What will trigger the next upward leg in USD? The answer, according to Morgan Stanley, is in China’s hands. 

Our thesis, is that ahead of the lunar New Year (Feb 8) and China hosting the G20 (Feb 26-27), there is a strong incentive for policymakers to keep RMB stable. Moreover, we note the risk that USDCNH could be driven down in the near term amid recent press reports on speculation against RMB. The FX reserves data over the weekend will be an important test. Given some in the market are expecting a very large decline ($150-$200bn), a smaller fall in reserves could ease market concern and contribute to a near-term strengthening in CNH,” MS argues.

“However, the price for FX stability is high. It requires preventing capital outflows by offering attractive real yields. The problem is that current real yields may be too elevated to inspire economic growth. Instead, high real yields risk a faster and more painful deleveraging. Hence, economic weakness is likely to stay, in our view. Other Asian surplus economies offer similar dynamics, explaining why we look east and not west when trading FX. Unless, the Fed radically overhauls its current reaction function signaling almost unconditional monetary accommodation, it will be Asian data, the evolution of currency reserves and easier local central bank policy which drive USD and global markets,” MS adds.

Accordingly, the current USD downward correction should be limited, with implications going beyond FX markets. Correlations are high and the recent USD decline helped catalyze an oil rally, spilling over into tighter corporate spreads and providing shares with an urgently required lift. The high correlations are due to FX, commodity and equity markets trading similar frameworks. This framework is based on overcapacity, leverage and low return on investments. The Fed pausing or the BOJ, the ECB and other European central banks pushing deposit rates into the red will do little to change these dynamics,” MS argues.

This article originally appeared at eFXnews.

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