Rotating into select EM FX

In December, the trade-weighted (TW) USD index has fallen a further 1.4%, bringing its cumulative drop since late March to 13%.  This sizeable decline together with the accumulation of extended speculative USD shorts suggest that some consolidation is due. However, the greenback remains overvalued; the Fed will maintain its supper accommodative monetary policy while global trade and growth are in the midst of a strong recovery. All this implies that further dollar weakness is likely for the next year, albeit at an appreciably slower pace.

We believe that most G10 currencies are approaching “maximum gains” while a select group of emerging market currencies have only recently started to gather upside momentum. In our view, while G10 FX will remain well supported against the USD, 2021 is likely to see a rotation towards certain EM FX with attractive valuations, robust external balances and significant exposure to China’s economic activity (see below). 

For end-2021 we have pencilled-in EURUSD at 1.25, a very strong resistance level, unless the global trade recovery is stronger than we expect. EURCHF should also move higher, supported by improved risk appetite and Swiss residents’ outflows.

Under our central assumption of a “deal Brexit", we see GBPUSD approaching fair value (around 1.37). Although the weaker USD may lift sterling higher, we think that Brexit headwinds will make it hard for the currency to climb sustainably beyond this level. However, the risk of a no-deal has certainly increased recently; if it happens, we would expect GBPUSD to drop rather swiftly to the 1.20-1.25 area, and EURGBP to rise towards parity. USDJPY remains in a slow downward trend, aided by substantial JPY undervaluation and an appreciable slowdown of equity outflows from Japan.

We expect the NOK to outperform the SEK in 2021, while most of the gains for the core commodity FX bloc are already behind us.

We stay bearish on USDCNY, forecasting 6.51, and 6.40 on three- and twelve-month horizons. Beyond superior macro fundamentals and much-improved balance of payments flows, the increasing tolerance of authorities for a stronger CNY is a key reason. With Mr Biden winning, we assume some reduction in trade uncertainty, but not an automatic or rapid reduction in Section 301 tariffs on Chinese goods. Still, a reduction is plausible, and would introduce further downside risks to our current forecasts.

Main risks to our views

The main upside risk to our forecasts comes from a stronger recovery in global trade, which will send the USD into a steeper decline and support bigger and broader rallies in the G10 and emerging markets. On the downside, we see the following risks: First, the Fed turning less dovish and so triggering a market reaction like 2013’s “taper tantrum”. Second, a delay in the development/distribution of Covid-19 vaccines would increase the risk of new restrictions and economic disruption. Third, a premature withdrawal of fiscal support.

In the Nordics, we maintain our preference for the NOK over SEK, while in the core commodity FX bloc we now see CAD outperforming. That said, the pace of appreciation of all cyclically sensitive G10 currencies vs the USD is set to slow.

The US dollar-Chinese yuan cross (USDCNY) has now breached the 6.90 – 7.15 range we assumed. This mostly reflects a weaker USD and fast improving Chinese balance-of-payments dynamics, but very recently, markets have begun pricing in a Biden presidency and lower tariffs. We revise down our USDCNY forecast to 6.75 and 6.68 on a 3- and 12-month view. A reduction in tariffs under a Biden presidency would be CNY-bullish, and should see CNH recover lost ground against other currencies, including the EUR.

In emerging markets (EM), we remain structurally neutral on the overall GBIEMFX index, but our forecasts now show a modest spot return of 0.40% on a 12M view,  with the bulk of the gains coming in the next six months (a successful Coronavirus vaccine would help accelerate this process).

Country selection remains crucial, and we continue to prefer currencies with low debt, high exposure to Chinese infrastructure spending (KRW and CLP), EURUSD upside (PLN and CZK), and the tech sector (TWD). In Asian FX, we have upgraded INR to "modestly bullish" and remain "modestly bullish" on the CNY (but would upgrade to bullish if there were more evidence that a Biden Presidency comes alongside a reduction in tariffs).

Main risks to our view: First, a second strong Covid-19 wave that again disrupts economic activity and increases demand for dollars. Second, the euro appreciation may have become an unwelcome development for the ECB. Although the room for policy action is far more limited than in the past, any verbal intervention is likely to weigh somewhat on the common currency and support the dollar. Third, a re-escalation of China-US trade frictions could halt the recovery in global trade and would underpin the greenback.

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