investment insights
Dollar weakness will not prop up emerging currencies
Key highlights
- Market sentiment has improved over the last few weeks as the global growth rate of Covid-19 cases is slowing, and an unprecedented combination of fiscal and monetary support has been issued.
- Nonetheless, there is no shortage of risks, associated primarily with the possibility of a second virus wave as well as the negative economic side-effects of large-scale lockdowns.
- It is now certain that the global economy is facing a deep recession. However, the external nature of the shock together with the sizeable fiscal and monetary stimulus make us optimistic that the second half of this year will see a gradual economic recovery.
- The confluence of a world GDP recovery with near-zero rates in the US and a sizeable expansion of the Fed’s balance sheet argue for a weaker dollar against major reserve currencies such as the euro, Swiss franc, Japanese yen, and sterling.
- However, the US dollar could remain supported against a large number of emerging market currencies, which are dependent on (lower) commodity prices and/or are vulnerable to the virus epidemic due to poor health infrastructure.
- That said, we maintain the view that the yuan and parts of Asia FX are likely to outperform.
- The key risk here is the possibility of a strong second virus wave that could reignite a dollar liquidity squeeze (akin to that in March), which in turn would result in renewed US dollar appreciation.
The last few weeks have seen a partial reversal of the asset price moves that marked March. Global equities have risen, oil prices have rebounded from the lows on the OPEC+ decision to cut oil production by 10 mn barrels a day, and the US dollar has come off by 3% since its high on 23 March. The backdrop for all this has been the global growth rate of confirmed Covid-19 cases slowing visibly, and monetary and fiscal policies stepping into uncharted expansionary territory.
Nonetheless, there is no shortage of risks. Uncertainty regarding the virus spread is still present (not least because of the possibility of a second wave), while national lockdowns are beginning to take their toll on economic activity. Still, policy responses have been enormous and will likely cushion the deep impact.
In summary, our working assumptions remain unchanged and revolve around the following topics:
- The virus pandemic and the associated country lockdowns have thrown the global economy into a deep recession. However, we still see the odds favouring a recovery in H2 2020 as confinement restrictions are gradually lifted. We note that this process will be aided by the significant amount of stimulus deployed by governments and central banks.
- The US Federal Reserve (Fed) appears to have been successful (at least so far) in taming the huge problem of USD liquidity squeeze that led to the USD surge in mid-March. Consequently, the recent normalisation in FX and money markets is likely to continue.
- We still feel that the significantly lower US yields and the enormous expansion of the Fed’s balance sheet (which will start including junk-rated bonds) will trigger a depreciation of the USD on a trade-weighted (TW) basis.
- As for energy prices, the USD 10-15 bn barrel-per-day (bpd) cut promised by OPEC-Plus and Western producers – while commendable – has seen energy prices give up their some of their gains. With a likely large degree of demand destruction (between 15-35 mn bpd) and supply cuts expected to occur from May onwards, energy prices face downside risks. However, our EMFX valuation model suggests the asset class is fairly valued at best, implying that downside risks remain for several EM currencies.
We continue to see EURUSD at 1.16 for year-end, EURCHF at 1.08, GBPUSD at 1.28, and USDJPY at 103. However, we reiterate that uncertainty remains high and the price action may be subject to increased volatility.
On the other hand, we expect the USD to be well supported against large parts of EMFX given the new “low-for-longer” backdrop for energy prices. However, we still anticipate that the yuan and parts of Asia FX will outperform after the initial shock.
Accordingly, our theme of a “tale of two dollars” remains intact: softer against the G10 reserve currencies (EUR, JPY, CHF, and gold), but stronger against EMFX (barring CNY and parts of Asia).
Clearly, the risks to our view are sizeable, but also symmetric. They include the following factors: 1) the pandemic worsening further and delivering a more severe and durable blow on the global economy (USD-positive via more severe USD liquidity squeeze); 2) failure by the Fed to address the USD liquidity stress issue (USD-positive); and 3) a very sharp rebound in the global economy in H2 2020 (USD-negative).
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