Much of the market focus in recent months has been on major reserve currencies, namely:
- The US Dollar which, contrary to bearish expectations and in line with our benign Dollar view, has treaded water in the past six weeks and since the Fed’s tweak on 27th August to its dual inflation and employment mandate;
- The Euro’s rapid appreciation in July, its more prosaic performance in August and the first half of September and speculation that the European Central Bank would try to jawbone the currency weaker. Instead the ECB as its policy meeting on 10th September resorted to verbal intervention “light”, in line with our core scenario that Brazen ECB verbal intervention against Euro was unwarranted and unlikely (9th September 2020).
- Sterling’s collapse last week and only partial recovery in the past four trading sessions. We are sticking to our view that the UK economy and Sterling face four potential headwinds in coming months, including i) fiscal stimulus measures being unwound, ii) a no-deal Brexit, iii) higher taxes and iv) a further re-tightening of lockdown measures in coming months (see UK & Sterling facing potential quadruple whammy, 4th September 2020).
Conversely, Asian currencies have seemingly fallen under the radar screen, for good reason. They have exhibited little directionality within very narrow ranges in the past month, particularly relative to high-yielding emerging market currencies.
We think this is the result of Asian central banks’ ability and willingness to keep their currencies on a tight leash, in order to minimise their disinflationary impact and maintain export competitiveness while at the same time capping the cost to governments, corporates and households of servicing sizeable foreign-currency denominated debt.
The Renminbi Nominal Effective Exchange Rate’s 2% appreciation in the past month, while unspectacular, is noteworthy and will be the topic of a forthcoming report.
Focus on the majors and EM high-yielders, Asian currencies largely out of the spotlight
Beyond the spike in US equity volatility in early September, much of the market focus in recent months has been on major reserve currencies, namely:
- The US Dollar which, contrary to bearish expectations, has treaded water in the past six weeks;
- The Euro’s rapid appreciation in July, its more prosaic performance in August and the first half of September and the likelihood of the ECB trying to jawbone the currency weaker; and
- Sterling’s collapse last week and only partial recovery in the past four trading sessions.
Conversely, Asian currencies have seemingly fallen under the radar screen, for good reason. They have exhibited little directionality within very narrow ranges in the past month. However, the Renminbi Nominal Effective Exchange Rate’s 2% appreciation, while unspectacular, is noteworthy and will be the topic of a forthcoming report.
US Dollar has treaded water in past six weeks, in line with our benign Dollar view
Market sentiment about the US Dollar has been almost unequivocally bearish in the past couple of months, with most analysts having forecast further Dollar depreciation. Media reports have argued that the Dollar NEER’s 7.5% depreciation between late-March and late-July, from arguably strong levels, pointed to the demise of the Dollar and the beginning of a structural and permanent shift in the currency composition of central banks’ FX reserves.
Our more benign Dollar view, detailed in Warnings about US economy and USD overblown (4th August 2020) has so far been vindicated. The Dollar DXY index, a weighted average of the Dollar against the Euro, Yen Sterling, Canadian Dollar, Swedish Krone and Swiss Franc, has traded in a narrow range of just 2.2% in the past six weeks and mark-to-market is broadly unchanged (see Figure 1). The broader Dollar NEER has weakened only 2%, due mainly to the Dollar’s depreciation against the Mexican Peso and Chinese Renminbi, and is still nearly 2% stronger than the average level which prevailed in 2019.
Our argument was that the Dollar’s depreciation between mid-June and early August was “mainly due to successful central bank policies to address imbalances in its supply and demand and a cyclical rotation out of Dollars into other FX reserve currencies, including the Euro […]. We do no think that FX price action in the past couple of months, including the Euro’s appreciation to multi-year highs, points to the beginning of a structural and permanent shift in the currency composition of central banks’ FX reserves. In the same way that apocalyptic forecasts in the past about the Eurozone and Euro have failed to materialise, current forecasts of the Dollar’s demise as the world’s number one reserve currency are at best extremely premature, at worst unfounded”.
Our perspective on the Dollar has since remained fundamentally unchanged. Specifically, we argued in US: Much ado about nothing (28th August 2020) that the Federal Reserve’s announcement on 27th August of a change to its dual inflation and employment targeting mandate had “limited implications for the Dollar near-term“. Since then the Dollar DXY index has appreciated marginally while the Dollar NEER is down only 1.5%, according to our calculations (see Figure 1).
Euro in a tight range following European Central Bank’s verbal intervention “light”
The Euro NEER’s sustained 4% appreciation between late-May, when the European Commission announced the details of a €750bn Recovery and Resilience Facility, and early August led to increasing speculation that the European Central Bank would have little choice but to try and weaken its currency in order to minimise its deflationary impact (see Figure 2). The argument that the ECB would resort to verbal intervention and potentially loosen monetary policy gained further traction in the run-up to the European Central Bank’s policy meeting on 10th September.
However, our view was that that ECB President Lagarde would refrain from explicitly trying to weaken the Euro, on the basis that the Euro NEER had appreciated only 1.8% since the ECB’s previous policy meeting on 16th July and thus had only a negligible deflationary impact and that the Euro had treaded water since end-July (see Brazen ECB verbal intervention against Euro unwarranted and unlikely, 9th September 2020).
In line with our expectations, President Lagarde in her press conference introductory statement resorted to verbal intervention “light”. She said that the ECB would assess future currency developments while acknowledging that the Euro’s appreciation was only one factor behind low Eurozone inflation and that ultimately the ECB and Eurozone faced more pressing challenges, namely “the elevated uncertainty about the economic outlook [which] continues to weigh on consumer spending and business investment”. Moreover, the ECB left its CPI-inflation forecasts for 2020 unchanged while revising up (not down) its inflation forecasts for 2021. President Lagarde and Vice-President de Guindos have since echoed their moderate concerns about the Euro and the Euro NEER and EUR/USD cross have remained in tight ranges in the past week (see Figure 2).
UK economy and Sterling still facing multiple headwinds
The Sterling NEER dropped 3.7% last week, its largest weekly depreciation since the peak of global risk aversion in March, in line with our bearish Sterling view (see Figure 3). We argued that the UK economy and Sterling face four potential headwinds in coming months, including i) fiscal stimulus measures being unwound (including the government’s furlough program on 31st October), ii) a no-deal Brexit, iii) higher taxes and iv) a further re-tightening of lockdown measures in coming months (see UK & Sterling facing potential quadruple whammy, 4th September 2020).
The main catalyst for Sterling’s collapse last week was arguably the second item on our list, specifically growing concerns that the UK and EU will fail to reach a trade deal in the next six weeks which would result in the UK having to adopt punitive WTO trading rules. The UK’s transition arrangement with the EU ends on 31st December but an agreement needs to be reached by around mid-October in order for the British and European parliaments to have time to ratify it. Negotiations over a UK-EU trade deal have made little progress in recent weeks due mainly to disagreements over UK state aid and fishing rights.
Moreover, the odds of these talks ending successfully were dealt a further blow by the British government’s recent publication of the Internal Markets bill which aims to supersede parts of the Withdrawal Agreement. The WA, including the Irish protocol, sets out the terms and conditions of the UK’s exit from the EU (which took place on 31st January) and was voted through by both the British and European Parliaments. The Internal Markets bill, which parliament is likely to pass into law given the ruling Conservative Party’s large parliamentary majority, effectively seeks to renege on parts of the WA in the event of both sides failing to reach agreement on a new trade deal. At best it dents the British government’s international credibility, including with the EU, in our view, at worst it is a breach of international law as some legal experts argue.
The Sterling NEER has rebounded 1.5% this week (see Figure 3) which we mainly attribute to investors viewing its level as attractive after last week’s sharp sell-off in, rather than any fundamental improvement in the outlook for the UK economy or currency. In the face of widespread opposition to the bill across the political spectrum, the government today agreed to amend the Internal Markets bill and grant parliament a right to vote before Prime Minister Johnson could trigger the law. This has seemingly contributed to Sterling’s appreciation for the fourth consecutive trading session but we would argue that Sterling’s vulnerabilities remain acute going into year end.
Majority of Asian currencies exhibiting little directionality within very narrow ranges
Unlike the Dollar, Euro and Sterling, Asian currencies have seemingly fallen under markets’ radar screen, for good reason in our view. In the past month the Japanese Yen, Korean Won, Malaysian Ringgit, Philippines Peso, Singapore Dollar, Taiwan Dollar and Thai Baht NEERs have exhibited little directionality within very narrow ranges (see Figure 4). Even the historically more volatile high-yielding Indonesian Rupiah and Indian Rupee have traded in far narrower ranges than their counterparts in Latin America (including the Brazil Real, Mexican Peso and Colombian Peso) and Emerging Europe and Africa (including the Russian Rouble and South African Rand).
Moreover the Rupee and Rupiah NEERs have moved by only +1% and -1% respectively in the past month according to our estimates, unlike other high-yielding emerging market currencies which have either outperformed materially (the case for most Latin American currencies and the South African Rand) or underperformed materially (Russian Rouble). The Rupiah NEER is admittedly at the bottom of its narrow one-month range but its 9.5% depreciation since early June has been gradual. The Rupee NEER is currently near the middle of its 2.3% range.
An important factor behind Asian currencies’ benign performances since mid-August is that the US Dollar and Chinese Renminbi have had diametrically-opposed fortunes, with the Dollar NEER down about 1.7% and the Renminbi NEER up about 2%. China and the United States are the largest trading partners for major Asian economies and therefore the Renminbi and Dollar have the largest weights in Asian NEERs (according to BIS data). Specifically, the Renminbi and Dollar on average account for about 26.3% and 12.3% respectively of Asian NEERs, according to our estimates.
As a result the weaker Dollar and stronger Renminbi have to a large extent cancelled each other out with respect to Asian NEERs. Moreover, Asian economies conduct a significant amount of their trade among themselves and therefore Asian currencies account for a large share of Asian NEERs. The fact that Asian currencies have traded relatively flat versus one another has further contributed to narrow NEER ranges and limited directionality.
Stable Asian currencies likely a by-product of targeted central bank monetary policies
We do not think this is a statistical aberration but the by-product of Asian central bank monetary policies designed to keep their currencies on a tight leash in order to maintain export competitiveness and minimise the disinflationary impact of their currencies at a time of depressed global economic growth. Headline CPI-inflation (WPI-inflation in India) fell in July-August from H1 2020 in all Asian economies bar Japan and the Philippines (and was very low in Japan at 0.4% yoy in July) and was in negative territory in Malaysia, Singapore, Taiwan and Thailand (see Figure 5).
At the same time Asian central banks have seemingly not allowed their currencies to weaken markedly, let alone intervened in the FX market to push them lower, which we attribute to their desire to cap the cost to governments, corporates and households of servicing sizeable foreign-currency denominated debt.
This is testament, in our view, to the willingness and ability of Asian central banks to keep their currencies broadly aligned with the currencies of their main trading partners – including the Chinese Renminbi and US Dollar, by intervening in the FX market to smooth and cap currency moves and adjusting broader monetary policy settings accordingly. We have explored this theme in previous Fixed Income Research & Macro Strategy reports, including Virus, volatility and valuations (27th February 2020).