There is increased discussion that several countries may be on the verge of a recession.

If we focus specifically on the FX market, it seems to us that recession speculation could drive currencies in many directions. The first port of call is to investigate the reasons why recessions might develop and how currencies will respond, before later looking at the consequences of any such downturns. Coming back to the first issue—the cause—we’ve already mentioned central bank tightening, as central banks find it difficult to "land" economies softly.

As such, the focus will probably be on those central banks that push the hardest to tighten policy, and, amongst the bigger G10 countries, this is likely to mean the Fed, probably followed by the BoE. The Fed is key because if it misjudges policy and tightens too much, any resultant recession will likely spread to other countries via a tightening of global financial conditions.

Hence, we can’t say that the dollar is most at risk because others will likely topple below the zero growth line as well. That’s not the same as a situation where, for instance, the Bank of England proves to be the one who misjudges the situation and pushes the economy into a recession. Here, the spillover effects would be more limit ed and the pound would presumably suffer. Instead, if the Fed is the one seen to be overreacting and thus risking a recession, the dollar could initially rise because tighter financial conditions would likely lead to a flow into "safe" assets such as treasuries and the dollar. Much would be dependent on spillovers from the United States.

Would we see a dollar shortage problem, for instance, as financial conditions tighten? That’s not clear because mechanisms such as dollar-supplying central bank swaps and repos have managed to avert dollar shortage problems and mean that dollar strength has been fleeting (as we saw in 2020 with the pandemic).

In addition, we also have to bear in mind that recession concerns could cause quite a decline in longer-term US rates as the market prices in the easing cycle to come, and that too could prevent a sustained dollar rally. "All told, we’d suggest that the ‘why’ part of the recession story could temporarily play out well for the dollar, pushing the euro, for instance, to parity or below, and the dollar/yen up to 140, but the longevity of this strength would depend on the consequences of the recession," Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said.

As far as the consequences of recession are concerned, Mr. Steve Barrow feels that if zealous central bank tightening pushes advanced economies into recession, then we’d typically fear most for the euro zone and the euro. The reason for this is that the debt dynamics of the region are a potential burden for the euro. As we’ve talked about many times before, euro zone countries issue debt in euros but don’t print euros. This can create a cascading risk in the debt market when debts are perceived to be excessive, as we saw during the 2010-12 debt crisis. Recessions worsen debt dynamics, and more so if the source of the recession is a sharp rise in policy rates and hence bond yields.

The US, UK, and many other advanced countries have poor deficit and debt dynamics as a result of poor prior fiscal management and, more recently, the pandemic. But they don’t have the unique dichotomy between debt issuance and currency issuance that we see in the euro zone. Policymakers in the region might be working on this by creating more commonly-issued debt, but that leaves us with little comfort should the euro zone fall into recession in the next year or two.