FX Compass: The Emergence of Central Bank Digital Currencies
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The Emergence of Central Bank Digital Currencies
In this week’s FX podcast David Atkinson talks with Alvin T. Tan, head of Asia FX Strategy for the Royal Bank of Canada. Alvin puts out regular research for RBC and recently wrote a piece about Central Bank Digital Currencies, or CBDCs. Among the topics that are covered:
How do CBDCs differ from both traditional banking and what we hear about cryptocurrency
What are the advantages of CBDCs, as well as the concerns and disadvantages
How will the world of payments evolve in light of these developments, particularly with the Chinese renminbi and the status of the US dollar as the global reserve currency
It was such a fascinating discussion with Alvin that we didn’t have time for our usual segment with Julia Allegretto so we have an abbreviated story in charts. First chart below is the number of businesses by country that take payments in cryptocurrency along with the kind of businesses that are getting into those kinds of payments.
One- to two-week view: The euro outlook remains bearish, as the EU, more than the U.S. or U.K., continues to struggle with the latest wave of the pandemic. This has forced EU countries to tighten (France) or prolong (Italy) restrictions, as vaccination progress in the EU has been slower relative to its peers. Moreover, the European Central Bank (ECB) has differentiated itself from the Fed by pushing back against rising yields with the announcement of a significantly faster pace of Pandemic Emergency Purchase Programme (PEPP) purchases. Finally, growth expectations in the eurozone (data last week came in weaker than expected) remain below those in the U.S. due to vaccine distribution, COVID-19 trends, and fiscal and monetary policy differences that all favor the U.S. On the fiscal front, the German Constitutional Court suspended the ratification of a legal act that allows the European Commission to borrow funds to pay for the recovery fund. Ultimately, this shouldn’t derail the process but does unnecessarily delay it. This sharply contrasts with the U.S., where the fiscal response has been quick and aggressive.
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 (GDP), 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, improving economic conditions, loosening of COVID-19 restrictions and April seasonal factors (tax- and dividend-related repatriations) provide near-term British pound (GBP) support. Given this, relative vaccine outperformance has largely been priced in, and supply issues and health concerns with AstraZeneca’s vaccine could slow the pace of vaccinations, derailing plans to fully reopen the economy by late June. However, it should be noted that the U.K. did start using Moderna’s vaccine this past week. Scottish politics are also moving in a GBP-negative way, as polls show Scottish nationalist parties may win a supermajority in the May 6 elections. This raises the possibility for another Scottish independence vote. Lastly, the relationship between the U.K. and EU also 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: While April kicks off a new fiscal year, the theme of rising U.S. rates posing upside pressure on USD/JPY continues, especially with repatriation for the fiscal year-end behind us. Given this, there are signs that the USD/JPY rally may be toppish. The yen (JPY) has depreciated over 6% in the past three months. This is the largest three-month move since the 2016 U.S. election. The current USD/JPY level is also way above where the Bank of Japan forecasted and the breakeven level Japanese corporates budgeted. On the virus front, the country is seeing a spike in infections that has led to more restrictions to discourage travel during Golden Week. While Japan’s relative virus numbers are a fraction of those seen elsewhere, Japan also lags on vaccine distribution, making it more vulnerable to outbreaks. As such, 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.
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 U.S. 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: Recent comments out of the Bank of Canada (BoC) suggest that the bank is comfortable with its current stance. As for the currency, the view remains constructive, as the Canadian economy continues to perform (GDP and jobs data both beat expectations), leading the BoC to signal that it will be the first G-7 central bank to start tapering assets should the economy continue on its current trajectory. As such, incoming data over the coming months will be important to monitor, as the BoC will want to see evidence of a sustained recovery. Given this, lockdowns in Ontario — Canada’s most populous province — are raising questions around the BoC’s ability to adjust policy near term and highlights Canada’s relative vaccine rollout underperformance. Thus far, the Canadian economy has proven resilient to lockdowns, as data has outperformed the bank’s first-quarter projections. This leads to economic optimism, especially with reports indicating the current lockdown will be shorter and less strict than the one in December. Further, Canada is expected to be one of the main beneficiaries of international spillover from President Biden’s stimulus plan. Ultimately, lockdowns shouldn’t affect medium-term tapering plans but could alter near-term timing and thus be a headwind against the recent run of Canadian dollar (CAD) strength.
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 tapering 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 illustrates 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: Relative economic outperformance (services PMI beat expectations, and growth forecast was upgraded by the International Monetary Fund), a current account surplus and relatively high yields still form the base for a constructive 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 (USD) strength, which argues against further CNY strength. To be clear, this reflects USD strength and not CNY weakness, as Chinese rates still support the yuan. As for data, first-quarter GDP and industrial production will be in focus. On the geopolitical front, U.S. and U.S. ally tensions with China are set to increase but are unlikely to lead to disruptive actions.
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 demand for goods. 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 USD outlook.
One- to two-week view: The Reserve Bank of Australia (RBA) continues to maintain a dovish slant, and this week’s RBA meeting only emphasized this point. The bank announced no changes to its policy package, as expected, and reiterated that rate hikes won’t be seen until 2024 at the earliest. The bank also maintained guidance that the shift in the yield target bond to the November 2024 bond will be “considered later in the year.” Given the reduction in government COVID-19-related support measures, still low global yields and a lack of inflationary pressures, expect the RBA to be slow to taper its stimulus even as it continues to acknowledge better-than-expected data. Overall, the RBA’s asset purchase program and expectations for U.S. exceptionalism are making it difficult for the Australian dollar (AUD) to do well. Australia–China tensions are also a factor, with China’s Commerce Ministry saying it will impose anti-dumping measures on some Australian wine imports for five years. This week’s labor market report will be the key economic release.
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 USD 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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