A Democratic sweep could sweep USDCNY off its feet

The US dollar has by now given back most of its gains from September’s “mini” rally. This reflects still-weak momentum dynamics, fundamental dollar headwinds, and low market appetite for chasing the greenback higher. We maintain the view of further dollar downside based on 1) the Federal Reserve (Fed)'s ultra-accommodative long-term stance, 2) negative US real yields, 3) a still-material dollar overvaluation, and 4) our base scenario of a Democratic sweep in the US elections. This last factor would likely lead the market to price in the reversal of the corporate rate tax cut.

That said, risk events and challenges do exist, including Brexit progress, uncertainty on the US election outcome, and developments on the pandemic front. This suggests that pace of USD depreciation has entered its second phase that will be slower and subject to more “two-way” price action.

We keep our target of 1.21 for the euro/US dollar (EURUSD) by year-end, and see some further modest gains in 2021. At the same time, we expect euro/Swiss franc to gravitate somewhat higher, especially since recent balance-of-payments data suggests a pick-up in Swiss outflows.

Turning to sterling, we believe that the time is ripe to turn constructive again. Despite political posturing, the two sides have made some progress and should become more pragmatic as time runs out. With sterling still undervalued and speculative positioning very clean, we think the currency is set for a hefty rebound towards 1.35. As for the Japanese yen, we still expect a gradual appreciation, which however now runs the risk of being slower given USDJPY’s ongoing decoupling from yield differentials.

We maintain our bearish USDCNY view, forecasting 6.75 and 6.68 on three- and twelve-month views, but risks remain to the downside. Improving growth, a less dovish PBOC, and sharply improving balance-of-payments dynamics support our more constructive view. While we assume a Biden win in the US presidential elections, we are not betting it would mean an automatic or rapid reduction in Section 301 tariffs on China goods. Still, a reduction is plausible, and would introduce substantial downside risks to our current forecasts.

In emerging markets (EM), we remain structurally neutral on the overall GBIEMFX index ahead of the US elections. While a Democratic sweep could result in reduced trade tensions that support large parts of emerging markets, increased fiscal spending and a potentially steeper US Treasury curve could actually first hurt some of the yield-sensitive, current account-deficit EM currencies.

Main risks to our views: First, a second strong Covid-19 wave that again significantly disrupts economic activity, reduces liquidity and increases demand for dollars. Second, the euro appreciation may have become an unwelcome consequence for the European Central Bank. 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 act as a brake. Third, a Trump victory in the US elections would suggest a return of global trade frictions and increased demand for dollars.

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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