China’s Biggest Fears Are Giving Dollar All the Support It Needs

(Bloomberg) -- The U.S. dollar is getting a boost from an unusual place -- China.

Increasing coronavirus infections, slower growth and rising risk of default in the world’s second-largest economy are combining to help fuel a stronger dollar, according to Morgan Stanley strategists. But at the same time, these factors are combining to keep the yuan in a tight trading range, which caps how high the greenback can go.

“As a large component of the Fed’s broad USD index, and an influential global currency, a relatively stable CNY limits how far the broad USD index can rally,” strategists led by Matthew Hornbach wrote in a note to clients Friday. 

A sharp jump in the dollar-yuan cross would lift the broad dollar index, as the renminbi has a heavy weighting in it, and there would be a spillover effect from other developing-world currencies, they wrote.

The renminbi is the second-best performing emerging-market currency against the dollar this year, gaining 0.7%. While China’s domestic woes suggest the country risk is “relatively high,” the yuan is set to continue outperforming most peers in a strong-dollar environment, according to the Morgan Stanley strategists.

“China’s balance of payment positions remains extremely strong, and at the same time, the authorities may well prefer to keep the CNY relatively stable to anchor sentiment,” they wrote. “This is why China’s FX policy is actually preventing a more meaningful rally in the USD.” 

Though Morgan Stanley doesn’t expect a big move in the currency pair, if the yuan weakens sharply, it may represent the final stages of the greenback’s rally. Last week, Wells Fargo warned the Chinese currency could fall as much as 2% in the coming weeks as traders weigh renewed regulatory and economic concerns. Meantime, strategists at JPMorgan Chase & Co. expect to see a slightly weaker yuan toward year end on the back of a firmer U.S. dollar. 

Morgan Stanley trade recommendations: 

• Likes the CNY as a carry trade; recommends long 10-year Chinese government bond position without FX hedge
• Recommends long CHN/TWD as a carry trade and CNY/TWD 3m NDF

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