US trade protectionism has been a key factor behind the US dollar strength, especially against Emerging Market (EM) currencies.
The good news is that global trade war risks have receded on the EU-US cease-fire and as NAFTA 2.0 shows signs of progress.
The bad news is that US-China trade tension is likely to get worse before it gets better.
The escalating US-China trade tensions have put the negative externalities on other Asian currencies from a weaker Chinese yuan in the spotlight.
Since mid-June, the yuan has weakened close to 6 per cent against the dollar and 5 per cent on a trade-weighted (China Foreign Exchange Trade System or CFETS basket) basis.
Because China is an important trading partner for most Asian countries, the yuan weakness has significant spillover effects, especially on currencies of smaller open Asian economies that are deeply plugged into China’s supply chains (e.g. Korean won, Singapore dollar and Taiwan dollar)
We downgraded the yuan forecast at the start of August, putting the three-month dollar-yuan forecast at 6.90 (old: 6.65) and 12-month at 6.50 (old: 6.30) to reflect escalating US-China trade conflict risk.
Since the forecast downgrade, we take comfort that there is a growing official recognition of the need to curb the bearish yuan market sentiment.
This should limit significant downside risks to our CNY forecast.
A shift from an earlier benign neglect of yuan weakness is underway in our view, as the People’s Bank of China (PBoC) is increasingly resisting market forces weakening the yuan.
The PBoC’s announcement that it has resumed the counter cyclical factor (CCF) is an indication that the central bank is uncomfortable letting the market steer toward a weaker yuan, and would prefer to have greater control of the dollar-yuan fix.
This is in line with its recent implementation of a 20 per cent reserve requirement associated with selling yuan and its warning that Chinese banks should avoid “herd behaviour” when trading the currency.
There is more in the policy toolkit should the need arise to further contain yuan depreciation pressures.
While yuan depreciation would help offset the adverse impact from Trump’s tariff measures, it runs the risk of triggering market panic and largescale capital outflow, as well sparking reactions from the US side and further complicates bilateral trade negotiations.
Trump has complained more than once about recent yuan depreciation by calling it a “currency manipulation”.
Should Trump want to officially label a country a currency manipulator, he has his next opportunity in October when the next US Treasury report on currency manipulation is due.
Overall, China’s reduced tolerance for further yuan weakness means that fiscal policy, particularly in infrastructure spending, is likely to increasingly bear the brunt of offsetting any damage from trade.
As the authorities step up efforts to support the currency, the yuan could decouple further from trade developments and anchor other Asian currencies, disrupting one important transmission mechanism from trade worries to stronger dollar.
This, along with increasing challenge to the theme of growth divergence between the US (firmer) and the rest of the world (softer), suggests that while the dollar may yet rally a bit more, it is close to its peak.
The November US midterms election may be a dollar-bearish event if Democrats win the House, which in turn would reduce the likelihood for another fiscal stimulus that would be needed to offset the fiscal cliff of 2020.Disclaimer applicable to recommendation
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