Don't sleep on the prospect of more currency depreciation from the People's Bank of China, warns Bank of America Merrill Lynch, calling for a "great divorce" between the U.S. and the world's second-largest economy in the coming year.

David Woo, head of global rates and currencies research, laid out the case for the team's favorite trade of 2016—buy USDCNH six-month forwards—in his preview for the year ahead:

"On the eve of the December FOMC meeting, we think the question is not whether the U.S. economy can live with higher interest rates and a higher U.S. dollar. The question is, given the semi USD/RMB peg and China's increasing open capital account (which come at the expense of China's monetary independence), whether China can live with higher U.S. interest rates and a higher U.S. dollar. We are skeptical. This why we think the USD/RMB peg, a marriage of convenience that has been the anchor for the global growth model for the better part of the last 15 years, is headed for a divorce, and we think the RMB devaluation on Aug. 11 was a first small step in this direction."

The strategist doesn't think the motive for depreciation is to put Chinese exporters in a position to seize a larger share of global demand by improving their competitiveness. Rather, this is all about allowing the People's Bank of China enough room to enact easier monetary policy in the face of an economy whose growth is moderating.

"We believe the RMB will weaken further because, given the increased openness of China’s capital account, Beijing will not be able to lower interest rates and defend the RMB at the same time," wrote Woo, reiterating his long-standing call.

Bank of America developed a monetary conditions index for China, which tracks the real effective exchange rate and real interest rates, and concludes that the policy has become too tight:

"We forecast USD/CNY to rise to 7.0, which would represent 9 percent depreciation from the current level, compared with 3 percent depreciation implied by the forwards right now," wrote Woo. "We could see renewed decline of the RMB as early as the first quarter, as the combination of the inclusion of the RMB in the SDR and a December Fed hike (both of which are our central scenario) could turn out to be a perfect storm for the RMB."

The surprise depreciation in August was an attempt to reduce the extent to which the People's Bank of China was forced to intervene in currency markets to prop up the value of the currency—a process which drained domestic liquidity.

However, the market panic that ensued exacerbated the flow of funds out of the country, as investors and companies began to worry about the potential for subsequent devaluations that would erode the value of their yuan-denominated assets and raise the cost of servicing U.S. dollar-denominated debt.

Woo acknowledges that the consensus view on Wall Street has shifted away from the notion that another large-scale devaluation is imminent and towards the idea that the People's Bank of China was "one-and-done," in part because of the magnitude of the reaction to August's move.

Barclays, for instance, recently pushed back its call for further declines in the yuan.

"We acknowledge the strong resolve of the authorities to deter speculation and to maintain currency stability in the near term," wrote Jose Wynne, head of FX research.

First « 1 2 » Next