A. Dollar on a weakening Trend

• Even before Covid-19 turned into a pandemic, the USD was already losing momentum. The economic growth in 2018 and 2019 was supported by the Fed Reserve’s rate cuts and the use of its balance sheet. And with the global policy rates now effectively low, rate differentials do matter for the USD cycles. The 10Y rate differential between the US and DXY components suggests more weakness to the USD.
• With some easing from the March Covid-19 panic, the global monetary easing will provide some positive impetus to economic activities. Assuming that the second wave of the virus is well contained, there is ample room for a “mini reflationary” macro environment driven by the loose global monetary conditions that have been in place since 2016 and a continued scope for further trade reflation.
•  Nevertheless, the downside risk to the currency remains. This could happen if the US economic momentum continues to lag against the rest of the world (RoW) throughout the recovery period from the virus pandemic. Besides, the limited tolerance by the Fed for USD funding shortages suggests that USD liquidity will remain ample. And finally, even should a V-shaped recovery does emerge, it is unlikely for the Fed to start tightening its policy aggressively relative to other major central banks.

B. Euro: Taking centre stage with positive narratives

• The region’s potential “break-up” risk premium has eased significantly. Besides, the European Central Bank (ECB) has taken a more positive role this time around. The idea of a highly supportive central bank has not always been the case for the Eurozone over the last 20 years. The ECB has been moving aggressively although the size of the package is not huge. It expanded its bond purchases by a further €600 billion which can be seen as a step in the right direction for European policy and growth.
• Also, it is for the first time that both France and Germany, the two largest economies in the Eurozone, proposed a regional recovery fund paid for by joint borrowing, backed by the entire region. And this economic assistance will be largely in the form of grants rather than loans. Meanwhile, the funding for this aid would be through a jointly backed issuance that creates a new safe asset for the region, much more similar to a US Treasury.
• These proposals are a significant moment for the Eurozone and favourable to the EUR currency to strengthen. The upside risk on the EUR/USD would come from a weaker USD driven by: (1) a hampered US recovery from rising Covid19 cases and renewed local lockdowns; (2) further stimulus from the US Fed via QE; (3) bigger fiscal/current account deficits which may eventually result in portfolio balance pressure on dollar assets over time; (4) stronger FDI and reserve manager buying into the euro area than anticipated that will push the EUR/USD independently higher in contrast to ECB’s actions; and (5) a faster GDP reflation in China that could end up supporting the euro area’s business cycle.
• However, the downside risks for the EUR/USD can be influenced by: (1) the second wave of the virus impacting the world akin to the second Spanish flu wave; (2) renewed or rise in political uncertainty from Italy, Brexit or elsewhere; (3) trade wars blowing up again leading to retaliatory CNY weakness; and (4) a return of US exceptionalism with the RoW unable to reflate in a post-Covid world.

C. MYR benefits from weak USD, positive EM

• Bank Negara Malaysia (BNM) has taken a more positive role this time around. The central bank has reduced the overnight policy rate (OPR) by a total of 125 basis points during the year to now at 1.75%. And the current 2% SRR, the central bank has allowed all banks and principal dealers to use MGS and MGII papers to fully meet their SRR compliance until 31 May 2021. Such policy measure will allow banks and principal dealers to “substitute” their MGS and MGII holdings for liquidity locked under the SRR. Evidence of a highly supportive central bank was also reflected in some of the measures taken to support businesses and households during the movement control order (MCO).
• Fiscal spending was raised to RM295 billion with RM45 billion in the form of direct injection to support the economy impacted by the pandemic virus. With the relaxation of the MCO plus the monetary stimulus and fiscal support, there is growing evidence of a gradual pick-up in some of the business activities. The Purchasing Managers Index has steadily climbed above the expansionary/contraction threshold in June. The easing of the MCO resulted in stronger trade in June. Exports to key destinations like the US, China and Japan had a strong run in June. Overall, the economy may have hit the “trough” in 2Q2020 and should modestly improve in 2H2020 supported by the recovery measures.
• Furthermore, the upside risk for the MYR will be driven by firmer Asian currencies benefitting from the interest rate as well as growth differentials between the region with industrial economies. More so should the US recovery heads into trouble from rising virus cases and renewed local lockdowns and the Fed embarks on more QEs to stimulate the economy. This would result in asset reallocation in which this region is likely to benefit, especially with China expected to be the first major economy to emerge from a severe economic contraction. Thus, the region’s currencies are expected to appreciate by 0.5% in the next 3 months and continue to climb around 1% in 12 months’ time, in spot terms. The MYR would also benefit from the appreciation.
• Downside risks for the MYR can be influenced by: (1) the risk of the second wave of the virus impacting the world just like the second Spanish flu wave and resulting in lockdowns and MCOs; (2) noises from political risk, both domestic and elsewhere; (3) trade wars blowing up again leading to retaliatory CNY weakness; (4) geopolitical tension; (5) vulnerable commodity price movements i.e. crude oil; (6) global economy and/or domestic economy failing to reflate post-Covid; and (7) downgrade risk by FTSE Russell and rating agencies.

D. Other major currencies

1. Lagged recovery in GBP

• UK economic data suggests that the economy is still lagging behind many other G10 countries in the race to recover from the virus. Brexit uncertainty/ negotiations can slow down the economy, given that the UK is heavily reliant on the services industry.
• Meanwhile, British fiscal response to the virus outbreak is by far the largest. Room for fiscal easing within the year remains high, especially with the BoE being cautious to provide additional QE and even lowering rates following the June meeting. It could see the gilt curve coming under upward pressure over the medium term. Higher yields caused by increased fiscal risk will likely weigh on the pound. But this may not happen as we feel the BoE will stand by and will likely increase asset purchases should a disorderly back-up in yields/ currency sell-off begins.

2. JPY is vulnerable long term

• The JPY’s extended long positioning could become vulnerable, especially when the trade reflation gains momentum. With a soft USD and higher commodity prices, it has raised speculators short position on this currency. For now, the Congress is the one to watch. Cross-market signals suggest higher nominal UST yields may frustrate those holding onto JPY long as the USD/JPY is likely to moderately rises.
• The yen is correlated closely to price behaviour in US equities and rates. JPY is in net long positions. Optimism about the reopening of economies amid huge amounts of stimulus had seen the safe-haven JPY weaken in the past couple of months. But concerns about the second wave of Covid-19 in addition to China-related tensions appear to be bringing back some support for the JPY.
• Headwinds facing the JPY come from the prospect of sustained dovish policy by Bank of Japan (BoJ). It boosted its virus lending programme to more than US$1 trillion. But it also signalled that it would take several years before the BoJ could raise interest rates. Thus, it will be tough for a rate hike before the Fed. This has allowed us to push back the first rate hike from October 2021 to July 2023 and expect the BoJ to maintain the current yield curve control until July 2023.

3. AUD in reflationary momentum in short term

• The Australian dollar’s (AUD) rally of over 30% from the yearly low could be related to the Reserve Bank of Australia’s (RBA) stance on negative interest rate policy (NIRP) which is seen to be unlikely, targeting a yield level rather than amount of purchases and climbing of commodity prices.
• Also, the RBA agreed that it will not intervene in the foreign exchange market, given that it has limited effectiveness when the exchange rate is broadly aligned with its fundamental determinants. This means it is not overly concerned about the recent strength seen in the AUD.
• However, a sustained surge of Covid-19 infections in Victoria, Australia’s second most populous state, and growing clusters in New South Wales and Queensland threaten to halt the risk-sensitive currency’s trot to fresh yearly highs. Melbourne's lockdown is worrying. It will negatively influence 3Q GDP. More fiscal support is expected. Also, as faster reopening takes place, these will help reduce the detrimental impact from the lockdown.
• The focus will be on the RBA’s forward guidance over the coming months. Any upwardly revision of its economic projection should have a material shift in the monetary policy outlook. It should heighten the appeal of the AUD if the central bank prepares to remove the yield target later this year. But it remains to be seen, especially if the unprecedented measures taken by monetary as well as fiscal measures help jumpstart the economy.
• However, risks to the AUD are fat tailed (second wave risks, health disappointment, US election), with particular worries on the evolution of US/China relations. The AUD reflationary momentum is likely to continue in the short term. Our 6– 12 month forecast is 0.73.

4. CNY gradual appreciation

• China is expected to be the first major economy to come out from a severe economic contraction. This, together with the large interest-rate differential between them and the advanced economies, should help attract capital inflows into China. That should provide support for a gradual appreciation of the CNY.
• Besides, it is unlikely for the People’s Bank of China (PBoC) to narrow the wide interest rate differential in the sense that it will not follow the Fed’s aggressive easing policy.
• However, the volatility could also increase subject to short-term tension with more anti-China rhetoric while the longterm anti-China rhetoric depends on who wins the US presidential election; the growing decoupling between the US & West with China, fuelled by the pandemic, Hong Kong, human rights violation targeting Muslim in Xinjiang, national security – China’s claim of dominance in the South China Sea and Asian countries from trade and detailed US policy sanctions on Hong Kong as well as China’s counter measures.

Source: AmInvest Research - 3 Aug 2020