policies will be aimed at outright tightening financial conditions, such as in the UK, Canada, New Zealand and now the U.S. Other central banks will attempt to ease financial conditions further, albeit at a slower pace than before, like the European Central Bank. And some will aim to maintain accommodative financial conditions like the Reserve Bank of Australia and the Bank of Japan.

For rates markets, we expect yields around the developed world to move higher over the forecast horizon, but only moderately so. And while we see real yields leading the charge, we don't foresee a tantrum occurring next year. We forecast 10-year Treasury yields will end 2022 just above 2%. That would represent a similar increase to what we saw in 2021.

As for the US dollar, we see two primary factors lifting it higher next year. First, we see a continued divergence between U.S. and European economic data. Recent U.S. economic strength should continue into the first half of the year. And expectations for future growth should stay elevated, assuming additional fiscal stimulus measures are approved by the U.S. Congress, in line with the Morgan Stanley base case.

At the same time, our economists have been expecting data in Europe to weaken. In addition, the worrying surge in COVID cases and the government responses across Europe pose additional downside risks. To be clear, we expect eurozone growth to be strong over the full year of 2022, yet it is likely that the economic divergence between the U.S. and Europe continues for a while longer.

This should keep the U.S. dollar appreciating against low yielding G10 currencies, such as the euro. We also expect further upside for the US dollar against the Japanese yen, driven by higher U.S. Treasury yields.

The second factor arguing for a stronger US dollar is central bank policy divergence. The Fed could strike a more upbeat and hawkish tone throughout next year, just as it has done more recently. On the other hand, the risk for the ECB is that its more hawkish members adjust their views in a more dovish direction, and then the ECB delivers more accommodation than expected, not less. If the upcoming Fed and ECB meetings this December go as we expect, they would set up the dollar for additional strength in the first half of next year.

As for higher yielding riskier currencies, we think four factors will support them. First, our economists forecast robust global growth next year. Second, they also forecast inflation will moderate from unusually high levels. Third, they see central banks maintaining abundant pools of global liquidity. And finally, we think this leads to only a moderate rise in real yields.

As a result, we have constructive views on the risk sensitive G10 currencies. In particular, we expect the Canadian dollar and the Norwegian krona to outperform the US dollar and lead the G10 pack. We see buoyant energy prices and hawkish central bank policies keeping these currencies running ahead of the U.S. dollar and far ahead of the euro and the yen.

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