The Japanese yen is set to outperform while the euro faces the strongest headwinds in 2024 if interest rate advantage continues to drive currency market outcomes, as it did in 2023
- Currency markets rewarded interest rate advantage in 2023, as usual.
- A simplistic rates-based strategy performed well, despite deviations.
- The Japanese yen may outperform while the euro is weakest in 2024.
Currency markets behaved true to form in 2023.
As a textbook explanation of what moves exchange rates might explain, the relationship between changes in policy interest rates set by central banks and the accompanying currency was a firmly positive one. That is, a bigger upshift in rates generally translated into a relatively stronger exchange rate.
Currency performance in 2023: a familiar story
Some mild deviations occurred, as usual. British pound out-ran the euro despite the European Central Bank (ECB) delivering more interest rate hikes than the Bank of England (BOE). This mostly reflected political normalization after chaos at the premiership in 2022 handed the UK unit an outsized loss compared to the push from monetary policy alone.
Meanwhile, the Canadian dollar outperformed its U.S. counterpart despite a bit more tightening from the Federal Reserve than the Bank of Canada (BOC). This too is an inversion of the prior year’s dynamics. The greenback found an extra boost as a cash-out destination amid the 2022 stock market selloff. The tables turned in 2023 as risk appetite improved.
A similar story played out for the Australian dollar. A stronger-than-expected U.S. economy helped underpin faster global growth than many forecasters feared and pushed Canada to overshoot start-of-2023 rate hike projections by nearly a full percentage point. Australia lagged as its main export market—China—struggled to capitalize.
Trading currencies using interest rate forecasts
Nevertheless, a simplistic strategy of ranking the six major currencies by the expected one-year change in benchmark interest rates as they are priced into the markets, then buying the top two and while selling the bottom two, performed well. Holding four equally sized positions in US dollar terms, it generated a return of 17.8%.
Last year, the basket would have called for buying the British pound and the euro while selling the Canadian dollar and the Japanese yen. As it happened, outsized GBP strength and JPY weakness more than made up for losses that this hypothetical portfolio would have suffered having been short the rallying CAD.
This approach could look quite different in 2024 as most major central banks begin to cut back interest rates.
The Japanese yen and the Australian dollar are at the top of the list because the Bank of Japan (BOJ) is expected to nudge rates a bit higher. The cuts envisioned for the Reserve Bank of Australia (RBA) are comparatively modest at about 0.50%. The euro and the U.S. dollar are on the chopping block, with 1.25-1.50% in cuts in view for the ECB and the Fed.
Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak
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