ISB: Fine-tuning our EUR and CNY forecasts


ISB: Fine-tuning our EUR and CNY forecasts

Published Date: 2021-01-13 | Source: INCE|Community | Author: Banque Lombard Odier & Cie SA

ISB: Fine-tuning our EUR and CNY forecasts

Fine-tuning our EUR and CNY forecasts: a slightly deeper dollar depreciation

- We bring forward the peak in EURUSD (to Q2 21 from Q4 21) and raise our forecast to 1.27 from 1.25

- At the same time, we revise lower our USDCNY forecast to 6.15 for Q3 21 to account for a higher EURUSD, a less dovish PBOC, and importantly, pencilling in a 50% probability of some Section 301 tariff reduction

- All other FX forecast adjustments will be presented in the upcoming January edition of the FX Monthly.

EURUSD: 1.27 around Q2 21

We are making two changes to our EURUSD forecast trajectory. First, we bring its peak level forward (to around Q2 21) and second, we raise the forecast from 1.25 to 1.27. Below we briefly explain our reasoning:

Timing: Dollar depreciation accelerated in the last few months of 2020 and in early January 2021. Taken at face value, this argues that the peak in EURUSD is likely to occur earlier than we expected, potentially in around Q2 of 21. This is because we find the market at a stage where valuations are handing the baton over to momentum, which has historically driven prices at a faster pace than fundamental factors.

A higher peak level (at 1.27): In parallel to accelerated USD downside momentum, a number of fundamental developments suggest the peak in EURUSD may be slightly higher than 1.25. These are:

1. Our estimate of EURUSD fair value has now increased from 1.18 to 1.20, driven by the improved projected current account surplus in the euro area (IMF numbers; see chart 1 on page 2). At current spot levels, EURUSD is slightly overvalued (2.5%). Our empirical work suggests that in the last overvaluation cycle (2017-early 2018), EURUSD hit an overvaluation of around 7%. This period was characterised by a solid euro area recovery, strong global trade growth, and rising raw industrial commodity prices, somewhat akin to the current environment. Consequently, we assume a similar level of overvaluation, suggesting that EURUSD could peak at around 1.27/28 (chart 1 on page 2).

2. While we were expecting US real yields to start settling at a slightly higher level, there has been some renewed pressure to the downside, stemming predominantly from increases in inflation expectations. Although US real yields should begin rising again, the starting level is certainly lower; such a process is likely to be accompanied by increases in core real European yields as well, especially on the back of a strong euro area recovery. Assuming the 10Y real yield differential between the US and Germany falls within the range of 0.2% to 0.5%, then EURUSD at 1.26/27 would be an estimate consistent with historical correlations.

3. Although equity and debt portfolio flows into the euro area picked up in H2 20 (data available until Oct. 20), outflows still were a bit larger than inflows. With improved sentiment towards the eurozone and a reasonable rolling out of the vaccine, it seems that the room for inflows to accelerate is greater than initially thought - which should underpin the euro further.

4. The rebound in Chinese imports from Germany - a good yardstick for EURUSD moves - has been sharper than most expectations (see chart 2). With the Chinese economic rebound being firm and broad-based, this tailwind is likely to prove more robust and enduring than previously anticipated. Assuming a return close to 2017 levels, a consistent EURUSD level would again be around 1.26/27.

5. Despite the increase in Covid-19 infections in Europe in Q4 20, economic surprises in the region turned more positive. The spread between the Citi EUR economic surprise and the Citi USD economic surprise is now close to its highest level since 2015, which should lend some additional support to the euro.

6. EURUSD annual returns exhibit a consistent pattern of positive serial correlation, meaning that a positive return in year t tends to be followed by a positive return in year t+1 (see chart 3). Based on this "mechanical rule", our empirical result shows that a 9% EURUSD annual gain (in 2020) tends to be followed by a 3% spot appreciation in the following year (2021).

Balancing all these factors, we think it is reasonable to expect EURUSD to peak at around 1.27 close to Q2 21, and then adopt a relatively flattish profile potentially due to the recovery becoming somewhat more mature.

Risks to our forecasts

Upside risks: An even stronger economic and trade recovery as well as a more efficient rolling out of the Covid-19 vaccine.

Downside risks: Recovery losing steam due to bottlenecks in vaccine distribution or other black swan; the Fed turning less dovish and potentially causing a "taper tantrum" akin to that in 2013.

Chinese yuan: Further upgrading our constructive view

While we were increasingly constructive on CNY from Q3 20, at the beginning of November, we decided to lower the targets/forecasts to 6.40 (end of 2021). At the time, USDCNY was near 6.70 and - to place things in context - consensus forecasts for mid-2021 and end-2021 stood at 6.70 and 6.65. While consensus forecasts have now moved broadly in line with our path, we believe further downside is likely for USDCNY. We revise our forecasts, looking for a low point of 6.15 to be reached in Q3. Our revisions are based on the following two factors.

1. The upward revision to EURUSD to a peak of 1.27 should see USDCNY reach levels near 6.25. In fact, even at current levels, a simple comparison of USDCNY fixings with a broad dollar index suggests that fixings could quite reasonably move lower to 6.30 (see chart 4). With authorities having in recent months liberalised the fixing mechanism to make it more responsive to broader market movements, such a move seems likely on a weaker USD.

2. So far, while we have entertained the possibility of some reduction in Section 301 tariffs under a Biden presidency, we had not baked it into our forecasts, refraining from automatically assuming an eventual tariff reduction if Mr Biden came to power. Instead, our forecasts mainly reflected a weaker USD and improving Chinese macro and balance of payment fundamentals. We think it is plausible that, at some point later in 2021, the Biden administration will consider a reduction in these tariffs (potentially curbing the current rate of 13.8% to the mid-2019 level of 12.25%). Such a move would likely be greeted with greater trade-weighted CNY appreciation, with authorities likely allowing the CFETS trade-weighted RMB basket (on which USDCNY fixings are based) to rise to 98 compared to a 92-95 range largely prevalent over the past two years (see chart 5). Our modelling work suggests USDCNY could trough at 6.25 without a reduction in tariffs, and under 6.10 with a reduction. Applying a 50% probability, we arrive at a USDCNY target of 6.15 over Q2/Q3.

Beyond the two above factors for a change in forecasts, more medium-term factors embolden us to call for a further CNY recovery.

Firstly, we believe CNY appears reasonably valued. Despite the currency having increased 50% in real terms over the past 15 years, it is notable that China has managed to continue to increase its share of global exports. This share rose further after having stagnated over 2013-2016. Even if this reflects special items (such as higher exports of Covid equipment), the fact that the share remains healthy suggests competitiveness is not a concern, and that some further strength in the CNY could be tolerated.

Second, phases of recent CNY underperformance vis-à-vis other Asian currencies tended to coincide with weakness in balance of payment flows. However, the latter have been improving for several reasons: smaller services deficit, reduction in hot-money outflows, and improving portfolio flows. The last of these is a more structural move as China gains greater share in equity and bond benchmark indices. This suggests a story of CNY outperformance could remain with us for some time (see chart 6 on page 3).

Risks to our forecasts

Upside risks to USDCNY: A more major risk would be credit tightening leading to sharp weakness in Chinese activity (especially the property sector), in turn sparking capital outflows (like over 2014-15), resulting in USDCNY moving higher. However, this seems less likely, and a modest credit tightening beginning at some point in H2 will likely be more of a headwind for the economy in 2022. If Biden actually changes tack and flags higher tariffs, that too will present upside USDCNY risks. However, this seems less likely with Biden having expressed distaste over the off-the-cuff imposition of bilateral trade tariffs on China. The debate currently revolves around tariffs either remaining static, or potentially declining from current levels.

Downside risks to USDCNY: A higher probability of tariff reduction or a larger tariff reduction poses downside risks to our USDCNY forecasts, as does an even weaker USD.


I. EURUSD: Higher scope to overshoot recently upgraded fair value

II. EURUSD: Sharp rebound in Chinese import demand for German exports boosts confidence to call for upgrade

III. EURUSD annual returns exhibit positive serial correlation

IV. Chinese authorities have been allowing USDCNY to re-align with a weaker USD: more leeway remains here

V. A reduction in Section 301 tariffs could result in a stronger trade-weighted CNY

VI. Further structural portfolio flows should allow for recent CNY outperformance to continue for some time longer

Sources: Bloomberg, Lombard Odier

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