Is the world’s reserve currency – the USD – in trouble? It is easy to get gloomy over the USD’s prospects. Relative fundamentals that supported USD valuations eroded after the Covid-19 epicentre shifted to the US. Big cuts in US interest rates, ballooning expansion of the Fed’s balance sheet and massive fiscal stimulus are expected to weigh on the greenback.
US markets have started pricing in negative fed funds rates for next year even though the Fed is highly unlikely to choose a negative fed funds target rate for the foreseeable future. The Fed previously made clear a strong preference for QE and forward guidance to negative rates, which are problematic for banks’ profitability and the money market fund industry.
Do start to worry about the USD given its loss of yield advantage
The USD typically strengthens during times of financial market stress, given that it is viewed as the key global haven. But thanks to intervention on an unprecedented scale and speed, this prevented the economic and health crisis from turning into a financial crisis. The acute USD shortage was staunched. USD funding conditions continue to normalise to the detriment of the USD, as yields no longer favour the greenback.
We expect a weaker USD over the next 6-12 months but only moderately, not dramatically so. We are worried about the USD outlook but a few reasons serve as a reality check on excessive pessimism.
First, USD performance is likely to vary greatly depending on the shape of recovery for the global economy, as focus shifts from Covid-19 containment to economic reopening. Will the recovery in growth in the coming months be L, U, V or W shaped?
In a V-shaped world, the USD has the greatest scope to decline, especially against commodity currencies, which are best placed to gain from higher commodity prices alongside the economic upswing. FX markets appeared to be pricing in a “V-shaped” recovery, judging from the strong USD retracement against ‘higher quality’ commodity currencies such as NOK and AUD over the past month. This suggests that emerging market currencies are building a bottom, too, even though fundamentals, especially in Latin America, are not promising.
However, we would be wary of aggressively chasing USD weakness with so much uncertainty still abounding. If a second wave of infections occurs, markets may have to contemplate a second wave of lockdowns, at which point the letter "L" begins to enter the narrative. Economies may not open up as quickly as hoped. “U” is for uncertain. The new normal of soft social distancing suggests a more drawn-out U-shaped or W-shaped, rather than the V-shaped recovery as a more likely outcome.
Second, the US equity market has the largest share of potential winners in a post-pandemic world -- Tech, Healthcare and Communication Services (See here)-- relative to any large developed or emerging market equity markets. This implies capital flows are likely to remain supportive of the USD although mapping sector winners into currency performance is not a straightforward exercise.
Third, it is tough to find a compelling story in other major currencies such as EUR or RMB to depress the USD in a big way.
The recent war of words between the US and China on whom is to blame for the coronavirus outbreak is not good news for our baseline of RMB stability. The pandemic has accelerated the trend of rising US-China tensions, which was already an issue before Covid-19, as manifested in the trade war and technology rivalry.
China is deeply embedded at the centre of global supply chains. The coronavirus, which exposes the fragility of an economy built on outsourcing and just-in-time inventory, has reinforced concerns in the US over supply-chain vulnerability and the need to shift from just-in-time to a just-in-case model.
We refrain from making changes to our USDCNY forecasts (at 6.90 for 12M) for now although we remain alert to the risk of escalation from the dangerous US-China blame game. This year’s US presidential contest could be dominated by a China-bashing contest. There remain risks of economically damaging US measures and/or Chinese retaliation although a ratcheting up of US-China tensions which could weaken US economic recovery and raises uncertainty does not sound like an election winner for President Trump.
The EUR has struggled to shake off worries about Euro area political cohesion, which is essential to the long-term viability of the single currency. The12-month EURUSD forecast has been marked down to 1.13 from 1.15, given continued reluctance within the Euro area to agree to any form of material fiscal risk-sharing to cope with the Covid-19 crisis. Although the European Central Bank (ECB) is providing support through its asset purchases, it will eventually need political support if it is to effective mutualise individual countries’ debts. The German Constitutional Court ruling on the legality of ECB bond-buying has exposed the political limits to ECB’s capacity to ‘do whatever it takes’ to combat the pandemic’s economic damage.
Lack of political cohesion within Euro area is a key risk to the long-term viability of the EUR
At a broader level, this means the USD is not about to lose its place as a global reserve currency — after all, it is not easy to replace something with nothing, given that EUR needs to overcome its existential issues while China’s reluctance to reform its capital controls and liberalise its currency slows the RMB’s rise.
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Version: March 2020