Balancing global reflation with higher US yields

First, the reflation theme is global as activity and trade are picking up worldwide. In periods like this, global improvements in GDP growth prospects (USD-negative) are more important than the rise in US nominal yields (USD-positive). Second, despite the spike in US10Y nominal yields, real US yields, which are more closely correlated with USD movements, remain severely supressed and negative. Third, the TW dollar index is still overvalued and should come under some pressure in the months to come. Consequently, we maintain expectations of further modest USD depreciation this year. However, we note that if US nominal rates keep rising too fast, too soon, then this would put our forecasts at risk.

More specifically, we keep our EURUSD forecast at 1.27 at Q2 2021, but closely monitor developments in the European vaccination rollout programme. At the same time, we maintain our modest upward bias for EURCHF, given solid risk appetite and an acceleration in Swiss portfolio outflows. As things stand, we see the pair peaking around 1.10.

Despite sterling’s outperformance this year, we are reluctant at this stage to chase the rally and keep our forecasts unchanged. This is based on our expectation of structural headwinds due to Brexit and our anticipation of only a gradual lifting of the Covid-19 related restrictions. However, we will monitor closely development on the latter.

Turning to the yen, the upward move in USDJPY can be explained by the trimming of speculative USDJPY shorts and the rapid rise in US yields. We raise the pair’s forecast trajectory but maintain a bias for JPY strength on fundamental grounds.

In the Nordics, we reiterate our preference for the Norwegian krone and expect further NOKSEK upside. In the core commodity FX bloc, we expect moderate gains but upside is likely to be capped, mostly on less attractive valuations.

Solid expectations for emerging market (EM) Q1 growth and a stronger energy prices suggest emerging market currencies can appreciate in the coming months; that said, we reiterate our preference for a select subgroup of EM currencies. Our top pick remains the Chinese yuan, which should continue to receive medium-term support from strong underlying growth, accelerating flows to China and a gradual shift of the People’s Bank of China towards hawkishness. The possibility of lifting some of the 301 section tariffs by the US could also underpin the currency.

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 an even steeper decline and support bigger and broader rallies in the G10 and emerging markets. On the downside, we see the following risks: First, further rapid increases in US nominal yields. Second, the Federal Reserve (Fed) turning less dovish and so triggering a market reaction like 2013's "taper tantrum". Third, a delay in the distribution of Covid-19 vaccines that would increase the risk of new restrictions and economic disruption. Fourth, 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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