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.

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