According to analysts, with the global economy recovering next year, the U.S. dollar will face more downward pressure as investors opt for riskier assets, and the Federal Reserve keeps rates near zero.
The U.S. dollar’s widely expected decline was put on hold at the beginning of 2020 as many embraced the greenback for its safe-haven qualities. In March, the U.S. dollar index (DXY)peaked above the 102 marks. However, since then, the DXY has been sliding and trading near 2.5-year lows below the 90 marks.
Analysts are not ruling out some more U.S. dollar strength in the first quarter of next year, but many are confident that the overall trend for 2021 will be downwards.
The COVID-19 pandemic has only paused the U.S. dollar’s inevitable decline, said Bannockburn Global Forex chief market strategist Marc Chandler.
“The dollar was sought not only as a haven, but the unwinding of structured trades that used the dollar to fund the purchase of higher-yielding or more volatile assets (think emerging markets, for example) also lifted the dollar broadly,” Chandler pointed out.
Now that the emergency demand for dollars has subsided, the greenback’s downtrend can resume, he added, noting that the U.S. dollar’s third significant rally since the end of Bretton Woods is over.
“While we may have been early on the dollar bear call, it has become the consensus view … It seems the bearish outlook can be framed as a return of the twin-deficits. A large current account and budget deficit do not always translate into a depreciating dollar, but this time it likely will. The U.S. is not expected to offer the interest rate or growth differentials that attract the world’s savings at current prices,” Chandler explained.
The main drivers behind the dollar’s bear market are massive money printing, inflation, economic recovery, risk-on sentiment, and loose monetary policy.
“Dollar will weaken given the huge amount of debt and money printing in the U.S.,” said Goehring & Rozencwajg Associates managing partner Leigh Goehring.
TD Securities strategists pointed out that, in the short-term, the U.S. dollar could benefit from still surging new coronavirus cases, potential new lockdowns, and a pause in the economic recovery this winter.
“With the DXY index trading at its lowest levels in more than two years, we think a lot of the bad news for the dollar is now in the price. With the U.S. election and promising vaccine news behind us, investor attention could revert to macro fundamentals and the still-harsh realities of rising COVID infection rates worldwide,” the strategists said.
This uncertainty could last up to four months, noted ING chief international economist James Knightley. “COVID-19 cases are rising sharply, and containment measures are being re-introduced at a high economic cost. This window of vulnerability could last more than two, three, or even four months during which restrictions on movement could push up unemployment and weaken activity,” Knightley said.
Later in the year, however, the reflation trade will take over and weigh on the dollar, TD’s strategists noted.
“We expect the USD secular downtrend to persist, reflecting vaccines and eventual behavioral immunity that reinvigorates the reflation trade,” they said. “With the USD trading at about a 10% premium to its longer-term fundamentals, we look for the dollar to depreciate steadily over the course of next year.”
On top of that, money printing mixed in with economic recovery and increased consumer demand could also trigger inflation, taking away the U.S. dollar’s purchasing power, the analysts highlighted.
“In terms of what this means for markets – the focus will remain on so-called reflation trades. As global investment opportunities improve, our FX team believes the ‘safe-haven’ dollar will come under sustained downward pressure,” said Knightley. “Inflation may also start to make an appearance in the second half of 2021 with vibrant demand coming up against pandemic induced supply constraints in many sectors.”
In response, the Fed is likely to let inflation run hot after adopting its new flexible average inflation targeting.
“We suspect the yield curve will steepen further with 10-year benchmark government borrowing costs likely to test 1.5% in 2021 while the Federal Reserve keeps short-term borrowing costs pinned down close to zero,” Knightley stated.
President-elect Joe Biden is also likely to push for more stimulus next year, the economist added.
“Biden will be primarily focused on creating work for the 10 million people who lost their jobs due to the pandemic and are yet to find employment. That means we are likely to see another substantial fiscal stimulus focused on infrastructure and energy. The outcome of the two Georgia Senate seat run-off elections on 5 January will determine the scale. Current polling points to Democrat victories, which would give Biden the green-light to go big given his party would control Congress,” Knightley pointed out.
The dollar’s depreciation is likely to last the next couple of years, said Capital Economics U.S. economist Andrew Hunter.
“Real interest rates look like they will continue to fall, as inflation picks up, and the Fed will continue to keep its rates low,” Hunter explained. “The other main factor is that stocks continue to rise, and risk appetite is improving. This will coincide with weakening dollar.”
The more risk-on the investor sentiment gets, the more likely it is for the money to flow out of the U.S. and into emerging markets, analysts noted.
OANDA senior market analyst Edward Moya said that as the global economic recovery unfolds, the greenback will see “significant weakness.”
“Second half of the year is when the outlook will improve for emerging markets. This will further accelerate many carry trades that use the U.S. dollar as the funding currency, and it will have a snowball effect. The dollar will continue to slide on the belief that the Fed will be the last to tighten and emerging markets will raise rates sooner,” Moya said.