Foreign Exchange Sector Report

Sector report by Sudár Krisztián András, 27 November 2020

EXECUTIVE SUMMARY

The report takes a top-down approach to analysing the last year’s currency movements and what they mean for the future. The first section is a macro overview that discusses major trends in currency markets for the year, and then each section describes a certain geographical area. I have grouped the United States and Europe together, as I believe their price action is inherently connected, and discussing them separately would not paint the whole picture. Then, I will dive into China’s recent past and near future, followed by another section discussing other Emerging Markets, and I will top off with a brief section about the United Kingdom.

In my report I will make clear my reasons for taking a bearish stance on the World’s reserve currency, the Dollar, and why the Euro will prove to be stronger – at least in 2021. I attribute this mainly to the Fed’s easing programs, difference in the handling of the virus crisis, and the Dollar’s issues that are unrelated to the Eurozone but will definitely influence the spot price.

I am bullish on the Chinese economy, but bearish on the Yuan. The reason for this is that I expect a devaluation of the Yuan to occur quite soon as Biden’s easier stance on the country will allow Xi to aggressively expand, and the best tool for that is a devalued Yuan, leading to an increased trade surplus for the Country.

In the other major Emerging Market countries, I hold a positive view in terms of both economy and currency. A weak dollar and an efficient vaccine will make these vastly undervalued currencies to retrace their losses that they incurred during the pandemic.

The Sterling remains largely untradable in my view, as Brexit talks have gotten muddy and the markets started pricing in a weak, but existing deal. If the deal is to fall through – which it could on a seemingly random whim – the cross will cater and trend towards zero. Whether that happens or not, to me, seems completely unpredictable.

MACRO OVERVIEW

The COVID-19 crisis led to an unprecedented global economic downturn. A simultaneous supply and demand shock, caused by not underlying weakness but an exogeneous factor completely reshaped the World’s economy, and with it – its currencies. Looking back on the year, the Dollar’s role as a global gauge of risk sentiment solidified. In March, at the peak of the risk-off that took place in global markets, the greenback grew to its highest level for the year. Subsequently, the formula was that as the outlook regarding the virus worsened, the Dollar appreciated, and other currencies, perceived to have larger risk associated with them, fell.

The balance of risk on and risk off for the year is best illustrated by viewing the relationship between the Dollar and the S&P 500. The below graph illustrates exactly that.

Another large trend of the year was the role of Central Banks. Quantitative Easing programs were instrumental in keeping financial systems and economies afloat, although its efficacy is debated regarding its effect on the real economy. Many pundits argue that it disproportionately favours holders of financial assets, and by extension wealthier tranches of society. With the breakdown of conventional monetary measures, however, Central Bank’s hands are basically tied: there are no more rates to cut, with most institutions holding their funds rate around 0%, and therefore QE is their only option.

EUROPEAN UNION AND THE UNITED STATES

The economies of the two entities were both hit hard by the COVID-19 crisis and the lockdowns it brought. They employed similar fiscal and monetary tactics, most notably Quantitative Easing, to combat the recession facing their citizens.

A recent study by the European Central Bank laid support to the theory on many economists and finance professionals mind that while QE has proven to greatly benefit their country’s (or collection of countries) financial markets, and to a decent extent their economies, the opposite can be said about their currency spot price. In fact, a direct correlation can be drawn between the difference in the size of the two QE programs, and the change in the FX spot price.

This realization does not tell the whole story, however. It explains structural deviations in the spot price, but because of the systematical nature of quantitative easing, it does not account for shorter term fluctuations in the price movement. That aspect has largely been driven by the difference in the state of the coronavirus situation, both from a healthcare and an economic perspective. A significantly bigger rise in cases, new GDP numbers, employment figures have all shown to move the pair in a corresponding direction.

More recently, a political event has started weighing on the pair, and the effects of which, in my opinion will continue doing so for the next 6 months. In the week and a half before Election Day, demand for the United States Dollar grew drastically, as investors sought safety from an election that many pundits anticipated to be contested, and even might potentially bring civil unrest. These predictions all turned out to be wrong, and apart from Trump’s refusal to accept the results, the election was conducted peacefully, causing an immediate return to risk assets, such as the euro, sending the spot price back to September highs.

With a divided Congress, Biden will not be able to usher through a large stimulus check later in the winter – for that, he would have needed democratic control of the Senate. While two seats in the Senate are still up for grabs in Georgia, they will most certainly fall into Republican hands. With a larger stimulus bill out of the question, and with the president’s hand tied effectively in his proposed plans that would have brought increased spending, the Dollar is unlikely to be moved from his actions.

Nevertheless, I think the Dollar is ready for further depreciation. While increased fiscal expenditure is documented to bring an appreciation of the domestic currency, we can disregard that due to factors mentioned in the previous paragraph. Earlier lockdowns in Europe will surely weigh on Q4 GDP, but better containment of the virus will ultimately triumph over lagging economic indicators in determining the current spot price, as we have seen in recent months. The ex-Fed chairwoman, Janet Yellen, appointed by Biden as Secretary of Treasury, in cooperation with Powell will continue the unprecedented easing program, parts of which were shut down by Mnuchin, which will dwarf the ECB-s December QE plans.

With every news bit that comes out talking about the efficacy of various vaccines against the virus, the Dollar loses demand. It loses demand as the most popular and liquid financial products are denominated in the greenback, and when people’s appetite for risk returns, they offload their Dollars and exchange it for riskier assets.

From a technical analysis standpoint, the Dollar just breached a key level. There was a very strong support at 92 on the Dollar Index (DXY), and many traders suggested that a breach and a daily close below this level could send the Dollar on an immediate freefall below the 90 handle. The latter has yet to materialize, but it is very much worthwhile to keep an eye on.

I am expecting a further 5% appreciation in the spot price for the next 7-8 months, and therefore recommend the Invesco CurrencyShares Euro Trust ETF, ticker $FXE.

CHINA AND ASIA

One of the biggest winners of the 2020 US Presidential Election is certainly Xi Jinping’s China. Donald Trump had a rash, aggressive stance to his diplomatic efforts regarding the largest Asian power and economy, which ultimately led to a prolonged Trade War in recent years that weighed on both economies. The current president-elect, Joe Biden, and his Secretary of State, Antony Blinken, are very likely to take a negotiation based, level-headed, and most importantly, consistent stance towards other geopolitical players.

In addition to the United States diplomatic stance becoming more predictable and organized, Biden’s opinion about the way to manage the country’s relationship with China and Russia is the exact opposite to Trump’s. As evidenced by the 8 years he spent serving as Vice President to Barack Obama, his presidency will bring a tougher stance and the possibility of sanctions against Russia, and a more cordial relationship with China.

This level of comfort that a suspended Trade War, and an overall friendlier approach from the US will bring to the communist regime will allow the country to continue being expansionary in their fiscal and monetary policy. The need to remain expansionary might seem surprising at first given the rapid recovery of the country from the COVID crisis, but if you take a deeper look, you can find that most of the recovery was driven by heavy industry, and consumer spending is far from a complete recovery. The reliance on heavy industry by itself to continue the country’s growth is unsustainable, and additional measures must be taken

Most likely, this will lead to the People’s Bank of China devaluing the country’s currency, the Renminbi, to allow for a greater trade surplus and economic prowess. Further evidence to support this is the lack of real inflation: China’s inflation levels have largely stagnated for the year, and devaluing the currency is the best tool to counteract this. The case for devaluing the Yuan is also strengthened by the fact that the currency’s has been breaking numerous record levels against the Dollar in the months leading up to the election, a phenomenon that the country’s regulators historically have never left in play for too long.

The implication of a stronger Chinese Economy and a weakened Yuan, judging by historical trends and economic factors, is that the region’s economy will also be boosted. This leads me to recommend an investment into the Japanese Yen, a recommendation that is also supported by the fact that in the next 3-4 months, before Vaccines start rolling out, the crisis is likely to deepen, more lockdowns are to come, causing a surge of interest in haven assets. My choice for that would be the Invesco CurrencyShares Japanese Yen Trust, ticker $FXY. I see an appreciation of 2 to 4 per cent for the next half a year, and view this as a largely defensive move with decent potential for upside.

1.Effect of the last devaluation

EMERGING MARKETS

There is an array of countries whose currency movements are an almost perfect inverse of the dollar’s: those of Emerging Market countries. From this analysis, I opt to omit China, by far the largest component of the group as I have previously discussed its unique situation. For the rest, namely Russia, Brazil, and India, 2021 is shaping up to be a significant crossroads.

These currencies, and by extension economies, depend entirely on vaccines. With dense populations (even in the case of most of Russia’s population) and underfunded healthcare infrastructures, their best case scenario for a return to normal economic activity stems from a vaccine – lockdowns deal with the issue temporarily, but also damage the already frail economy during the process.

As the development process nears its end, and the next hurdle, manufacturing and distribution begins, a disheartening fact is becoming clearer and clearer. Those countries that need the vaccines most (e.g. have ill-equipped healthcare systems, large and dense populations, etc.), are the ones that will struggle with the establishment of an adequate distribution system the most.

This poses a significant threat to this group of countries and will require international cooperation. Having overcome this challenge, the next issue, from a currency and economy analysis standpoint, will be seeing how the central banks of these states choose to play their cards.

I am confident that Developed Market countries will take an active part in building the distribution channels, especially with Biden in office. As his hands will mostly be tied in domestic affairs, he will seek to afflict change in foreign policy, where he is not beholden to the republican-led Senate. As for central banks – with clear examples set by the Fed and the ECB, policy makers in Emerging Markets will certainly follow successful policies and learn from unsuccessful ones.

The bullish case is also supported by the fact that there is a record amount of funds flowing into the region in recent weeks – a clear sign of investors’ conviction in the play. However, the trade is far from being crowded as capital flows into emerging markets for 2020 are still net negative. With interest rates so low in most countries, it makes sense that most speculation and investment will play out in the Forex market, as opposed to the Fixed Income space – the latter is still poised for gains, but to a less dramatic extent.

Current exchange rates are vastly out of touch. The discount that these currencies trade at fails to account for the rapid recovery that efficient vaccines will bring, and they are also at technical bottoms. I am very confident that they will start appreciating in Q1 and Q2, and although my view is certain currencies will appreciate more than others, (namely the rupee and the real), diversifying our holdings is more important than slightly larger gains, and therefore I’d opt to recommend the WisdomTree Emerging Currency ETF, ticker $CEW. I have set a base price target of 5% on this ETF, but I would not be surprised if by the end of the year it would be nearing the low teens.

UNITED KINGDOM

The United Kingdom has been in a peculiar place this past year as it has been facing a double crisis. On one hand, you have COVID, and on the other, you have Brexit. There was a massive drop in Sterling’s spot rate in March, but since then, the Pound has recovered to almost the same level as  it was against the Dollar, and is down 5% for the year versus the Euro.

While in the past, Brexit proved to be the biggest driving force in price action, as talks of a deal get muddier and promises of reaching an endpoint get taken back constantly, markets have started pricing in a weak deal, and the price reflects that.

What this results in is that currently, is that the economy relies on an efficient vaccine to get back on track, but the currency does not. In my view, the currency won’t appreciate against the Dollar or the Euro on the back of positive developments in vaccinating the population, as the positive effect is the same for all three. What will drive price action, however, is a no-deal scenario. If this were to happen, Sterling would fall dramatically against the Euro, and even parity isn’t out of the question. Due to this uncertainty, I would refrain from taking a position in the currency as the progression of negotiation between the Bloc and the UK is impossible to predict.

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