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FX Year Ahead 2021: Too Much Dollar Pessimism?

It has been year of absolute chaos, but hopefully 2021 will be much calmer as the global economy heals its wounds. The overwhelming consensus in the FX arena is for the US dollar to sink further as the reflation trade dominates, lifting all other boats. The ‘catch’ is that much of this weakness may be baked in already. The story for the euro is not attractive either. While dollar weakness could dominate early on and push euro/dollar a little higher, the euro may not fare as well against other currencies. The wild card is the British pound, whose fate hangs on the Brexit endgame.

King dollar is out?

What a year. Countries went into lockdowns, international borders were shut, the retail industry was devastated, America saw massive riots, and crude oil prices turned negative. But there were some encouraging things too. Governments and central banks started working together after a long time, delivering a stimulus response so powerful that it eclipsed everything else. It seems that even a global pandemic is no match for extravagant government spending and rock-bottom interest rates.

The world’s reserve currency had a tough year too. It roared higher in March as investors looked for shelter from the storm, only to collapse after the Fed injected the US economy with a stimulus dosage much bigger than other central banks. Simply put, the US had a more aggressive policy response than most countries, and investors lost their appetite for hoarding dollars defensively once it became clear the sky was not falling.

The burning question is whether the dollar’s pain will continue into 2021. The consensus within the financial community is that it will, and there are solid arguments why. The main element is that US inflation is expected accelerate faster than other economies, pushing real interest rates lower as the Fed won’t allow US bond yields to move much higher. In addition, safe-haven demand for the dollar could fade as the global economy recovers and trade policy towards China calms down under a Biden administration.

The ‘catch’ is that much of this has already played out. The dollar has fallen dramatically and positioning by leveraged funds is now at very bearish levels, making it a crowded trade. This doesn’t mean the reserve currency cannot fall further. Rather, it implies that any risk-off episode or any other piece of dollar-positive news could spark an epic short squeeze and hence a powerful rebound.

Consensus trades often don’t play out as expected, precisely because they are so anticipated. It’s a complex world and a lot of things can go wrong. In this case, everything hangs on the assumption that things will return to normal quickly as the masses are vaccinated. That may turn out true, but markets seem to be underestimating the uncertainties.

There’s still a major risk of a wave of bankruptcies as government support is withdrawn, or an eviction apocalypse in America as the moratoriums expire. Or perhaps inflation could pick up more than markets expect, forcing the Fed to take its foot off the gas.

The bottom line is that while euro/dollar could continue to race higher for now amid all this euphoria, it may have trouble breaking significantly above $1.25-1.26, especially since the ECB might go to battle to defend that zone. On a simpler level, the US economy seems much stronger than the euro area, which may dawn on investors before long.

Euro doesn’t look pretty

There isn’t much to be cheerful about in the euro area. The economy is trapped in deflation, growth will likely remain soft for a while because of the prolonged lockdowns, and the ECB is almost out of firepower. On the bright side, EU leaders took a significant step towards a fiscal union in the midst of the crisis, but even that has been a painfully slow process.

One might ask then, why the single currency has performed so well. One part is that the weak-dollar story was even more dominant. The other part is that because inflation is so low, real interest rates in the euro area have risen a little. The calculation for real rates is nominal bond yields minus inflation, so the lower inflation falls, the more real rates rise – assuming the ECB holds the policy rate steady. It’s paradoxical, but deflation can sometimes boost a currency.

Looking into 2021, the euro is widely expected to continue marching higher, supported by the global recovery boosting demand for its exports and capitalizing on a broadly weaker dollar. Alas, this assessment may be overly optimistic.

In short, the recovery remains fragile. With most European economies still in a lockdown, the early part of the year could be brutal, and the political appet