What central banks are projected to do in 2023 looks to have already been priced into bond markets; how will this anticipated scenario affect inflation, which has likely peaked and is steadily declining, as well as global currency markets?
With their interest rate and balance sheet policies, central banks provided a safety net for the world economy during the pandemic in 2020 and 2021. Central banks started systematically removing that support system in 2022. It is projected that central banks will gradually accelerate their plans by 2023 as they continue to fight inflation, which many have suggested resulted from policies under COVID-19. To prevent a potential catastrophic recession, central banks will likely start restoring that safety net by lowering interest rates in 2024 to stimulate growth.
Bond markets, which are discounting machines that look forward, are already pricing in the concluding phases of what central banks will likely do in 2023. The possibility of looser central bank policies should increase demand for long-term government bonds when supply drops from decade-long highs observed in 2021 and 2022.
In 2023, central bank balance sheets will continue to shrink, showing that they are not actively buying bonds, but investors do not need to panic. Prices already reflect this projected decline in central bank purchases, which participants in the market have widely accepted. Of course, the unpredictable path of inflation and associated expectations will significantly influence central bank policies and macro markets. While many investors believe inflation will remain somewhat high for a reasonable period, several large banks are betting that inflation will fall faster than investors expect, even if it does not revert to pre-pandemic levels.
Lower global inflation should allow central banks to pause their policy tightening cycles. Lower U.S. inflation will likely lead to a less hawkish Fed; thus, markets should price lower policy rates and a weaker U.S. currency. Lower inflation in Europe and the United Kingdom should encourage the ECB and Bank of England to be less hawkish. Economic prospects in those areas should improve as rates fall, resulting in euro and pound currency gains. The U.S. dollar has peaked and will continue to fall until 2023. A drop in the value of the U.S. dollar typically reflects and contributes to favourable outcomes in the global economy. The U.S. dollar often decreases during growing global growth and rising global growth prospects.
As we expect a decline in dollar strength through 2023, it's crucial to remember that a weaker U.S. dollar and a stronger emerging market currency tend to loosen rather than tighten financial conditions in emerging economies. As their currencies rise, developing economies with U.S. dollar debt will see their debt-to-GDP ratios fall, decreasing borrowing costs and supporting growth.
In summary
The anticipation is for a cycle driven by lower U.S. inflation, lower U.S. interest rates, and a weaker U.S. dollar that, at least partially, reverses the negative loops that existed in 2022.