Dollar correction has not yet run its course

Some consolidation and a slower pace of depreciation now seem likely, following the abrupt decline and sizeable accumulation of short USD positions. However, 1) the Federal Reserve (Fed)’s shift to average inflation targeting, 2) negative US real yields, and 3) a still-material dollar overvaluation suggest that the USD has further room to fall, though there will be more "two-way" price action.

We maintain 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 EURCHF to gravitate higher and close some of the "unusual" gap with EURUSD. That said, upside is likely to be limited due to the lack of catalysts for Swiss outflows.

Sterling seems to have finally started catching up with the "no-deal" Brexit risk. Near term, we see GBP trading on the soft side. Only once a basic deal with the EU looks firmly in the offing will sterling manage to resume its appreciation. As for JPY, we see the recent stickiness around the 106 level as the outcome of two opposing forces: lower US yields vs rising risk asset prices. However, we still expect a gradual JPY appreciation, consistent with previous cycles of dollar depreciation.

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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