Our last in-depth US dollar outlook in August argued that weakening safe haven demand, febrile politics, and curve-flattening from the FOMC would contribute to a secular break lower for the US dollar. Since then, price developments in FX markets have generally met these expectations, although we believe the dollar is likely to see another significant leg lower over the next 12 months. The broad US dollar is at a two year low, while the Federal Reserve has signaled its loosest ever outlook for monetary policy.
Looking ahead, the outlook for the dollar will continue to be driven by these factors, as well as the newly emerging picture of a global economic recovery in 2021 as vaccination allows wide scale re-opening of major economies.
MONEX EUROPE FX FORECASTS
Our view remains that the dollar is likely to see further weakness in 2021. However, the scale and pace of recent dollar weakness, and the fact that many of our core long-term views from August remain unchanged, mean that our forecasts for further depreciation are relatively tame compared to many other sell-side institutions. In this outlook, we highlight several changing aspects of the outlook for the dollar, in relation to our house view for 2021:
- Like many peers, the US economy will face high unemployment as a result of events so far in 2020 and the current peak in Covid-19 infections. This is true even in the likeliest scenario of rapid vaccine deployment resulting in sustainable economic re-opening in H1 2021. However, the pace of labour market recovery remains unknown. Crucially, even the current level of fiscal stimulus will likely mean a faster recovery than from the 2009 global financial crisis. The outcome of January’s runoff elections for Senate seats in Georgia will be an important, but probably not a decisive factor for the US dollar.
- In the short run, the lack of fiscal stimulus in the US provides additional impetus to the Fed for near-term tweaks to forward guidance and asset purchases. The importance of the Federal Reserve’s strategy review is difficult to overstate. Although much of the recent bout of dollar weakness has been driven by lower expectations of Fed policy rates, we believe the Fed’s policy change will equally relevant for the dollar – and capable of spurring marginal depreciation – in 2021.
- Interest rate differentials and safe haven demand were the two primary channels of USD appreciation over the last decade. With global growth improving and the Federal Reserve taking a structurally move dovish approach to unemployment and upside inflation risk, neither of these look likely to provide any support in the near future. The dollar also looks exposed in the context of its high valuations. Although risks exist in the form of negative shocks to growth or an asymmetric global recovery, the likeliest outcome is further dollar weakness in 2021.
Broad dollar falls to lowest levels since 2017
US RECOVERY WILL BE REAL – BUT LIKELY TO LAG MANY PEERS
Since our August outlook, the short term growth prospects have worsened considerably in the US, due to a second peak of Covid-19 infections of the sort also underway across much of Europe. It goes almost without saying that the 33.1% annualised, seasonally adjusted growth seen in Q3 will not be repeated in Q4. Much of this recovery was a simple “turning back on” effect after Q2’s 31.4% contraction, but even once this is accounted for, the path of growth has slowed significantly with the latest wave of Covid-19 infections. High-frequency data, especially pertaining to the food industry, illustrates the rapid slowdown in activity that has accompanied this latest surge. As cold weather sets in, it seems plausible that this latest wave will intensify, possibly prompting broader public health action. The timing of the Thanksgiving public holiday may have provided a fresh surge in cross-country infections, further complicating the situation. Expectations for Q4 growth among institutions are low, with the median forecast submitted to Bloomberg currently sitting at a 6% seasonally adjusted rate.
Second wave of infections likely to weigh on hospitality sector over winter
The US labour market recovery has slowed with the wider economy in recent weeks, and represents a considerable source of additional uncertainty. As of October’s non-farm payrolls report, official unemployment was 11.1 million, or 6.7%, with another 6.7 million jobless but not looking for work. Although payrolls have been steadily expanding since April’s trough, November and December are likely to see far smaller growth, or even an outright contraction in payrolls, leaving a large pool of slack in the labour market. The economic costs of the second wave, and their concentration in already vulnerable hospitality sectors, is further complicated by uncertainty over fiscal relief measures. Unlike the initial March shock when incomes were supported by direct disbursement from the Treasury and additional fiscal stimulus in the trillions, no additional spending has been released by lawmakers in response to the latest developments. Consensus forecasts for Q1 2021 are even more pessimistic than for the last quarter of 2020, with a median of 3.1 submitted to Bloomberg and many major institutions such as JPMorgan, AXA, and Bloomberg Economics expecting an outright contraction. This is entirely plausible should the current peak of infections be sustained by colder weather, forcing authorities to impose tighter restrictions.
Despite the relatively grim near-term outlook, rapid vaccination is likely to mean that the US and other large nations will return to rapid recovery of the sort seen in Q3 in the near future.
Vaccines from Johnson & Johnson, Novavax, AstraZeneca, Moderna, and Pfizer-BioNTech are all in advanced stages of testing or approval, with the latter 3 having published encouraging efficacy data in recent weeks. Evaluating the exact timeline of delivery and judging how long it will take to vaccinate meaningful proportions of the population is difficult. However, it seems likely that enough of the US population will be vaccinated to prevent allow full re-opening by around the end of Q2 2021. Goldman Sachs analysts estimated that 50% of the US population would be vaccinated by the end of Q2 in major developed economies, with the US reaching this mark in April, later than the UK but before the EU, Japan, and Australia. At this point the US economy will be facing a recovery of the sort seen in Q3, with the key unknowns being the trajectory of the labour market, and the extent to which consumer behavior has been “scarred” by unemployment and uncertainty. Estimates of full-year GDP growth are highly uncertain for these reasons, but as an indication, the Bloomberg weighted average forecast for full-year real gross domestic product growth in 2021 is 3.8%, following a contraction of 3.6% in 2020.
2021 US Real GDP growth forecasts submitted to Bloomberg
FED’S NEW STRATEGY WILL BECOME EVEN MORE RELEVANT AS RECOVERY ENTERS FULL SWING
The Federal Open Market Committee’s framework review resulted in two major changes to the Federal Reserve’s monetary policy strategy. Firstly, the FOMC has moved to average inflation targeting from targeting the level of inflation. New, official guidance now states that the FOMC “seeks to achieve inflation that averages 2 percent over time”. Secondly, the importance of maximum employment as a trigger for rate hikes has been greatly decreased. Jerome Powell and official forward guidance have made it clear that rates will not rise until inflation has met the 2% target, is track to exceed the target for an averaging period, and employment has reached estimates of its maximum sustainable level. This change represents a move to a significantly more dovish reaction function for the Federal Reserve than during the 2010s, when falls in maximum employment led the FOMC to hike interest rates in anticipation of future increases in inflation based on a Phillips Curve relationship. With the US economy outperforming many peers over the course of the 2010s, this led to dollar appreciation based on widening interest rate differentials during periods of strong US and global growth – more on this later in the next section of this outlook.
In a practical sense, the formal announcement of the change has had a mild steepening effect on the shape of the US yield curve, as wider changes in expectations of long term growth have led to longer-dated treasuries seeing a steady increase in yields since August. However, the Fed’s strategy shift has been effective in keeping the front end of the yield low, resulting in the steepest US Treasury curve since 2017, judging by the spread between 2 year and 10 year yields.
US Treasury Curve Lower – But Steeper than 1 year ago
Looking ahead, both the internal balance of opinion at the Fed and the wider economic and political context of the US means that FOMC policy will be “in play” to a greater extent than several key peer central banks. This is true both in the short term, when both asset purchases and forward guidance are likely to have a low bar for being changed to provide more accommodation, and in the long term, when the Fed’s dovish reaction function will be of relevance during the expected global recovery in 2021.
In the short run, there is a strong argument for the Fed to seek to provide additional monetary support to cushion the incoming Q4 and Q1 slowdown. Although fiscal support was aggressive and timely in the months immediately following the initial March and April shocks, further fiscal support has yet to be passed by congress, placing a premium on short-term monetary support. With the Treasury withdrawing backstop funding for the Fed’s Section 13(c) lending facilities, the Fed’s ability to provide credit easing is now restricted to more general asset purchases. November’s FOMC minutes revealed that members discussed extending the maturity of asset purchases, the primary alternative means of achieving credit easing. In addition to changing the composition of asset purchases, the FOMC may also choose to provide clearer guidance on the yield curve, on monthly purchase targets, or both. Changes in forward guidance are another possible avenue of additional easing. The current guidance is that interest rates will not rise until:
Labour market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.
Although this is arguably the most dovish forward guidance ever offered by a major central bank, there is still scope for clarification. One major area of potential additional forward guidance is the duration of asset purchases, which are not covered by the current “triple lock” guidance concerning rate increases. Any of these options would lower Treasury yields over the 3-5 year horizon, and likely continue to contribute to marginal dollar weakness.
USD CONTINUES TO LOOK VULNERABLE WITHOUT KEY PILLARS OF HAVEN DEMAND AND HIGH REAL RATES
Two of the key drivers of dollar strength over the last decade and beyond have been safe haven demand during times of heightened uncertainty, and interest rate divergence driven by rate hikes from the Federal Reserve. This dynamic has given birth to the popular “dollar smile” analogy, a simple mental model of growth and fx dynamics the dollar strengthens both when global growth is poor due to haven demand, and also when US and global growth is relatively strong, due to expectations of Fed rate hikes. Dollar weakness is reserved only for periods of mediocre US growth, but acceptable global growth. We would characterise the most recent phase of dollar strength, stretching from 2019 to early 2020, as being driven by haven demand stemming from the Trump administration’s trade wars. In contrast, the initial increase from 2014-2016 was driven by US yields remaining relatively high amid low rates and inflation elsewhere. In our August outlook, we argued that the dynamics underpinning the interest rate channel of USD strength were changing – that lower US real yields and a more dovish reaction function from the Fed would result in less USD strength in times of strong relative growth in the US.
As a result, the dollar smile would become a dollar smirk:
Dollar smile becomes dollar smirk
Recent events have made us more confident in this assessment of dollar dynamics in 2021. Encouraging vaccine developments now mean that it is likely the global economy will experience a sharp recovery in 2021. Although the trade policy of the Biden administration remains a key unknown, a period of risk aversion driven by erratic tariff decisions seems highly unlikely. Both of these developments will contribute to a lasting reduction in safe haven demand, removing this leg of support from the dollar. Additionally, the Federal Reserve’s “triple lock” commitment to keep rates unchanged until inflation is at target and on track to exceed target, while unemployment is at its maximum level, should contribute to a significantly less reactive yield curve during the 2021 growth upswing. As such, the bar for economic outperformance to cause dollar strength seems set exceptionally high, especially considering the high unemployment levels from which the recovery will be beginning. Valuation provides another reason for sustained dollar weakness – against major currencies such as the euro, the dollar remains unusually strong both on a historical, and inflation-adjusted or purchasing power parity basis.
USD levels remain elevated: Cost of a Big Mac burger purchased in local currency, converted to USD.
A big mac burger purchased in South Africa using Rand is 62% cheaper than one purchased in USD in the US using dollars.
A CROWDED TRADE?
Our argument for dollar weakness is not unique – dollar weakness has become an overwhelming consensus trade among sell-side analysts. This naturally introduces a note of caution, and so we provide a few additional thoughts on risks to our views:
- The most obvious possible cause of dollar strength would be a sudden deterioration in global risk appetite, causing a revival of the haven demand that supported the dollar over much of 2018 and 2019. The nature of unknown risks is that they are unknown – as coronavirus was in 2019, for example. The most immediately plausible avenues for increased risk appetite stem from the coronavirus itself, should vaccine effectiveness or distribution fail to meet very high market expectations.
- Although our judgement is that the bar for dollar strength due to US macro outperformance is set high in 2021, Georgia’s runoff Senate elections in January could introduce a wild card for currency markets. Joe Biden’s plans as an incumbent included net fiscal stimulus and infrastructure spending running in the trillions. With a GOP controlled Senate still the likeliest outcome, market expectations for growth and inflation in the US would be upended should Democrats win both seats and take control of the entire legislature.
Author: Ranko Berich, Head of Market Analysis