What happens to forex during a recession or stock market crash?

Posted: 17 February 2023 7:00 am

The US dollar usually rallies as investors look for safe havens to protect their wealth. Will it rise again if the US goes into recession?

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The threat of a recession is a difficult time for any market and the foreign exchange market is no exception.

Recessions can cause significant changes in the value of currencies and often lead to a more volatile period for forex traders.

While investor attention has been focused on the turbulence in stock markets globally amid the sharpest ever tightening by central banks around the world, the bigger and more relevant forex markets have been showing a fluctuating trend, particularly when it comes to the US dollar – the world’s dominant reserve currency.

“Generally, the US dollar index is perceived to carry a safe-haven status and hence, it may be expected to find traction during a recession,” Jun Rong Yeap, IG market strategist, Singapore, said.

“That said, there are instances where the US dollar index plunged during past economic downturns, so the relationship is not as clear-cut and other factors could come into play as well.”

Economic uncertainty

The turmoil comes against the backdrop of a looming downturn in the global economy. That key concern was defined by major central banks pushing aggressive interest rate hikes last year in order to stamp out inflation that emerged out of the COVID lockdowns.

Most economists believe price increases may have peaked across developed economies, but inflation pressures are not going away anytime soon.

Goods prices have eased as supply chains have reopened, but inflation has remained stubbornly high thanks to record low unemployment and tight labour markets that have kept wages elevated.

Given this situation, investor concerns have grown that central banks including the US Federal Reserve, the European Central Bank and the Bank of England will continue their monetary tightening in an effort to “finish the job”, raising the prospect of a recession in major economies such as the US, UK and Europe.

Despite rising rates, “there are some expectations that the US economy may still deliver a ‘soft landing’,” Jun Rong Yeap, explained.

“In the event where a US recession occurs, risk-sensitive currencies such as the pound and euro may face some headwinds.”

This in turn creates an uncertain outlook for other trade-reliant economies such as Singapore. The Asian island nation’s output, which is estimated to have grown 3.5% in 2022, is set to slow down to between 0.5% and 2.5% this year as major economies head towards a recession.

The Singapore government expects the country’s formidable exports to post zero growth in 2023 in the best-case scenario and decline 2% in the worst. While China’s reopening could lift exports, any gains may be offset by a decline in demand from other major markets such as the US.

“On the other hand, Singapore’s strong credit rating of AAA allows its government bonds to attract safe-haven flows in times of economic uncertainties, which could support SGD strength against its regional peers,” Jun Rong Yeap said.

Why the US dollar is likely to rally

The US dollar’s role in the global economy means it is used by most central banks around the world for international trade and financial transactions. Its reliability and status as a global reserve currency also means it is considered a safe-haven currency, therefore it typically strengthens during times of uncertainty.

That is exactly what happened in 2022. The Federal Reserve’s aggressive rate hike cycle led to higher US Treasury yields, which in turn contributed to the dollar’s strength. Investors also gravitated to the US dollar to shelter from heightened market volatility due to soaring energy prices and Russia’s invasion of Ukraine.

The US dollar index surged nearly 20% against a basket of major currencies to touch its highest level in nearly 20 years, peaking in September at 114.43.

However, the greenback has reversed course since then as investors have increasingly bet that the Fed is moving close to slowing the pace of its rate hikes. Despite the sell-off, the currency still rose 8% for the year – its best performance since 2014.

Analysts widely believe the US dollar is poised to rise again in 2023, with the country’s central bank indicating its willingness to tolerate economic pain in order to restore price stability. With policymakers on course to raise US interest rates further and keep them high for longer, uncertainty in the form of a looming recession is again set to draw investors back to the US dollar.

Rising rates will continue to make the US dollar an attractive asset and a recession will increase its appeal as a safe-haven currency.

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What are the implications for other currencies?

The appreciation of the US dollar is viewed as a major global challenge for most countries, particularly emerging market economies. A strong US dollar feeds into inflation pressures overseas by making other countries’ imports more expensive. It also makes it more difficult for them to service US dollar-denominated debt.

Often, countries respond by resorting to foreign exchange interventions to strengthen their currencies. Central banks also respond to inflation as well as currency weakness by raising interest rates, but this has the effect of slowing their economy.

Take the example of Singapore’s central bank. The Monetary Authority of Singapore (MAS) has tightened policy 5 times since October 2021 to tame inflation. That resulted in the Singapore dollar strengthening against the US dollar in 2022, bucking global currency trends which saw the greenback rise against most other currencies.

But the MAS is now largely seen to have done with the tightening. The central bank, which conducts monetary policy using exchange rates due to Singapore’s heavy reliance on trade, is expected to leave its exchange rate settings unchanged at its next scheduled meeting in April, in an effort to support the slowing economy.

Analysts believe this is likely to result in the Singapore dollar weakening this year, particularly against the Malaysian ringgit, the Thai baht and Japanese yen. The local currency could also weaken versus the yuan amid the optimism surrounding China’s reopening.

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