Estrategia y temas
February 27, 2023
Volatility is back in the foreign exchange market
The US dollar rebounded in February, after falling sharply between October and January
It will be difficult for the greenback to appreciate further given current fundamentals
Automatically, most other currencies will benefit

CHART OF THE WEEK: "Major currencies enjoy the depreciation of the US dollar"


Foreign exchange trading has an average daily volume of over seven and a half trillion dollars (USD 7,500,000,000,000). This tremendous liquidity makes it the largest financial market in the world. Unlike equities or bonds, the forex market is not centralised in an exchange, but is made directly between the parties, mainly through networks of specialised traders. The main players in the market are investment banks, followed by large multinationals, brokers and central banks. The major currencies traded are the US dollar, the euro, the Japanese yen, the British pound, and the Chinese yuan (see Fig. 2).

The main strength of the forex market is that there is always at least one appreciating currency. It thus allows the smart investors to generate returns in all circumstances, whether the economy is growing or shrinking, whether the environment is hyperinflationary or deflationary, whether central banks are tightening or easing monetary policy, whether equity or bond markets are soaring or contracting, etc.

The other advantage is that the forex market is extremely efficient, at least in the very long term. The Purchasing Power Parity (PPP) approach states that goods and services should have a single price in all countries of the world once converted into the same currency. In concrete terms, if a good or service costs 1,000 euros in Paris and 1,290 dollars in Washington, the exchange rate between the euro and the dollar should be 1.29. If it is lower, at 1.06 for example, then consumers will sell their dollars, buy euros and acquire the cheap good in Paris. In doing so, they will increase the demand for euros and decrease the demand for dollars.

The exchange rate will appreciate, gradually rebalancing the price of goods and services between the Eurozone and the US. In practice, large imbalances can be observed in the short term, but the PPP is eventually respected over a 10-year horizon (see Fig. 4). It is therefore easy for a patient investor to generate performance that is based on this approach.

After several years of calm, volatility returned to the foreign exchange market in 2022 (see Fig. 3). The last five months are a perfect example. After depreciating by -12.1% between the beginning of October and the end of January, the US dollar has just gained some +4.5% in February (see Chart of the Week).

We have regularly detailed the reasons why the greenback has been a strong currency in recent years: economic growth, interest rate differentials, pandemic issues, geopolitical tensions, investor behaviour, etc. Some of these positive factors began to fade at the end of last year, notably the monetary policy divergence between the US and the rest of the world, justifying a relative weakening of the dollar. Broadly, as fundamentals normalise, the extreme overvaluation of the dollar is no longer sustainable (see Fig. 5).

As the dollar weakens, most other currencies are bound to appreciate. Among the main beneficiaries, the euro seems a natural favourite. Admittedly, the single currency could be held back by the consequences of the war raging in Eastern Europe, but this is less of a handicap than those faced by the yen and the pound sterling. The former is suffering from the monetisation of Japanese debt, while the latter is facing the multiple impacts of Brexit and their toxic consequences.

Among the smaller currencies, the beneficiaries of late 2022 could well be the winners of 2023:

  • The Korean won is benefiting from the recovery in world trade and the relative weakness of energy prices. As South Korea is a very open economy, these two parameters have a positive scissor effect on the won exchange rate.
  • The New Zealand dollar is twice as dependent on the reopening of China; directly for its agricultural exports, and indirectly via Australia which exports some of its metal production to China.

Within the basket of currencies that lagged behind at the end of 2022, three seem to stand out:

  • The Canadian dollar is a currency sensitive to energy price fluctuations. Some believe that it has over-reacted to the downward movements in oil prices. The North American currency has also been hurt by the recent decision of the Bank of Canada (BoC) to stop raising its key interest rates. By being one of the first central banks to loosen its stance and consider a "pivot", it has drawn investors away to more lucrative bond markets. The BoC was simply ahead of its peers and demand for CAD weakened exaggeratedly. A revival of interest is to be expected.
  • The Chinese yuan has already started to benefit from the support of the fiscal and monetary authorities, and the end of the zero-covid strategy, but traders have not yet priced in the competitive advantage generated by low inflation in China. In two years, according to the Purchasing Power Parity approach, the equilibrium value of the CNY has risen by +7.2% against the dollar, while the exchange rate has fallen by -8.4%. To close this gap, the dollar would have to trade at 5.86 yuan.
  • The Swiss franc is tending to appreciate, including against the dollar (see Fig. 6). Switzerland's economic fundamentals make the franc a qualitative reserve currency, which only gold manages to outperform. The inflation differential alone justifies between +4% and +6% annual appreciation of the franc's exchange rate against the greenback. Its appreciation potential is therefore structural.


As long as there is an appreciating currency, investors who turn to the foreign exchange market have the opportunity to make gains regardless of the economic environment. In 2023, if the dollar weakens towards its fair value, then most other currencies will generate positive returns. As good news never arrives alone, exposure to currencies increases portfolio diversification.