Mizuho daily – Soft USD & hard markets, PBoC responds, RBA hold

By Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

Soft USD & Hard Markets

Admittedly, UK and US holidays warrant discounting market moves. But the idea of a soft USD and increasingly hard (to read) markets predates yesterday’s holiday; and may persist beyond. For one, a softer USD that is manifesting despite slight firmer UST yields not only challenges yield-driven FX analysis, but also suggests more complex relation between inflation expectations (breakevens) and nominal yields.

And this may set the stage for more abrupt reversals.

In addition, softer USD not corresponding unequivocally to “risk on” markets (EuroStoxx drop overnight) undermines familiarity about “RORO” USD and “left-half of USD Smile”.

Above all, a weaker USD as US recovery continues to outpace also sits precariously; and could suddenly turn on monetary policy shifts (e.g. “taper” talk). The upshot is that one should not be seduced into carelessness by the ostensible ease of trading a bearish USD trend.

The reality is that EUR bump-up above 1.22, USD/JPY slip below mid-109, AUD pick-up to mid-0.77 and USD/SGD slip to test 1.32 are positions of latent tension, not unbridled tailwinds.

And the PBoC’s subtle pushback via FX reserve requirement tightening to subdue AXJ gains.

What to Make of PBoC’s FX Reserve Requirement (FRR) Tightening

Given the layers of complexity involved, the consequences of, and motivations for, the PBoC tightening FX reserve requirement (FRR) by 200bps to 7% (from 5%) are worth unpacking. At least beyond the knee-jerk slip in CNH for the former (i.e consequence) and the policy line declaring that the motive is to “strengthen FX liquidity management at financial institutions”.

First off, the most proximate impact of this reserve requirement tightening is that it raises Chinese banks’ (opportunity) cost of holding foreign currencies (mainly USD). If banks presumably pass this increased cost of foreign currency holdings, this may nudge a a conversion to CNY, and attendant CNY appreciation.

At face value, this ought to be an inconvenient invitation to a stronger CNY, precisely what the PBoC wants to avoid. But the dominant impact is from higher USD funding cost resulting in more precautionary hoarding of USD.

And forward-looking markets pricing in curtailed inwards FX flows into Chinese banks suggests FRR tightening has stalled CNY appreciation on balance.

Crucially, by moderating the build-up of, as well as demand for, foreign currency desposits, this will act as stabiliser for CNY if downward pressures build as well.

Simply put, the tighter FRR acts as a counter-cyclical (vs. capital inflows) stabliser for CNY; dampening appreciation pressures as well as pre-empting vulnerability to sudden outflows.

An afterthought is that this may provide the PBoC with greater confidence in checking excessive CNY gains, as the risk of a brutal swing on the flip side is mitigated.

Upshot: While FRR tightening was fairly efficacious in stalling excessive CNY appreciation, it is really a counter-cyclical tool for wider FX stability.

RBA Set for Status Quo

With policy accommodation front-loaded, fiscal policy stimulus on the generous side and the economy on a steady mend, the RBA has no reason to accentuate its dovish stance.

But equally, it will not be in a rush to revoke policy accommodation either. Status Quo is the name of the game for now.

With;

i) RBA cash rate at record low of 0.10%;

ii) YCC anchor for 3Y AGB yields at this cash rate, and;

iii)  a second A$100 QE (A$5bn/week) set to run through Sep 2021; the bar is high for further policy easing amid continued recovery.

In fact, the point is that the RBA is wary of premature normalization talk watering down current policy efforts -whether due to upside yield volatility and/or excessive AUD surge.

What’s more, the RBA will also be inclined to wait and watch the path and pace of the recovery once fiscal support fades. This has understandably been a point of uncertainty for the RBA. And so “cruise control” is the optimal policy tone at this juncture.

Credit: Mizuho Bank Ltd