FX Compass: Connecting Emerging Markets with the US Dollar
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Connecting Emerging Markets with the US Dollar
In this week’s Global Perspectives, Julia Allegretto and David Atkinson discuss a recent research piece from RBC on the interaction of emerging market (EM) yield curves and the US dollar. Among the findings:
Emerging market yields curve tend to steepen in reaction to capital fleeing those countries
That capital flow weakens the local currency against the US dollar
The sharp decline of the Turkish lira is actually somewhat isolated due to liquidity
Next week we are going to start tackling the issues piling up in the supply chain (and the Suez canal)
One- to two-week view: The euro outlook remains bearish. First, the European Central Bank (ECB) has differentiated itself from the Federal Reserve by pushing back against rising yields with its announcement of a faster pace of PEPP purchases. Second, vaccine rollout has been slow, and new cases are surging. Moreover, survey data shows a higher reluctance to take the vaccine in Europe than in the U.S., which suggests an increasing gap between the eurozone and the U.S. and U.K. Thirdly, recent PMI data, which surprised to the upside, doesn’t fully account for the recent increase in coronavirus cases that have led to both an extension of existing measures and the addition of new ones (see France and Germany among others). Overall, vaccine distribution, COVID-19 trends, and fiscal and monetary policy differences support the expectation that growth rates in Europe will lag growth rates in the U.S.
Three- to six-month view: Heading into the year, we questioned the euro’s ability to continue strengthening, as many factors (valuation, yield compression, removal of sovereign risk) have faded. If anything, aggressive fiscal stimulus in the U.S. only adds to euro pressure, as it sharpens the difference in U.S. and European growth. Notably the U.S. lost less output than the euro area through the pandemic, and the U.S. fiscal response has also been stronger. Case in point, the U.S. is sending out stimulus checks worth 2% of gross domestic product, while Europe is contending with slower vaccinations and constant pushbacks on when economies will reopen. Finally, on monetary policy, the ECB has committed to a significant increase in PEPP purchases and has understandably shown more concern for financial conditions than the Fed, leading to policy divergence that should pressure the euro.
One- to two-week view: Good vaccine progress, an overall improvement on the COVID-19 situation, a larger-than-expected fiscal package and improving PMIs all bring upside risk to British pound forecasts. It should, however, be noted that the unemployment rate, which beat expectations, is distorted by furlough schemes so had a limited impact. Given this, relative vaccine outperformance has largely been priced in, and the BoE struck a more cautious tone at its last meeting on the economic outlook that reflects elevated economic uncertainty. Lastly, the relationship between the U.K. and EU remains in flux. While both sides have issued constructive comments, strains remain over vaccine exports, although this impacts the EU more than the U.K. given the U.K.’s inoculation outperformance. Overall, the pound is expected to hold steady.
Three- to six-month view: The building block for the pound’s outperformance remains the same as it has been all year. The U.K.’s effective vaccine rollout program gives the country a good head start relative to other developed market countries in reaching the herd immunity needed for a sustained relaxation of lockdown measures. Additionally, the recent budget delivered a surprisingly large increase in fiscal support that turned fiscal measures from a headwind to a tailwind. Given this, there are reasons to remain cautious. The first reason is that the economy isn’t moving ahead of its peers but simply catching up to them. The second is that while vaccines help relative near-term economic outperformance, they won’t impact the sustained trend rate of growth that is more relevant to the medium-term outlook. Recent economic data made clear how disruptive Brexit has been to trade. While levels should recover as business gets adjusted to the rules, the point is that Brexit will have a negative effect. So while the U.K. economy is fast out of the gates, questions remain about its stamina.
One- to two-week view: Initial reaction to the Bank of Japan’s (BoJ) policy review was relatively muted. Looking ahead, markets will be watching rates to gauge the effect of the widened YCC band and the BoJ’s ability to cut rates further. As for the currency, USD/JPY likely ranges trades with a bias for weaker, as it remains driven by the reflationary narrative that leads to overseas yields coming under increasing upward pressure while Japanese yields remain suppressed by yield curve control, although the widened band does allow for a bigger rise. Flow wise, Japanese investors returned to being modest buyers of foreign debt after a month of large-scale selling. However, with data showing banks responsible for the lion’s share of flows, the impact on the yen should be limited.
Three- to six-month view: The sharp rise in yields during the back half of February through the first half of March necessitates a lift up of yen target rates. While the yen will be influenced by the direction of nominal rates in the near term, the medium-term outlook remains downward sloping, with moderate yen outperformance versus the dollar still expected. This view reflects Japan’s underlying balance-of-payment strength, relatively cheap valuation and real rate advantage. The trend of Japanese portfolio flows will also be important, as the good part of the yen’s cheap valuation came from unhedged outflows over the past couple of years. Rising crude prices should also weigh on Japan’s trade balance, but the current account is still expected to remain in a comfortable surplus. Given this, a delayed reopening will likely erode Japan’s trade surplus and weigh on the currency.
One- to two-week view: Canada has been lagging its peers in vaccine distribution, but this should be helped by the Biden administration “loaning” 1.5 million vaccine doses to be paid back at a later date. Overall, the view remains constructive, as the Canadian economy continues to perform ahead of Bank of Canada (BoC) projections, leading the BoC to signal that it will be the first G-7 central bank to start tapering assets. Employment data this week will be the key release. While the Canadian dollar (CAD) remains susceptible to global risk sentiment and broad dollar moves, CAD outperformance is still expected, as the economy has been resilient (strong labor market report) and the country scores well on high vaccine procurement and falling case numbers.
Three- to six-month view: The CAD outlook remains bullish due to continued Canadian growth surprises, with an incoming wave of U.S. fiscal stimulus, the rising likelihood of BoC tapering, and commodity sector outperformance that supports Canada’s terms of trade. In essence, the CAD offers both U.S. dollar–proxy qualities and pro-cyclical exposure. With economic data outperforming BoC projections, the bank will likely have to address taper at its April meeting. Regarding U.S. stimulus, the unique composition of fiscal support could cloud how much the Canadian export sector benefits, but it will receive a boost. Moreover, the correlation between U.S. and Canadian rates illustrated the economic links between the two countries as well as similar central bank reactions to rising yields. The OPEC+ decision to hold production flat also benefits the CAD. On the negative side, Canada’s inability to manufacture vaccines domestically means it is lagging peers on deployment, making it vulnerable to a slower reopening and a more dovish BoC.
One- to two-week view: China’s economic data has turned more mixed but continues to be robust on balance. Relative economic outperformance, a current account surplus and relatively high yields still form the base for a constructive Chinese yuan (CNY) view, although this has become more balanced. Rising U.S. rates and growing U.S. exceptionalism have shifted the balance of major rate differentials toward U.S. dollar strength, which argues against further CNY strength. To be clear, this reflects U.S. dollar strength and not CNY weakness, as Chinese rates still support the yuan. On the geopolitical front, coordinated sanctions by the U.S., Canada, the U.K. and the EU were imposed. China responded by sanctioning 10 EU individuals and four entities. The initial reaction was for CNY weakness, but that subsequently faded, as these sanctions are largely symbolic; however, the coordinated effort reflects the Biden administration’s different approach to China, and the U.S.–China relationship does warrant watching.
Three- to six-month view: The CNY has proven to be less sensitive to rising U.S. yields relative to developed market currencies. This result is in line with historical data that shows interest rate differentials as not a significant driver of USD/CNY due to central bank oversight and tight capital controls that negate the effect of interest rate differentials. However, the significant rise in U.S. yields cannot be entirely ignored. China’s export sector continues to outperform and should benefit from the continued global recovery and associated increase in goods demand. On the capital front, continued interest in reallocation of funds into Chinese bonds from global fixed-income investors should mean durable bond inflows, even amid a global bear market for bonds. Overall, the CNY still enjoys a constructive medium-term backdrop, but further gains will be hard to come by due to a more constructive U.S. dollar outlook.
One- to two-week view: Recent comments and actions out of the central bank confirms its dovish slant. To this point, Reserve Bank of Australia (RBA) Governor Philip Lowe has re-established RBA as one of the few G-10 central banks that have taken action against a rise in yield. While the central bank refrained from saying the Australian dollar (AUD) is overvalued, the bank did note that it would like to see the currency lower. On the economic front, this week’s labor market report will be closely watched, as the government’s employment support program is ending soon. Overall, the RBA’s asset purchase program and expectations for U.S. exceptionalism are making it difficult for the AUD to do well.
Three- to six-month view: Idiosyncratic issues, such as a negative AUD–USD rate spread and a central bank that is actively pushing against rising yields, should see the AUD drift lower over the medium term. Iron ore accounts for a significant portion of Australia’s exports. Thus far, iron ore prices have been a support, but pressure on Chinese steel margins should see a drop in production demand. On the yield front, U.S. yields are around the point at which the relationship between the U.S. dollar and yields turns positive, meaning any further rise in yields should be dollar positive. Speaking of yields, the central bank knows that reflationary spillovers like higher rates and unwarranted currency appreciation can disrupt the recovery. As such, the RBA has proven itself to be one of the few central banks willing to push back on rising rates. Not only has the bank increased its asset purchase program, but it has shown a willingness to target purchases toward the most relevant part of the yield curve.
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