2020 has been an exceptional year. While there are many things that will be left in the rear-view mirror as we head into 2021, yuan exceptionalism one of the things that should persist — albeit due to different drivers.
In 2020, a strong Chinese current account was a key driver of yuan strength as a wide trade surplus and a narrower-than-usual services deficit provided consistent support. Looking at 2021, the support from China’s current account is likely to ebb a bit as the global recovery helps close the gap between China-U.S. growth and pulls back on abnormally high export demand for Chinese-made COVID-19-related equipment. However, bond inflows seeking relatively higher yields should continue, especially with hopes high for U.S. tariff reductions and easing of financial sanctions.
On balance, stronger capital account flows should offset softening current account flows and leave the overall Chinese balance of payment surplus supportive of yuan appreciation. Should the People’s Bank of China continue its light-touch approach to foreign exchange that has categorized the post-Phase 1 era, then the path toward appreciation would be cleaner than seen in the past. Due to these factors, further yuan strength is expected, with the majority of the yuan’s gains likely to come during the first half of 2021, when the economic backdrop is more supportive, vaccine optimism is near its peak, and hopes for reconciliation between the U.S. and China remain high during the early days of the Biden administration.
Yuan strength should also benefit the rest of the emerging markets (EMs) due to the yuan’s increased importance to emerging market FX. This increased importance has been a decade in the making and reflects China’s evolving role in global trade. Previously, China was the factory of the world and bought intermediary items from EM countries. However, due to deliberate policy decisions, China has rebalanced growth drivers away from exports and toward domestic consumption, making China the largest independent driver of external demand for the rest of EM.
1–2 week view: The European Central Bank (ECB) held rates unchanged but extended and added funds to its pandemic emergency purchase program. The bank did address the euro exchange rate, but, given the euro’s recent run, this statement was not much of a protest. The EU also passed its budget and stimulus package, but this was expected. Overall, the market bias is still one of optimism on global growth. This should keep the euro supported, but lingering uncertainties should see the market cautiously building long positions on what could be a very choppy and volatile end-of-year.
3-6 month view: The euro’s performance in 2020 was mainly driven by factors other than European economic performance. With the factors that pushed the euro higher in 2020 having faded or starting to fade, gains in 2021 should be harder to come by. Near-term optimism on a recovery in global growth helps the euro higher, but the single currency should dip into year-end as U.S. yields rise, the European Central Bank continues to fight deflation and market focus shifts to questionable domestic growth fundamentals. In essence, it is difficult to see a sustained euro rally without European economic exceptionalism and the prospects of ECB rate hikes.
1-2 week view: Cable gapped up around 100 points higher than where it closed on Friday after the U.K. and the EU announced talks will continue past today’s deadline. Ultimately uncertainty remains high and Brexit headlines will dominate all other factors this week. A skinny deal narrowly is the base case but the distribution of outcomes for sterling skews to the downside. Should there be a no-deal outcome, expect GBP/USD to drop to the mid- to low 1.20s in the interbank market. Conversely a deal should see a relief rally taking the pound higher.
3-6 month view: The path for the pound in 2021 will depend on the interaction between the realities of Brexit and the speed and extent that the U.K. economy can recovery from the pandemic. On the pandemic, the U.K. economy’s underperformance arguably makes it one of the biggest beneficiaries of a vaccine. However, Brexit drags to growth, and massive fiscal deficits represent counterarguments. Market are assuming a skinny deal. While this is better than a no-deal exit, a skinny deal still represents a negative economic outcome relative to the status quo. This is why the pound is expected to drift lower after the initial relief rally as markets refocus on the fact that a skinny deal is still a fundamentally bad development.
1–2 week view: The core view remains to add on rallies as USD/JPY is expected to continue to move lower due to Japan’s real-interest-rate advantage, a pullback in outbound investment flows and stalled U.S. stimulus talks. On the U.S. dollar side, optimism around a global growth should continue to pressure the dollar, lending another factor biasing USD/JPY lower.
3–6 month view: 2021 should bring trend yen strength as a real yield advantage and inflation spreads remain in the yen’s favor. While the Japanese economy should benefit from Asia’s relatively low COVID-19 infection rates, a persistent negative output gap means a lack of inflationary pressures. As a result, real yield spreads and relative U.S.-Japan inflation expectations support yen strength, as does a drop in outbound investments. The increasingly crowded low-yielding currency club has reduced the yen’s role as a funding currency, and the yen’s cheap valuation has deterred yen shorts.
1–2 week view: The Canadian dollar continues to find support from the market’s positive outlook on global growth. The Bank of Canada met this past week and left rates unchanged, as was widely expected. If anything, the lack of concern surrounding the CAD’s appreciation opens up the path to further appreciation. Overall, the bias remains for CAD appreciation as the economy has bounced back stronger than expected. However, given the magnitude of the recent move and proximity to year-end, markets could be hesitant to initiate new risk positions.
3–6 month view: The loonie should continue to be driven by market sentiment. The CAD’s underperformance to its peers in 2020 reflects the currency’s ties to oil. For 2021, a global recovery should support a rebound in oil prices and the CAD. As such, the expectation is for the CAD to continue to strengthen as positive vaccine developments support broader risk sentiment and the ongoing global rebound. On the monetary front, the Bank of Canada and the Fed are unlikely to be major factors in the exchange rate, as policy actions out of both banks have been very similar.
1–2 week view: U.S.-China tensions flared again, with both sides taking action, but markets continue to look through the rhetoric. China’s performing economy, current account surplus and relatively high yields form the base for a bullish view and support a continued drift lower for USD/CNH. On the vaccine front, the UAE announced that China’s COVID-19 vaccine has an 86% efficacy rate after conducting their own clinical trials.
3-6 month view: Based on China’s GDP growth outperformance, effective COVID-19 suppression, relatively higher interest rates and portfolio inflows, the yuan should continue to add to gains. Tail risks to this narrative come through trade policy. Given this, the Biden administration should reduce tensions and rhetoric and pursue a more deliberate trade policy. Regarding monetary front, the People’s Bank of China is unlikely to push heavily against further currency appreciation, due to the desire for greater yuan internationalization and two-way flexibility in exchange rates. CNY gains could potentially turn to consolidation at the end of 2021 as China’s relative growth outperformance slows and the tourism deficit starts to rise again.
1-2 week view: The continued rally in iron-ore prices has helped the Australian dollar move higher despite continued tensions with China. There is little to add that hasn’t already been written. The U.S. dollar continues to be pressured as global sentiment remains positive, so the AUD should continue to find support. But one also has to acknowledge that current levels are unattractive, so expect markets to wait for dips before adding new AUD longs.
3-6 month view: Near-term price action has been driven more by the currency’s correlation with global equity markets than with domestic factors. Once we are past the pandemic and risk assets start to normalize, the relationship between the AUD and the stock market should fade and give relative monetary policy increased significance. This is important as the Reserve Bank of Australia (RBA) has committed to catching up with other central banks, ensuring relative accommodation. The RBA’s commitment and capacity to expand relative asset purchases should see the currency lower.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to remain unchanged at 0.10%
Expectations for rates to remain unchanged at -0.10%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
U.S. Industrial Production
Expectations for 0.3% month-over-month increase
U.S. Retail Sales
Expectations for a 0.2% month-over-month decline
U.S. Manufacturing and Services PMI
Expectations for a 56.0 and 55.8 print, respectively
U.S. Initial Jobless Claims
Expectations for a 780,000 print
Expectations for a 0.1% month-over-month increase
EZ Manufacturing, Services and Composite PMI
Expectations for a 53.0, 41.5 and 45.5 print, respectively
U.K. Unemployment Rate
Expectations for a 0.2% increase to 5.0%
Expectations for a 0.1% month-over-month increase
U.K. Manufacturing, Services and Composite PMI
Expectations for a 56.0, 50.5 and 51.3 print, respectively
German Manufacturing, Services and Composite PMI
Expectations for a 56.5, 44.0 and 50.6 print, respectively
German IFO Business Climate, Expectations and Current Assessment Survey
Expectations for a 90.0, 92.5 and 89.0 print, respectively
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This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. City National Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.
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