We are only two weeks into 2021, and it has already been an eventful year. The Federal Reserve has confused markets with its mixed messages. The U.S. is preparing for additional, massive fiscal stimulus, and COVID-19 infections are rising, not falling, during this second lockdown. Vaccinations, relative to official targets, are also off to a slow start.
Starting with the Fed, it appears that tapering talk out of some regional Fed presidents was a bit premature, as Fed Chair Jerome Powell and other notable Fed officials have pushed back against the notion that the Fed is thinking of changing its accommodative stance this year. The reality is that the U.S. is still suffering through a second COVID-19 wave, and U.S. data is on a downtrend. Clearly, the Fed will start to normalize policies when the economic recovery, but in the meantime, expect the Fed to remain on hold and accommodative despite conflicting statements over the past couple of weeks.
Regarding fiscal stimulus, the amount being discussed in the U.S. is massive. This past week, President-elect Biden released his proposal that amounted to $1.9 trillion. When added to the $900 billion already agreed upon during the holidays, you get a total that is roughly three times the size of the EU Recovery Fund. Moreover, the EU Recovery Fund will be spent over seven years, making the U.S. plan more front-loaded. If this latest round of U.S. fiscal stimulus is approved, it should be positive for risk. If the Fed remains on message and avoids further tapering talk, this additional fiscal stimulus should also lead to U.S. dollar weakness.
As for macro policy, the impact on the U.S. dollar is mixed, with near-term weakness likely followed by longer-term strength. As long as the global economy remains in a recession, macro policy in the U.S. will support global risk sentiment and keep the U.S. dollar weaker. However, supportive fiscal and monetary policies should eventually lead to a stronger U.S. recovery and a stronger U.S. dollar. This could happen through either the Fed eventually starting its normalization process or the market responding to a critical mass of strong U.S. data.
Beyond the U.S. dollar, differentiation in G10 FX will likely be based on vaccination progress during the year. Countries able to vaccinate their people sooner will be able to recover faster. Based solely on this, there could be downside risks to the euro unless Europe is able to accelerate its vaccination rate in the weeks ahead. Conversely, the British pound could benefit if the good progress on vaccinations accelerates based on the government’s plan for more vaccination centers. And of course there is Italy, where political uncertainty has increased after former Prime Minister Matteo Renzi pulled his party’s support from the coalition government. Snap elections are not the base case but represent a risk to the euro.
One- to two-week view: The single currency continues to hold on to much of the gains made since November as global reflation and U.S. dollar (USD) weakness provide support. Conversely, the blue wave/ripple has seen U.S. yields move higher, throwing a lifeline to the USD on the margins. Given this, absolute yield levels are still low, and the Fed’s tolerance for rising yields is still to be seen. Notably, Fed Chair Powell has pushed back on tapering talk. Furthermore, Europe is facing increased lockdowns that imply downside for first-quarter GDP. And, of course, there is the political turmoil in Italy. Early elections are not the base case but represent a risk to the euro. Overall, the expectation is for consolidation, with risks of a pullback, on the cross-currents describe above.
Three- to six-month view: The euro’s performance in 2020 was mainly driven by factors other than European economic performance. With the factors that pushed the euro higher in 2020 having faded or starting to fade, gains in 2021 should be harder to come by. Near-term optimism on a recovery in global growth helps the euro higher, but the single currency should dip into year-end as U.S. yields rise, the European Central Bank (ECB) continues to fight deflation, and market focus shifts to questionable domestic growth fundamentals. In essence, it is difficult to see a sustained euro rally without European economic exceptionalism and the prospects of ECB rate hikes.
One- to two-week view: The twin issues of COVID-19 and Brexit should dominate the headlines in the U.K. On Brexit, the immediate economic impact from custom duties, cross-border trading, tariff duties, etc. should be more pronounced than progress on equivalence. On COVID-19, the emergence of a mutated strain that is more contagious and a third national lockdown are the focus, with recent economic data underscoring the weakness in the economy and the increased likelihood of a contraction in first-quarter GDP. With additional fiscal and monetary stimulus is expected, the impending discussion on negative rates will be interesting to watch going forward with the Bank of England meeting in early February.
Three- to six-month view: The path for the pound in 2021 will depend on the interaction between the realities of Brexit and the speed and extent with which the U.K. economy can recover from the pandemic. On the pandemic, the U.K. economy’s underperformance arguably makes it one of the biggest beneficiaries of a vaccine. However, Brexit drags to growth and massive fiscal deficits represent counterarguments. A Brexit deal was reached, but this result still represents a negative economic outcome. As a result, the pound is expected to drift lower after the initial relief rally as markets refocus on the fact that a skinny deal is still a fundamentally bad development.
One- to two-week view: The core view remains to add on rallies, as expectations remain for USD/JPY to continue to move lower due to Japan’s real interest rate advantage and a relatively cheap yen versus the current level of yields. But in the very near term, USD/JPY should stay supported by blue-wave dynamics. Regarding the blue wave, Democratic control of the Senate should be more relevant regarding the ability to control the agenda than the chances for more progressive policies. Regarding Japan, the country has announced a state of emergency for seven more prefectures on top of last week’s lockdown for the Greater Tokyo area. In total, nearly 60% of the country’s GDP is now under lockdown. Expect the yen to remain in its current range.
Three- to six-month view: 2021 should bring yen strength as a real yield advantage, and inflation spreads remain in the yen’s favor. While the Japanese economy should benefit from Asia’s relatively low COVID-19 infection rates, a persistent negative output gap means a lack of inflationary pressures. As a result, real yield spreads and relative U.S.–Japan inflation expectations support yen strength, as does a drop in outbound investments. The increasingly crowded low-yielding currency club has reduced the yen’s role as a funding currency, and the yen’s cheap valuation has deterred yen shorts.
One- to two-week view: This week brings the Bank of Canada, and while the bank is expected to be on hold, there are talks of doing a “micro-cut.” In the near term, the outlook remains choppy and capped by the course of the virus. However, extended fiscal support, accommodative monetary policy and encouraging news on the vaccine front should keep the economy supported and prevent a collapse in sentiment. Expectations for additional fiscal stimulus in the U.S. also bodes well for Canada given its integrated supply chains. Bias remains for further loonie appreciation, with rising U.S. yield providing the counterargument.
Three- to six-month view: The loonie should continue to be driven by market sentiment. For 2021, a global recovery should support a rebound in oil prices and the Canadian dollar. As such, the expectation is for the Canadian dollar to continue to strengthen as positive vaccine developments support broader risk sentiment and the ongoing global rebound. On the monetary front, the Bank of Canada and the Fed are unlikely to be major factors in the exchange rate, as policy actions out of both banks have been very similar.
One- to two-week view: Growth indicators continue to point to an ongoing recovery in the Chinese economy. Relative economic outperformance, a current account surplus and relatively high yields form the base for a bullish view and support a continued drift lower for USD/CNY. Eventually, COVID-19 vaccine distribution will allow the rest of the world to close the growth gap, but a persistent yield advantage and strong foreign investor inflows support further gains. Recently, Chinese officials took several steps to limit capital inflows and promote capital outflows, signaling their concern over yuan strength. Nevertheless these steps should only slow, not reverse, the current trend.
Three- to six-month view: China’s GDP growth outperformance, effective COVID-19 suppression, relatively higher interest rates and portfolio inflows should support the yuan. Tail risks to this narrative come through trade policy. Given this, the Biden administration should reduce tensions and rhetoric and pursue a more deliberate trade policy. Regarding the monetary front, the People’s Bank of China is unlikely to push heavily against further currency appreciation due to the desire for greater yuan internationalization and two-way flexibility in exchange rates. Chinese yuan gains could potentially turn to consolidation at the end of 2021 as China’s relative growth outperformance slows and the tourism deficit starts to rise again.
One- to two-week view: Markets have picked up where they left off last year, with optimism around medium-term growth trumping near-term virus concerns. Adding to market risk appetite is the reintroduction of a blue-wave scenario in the U.S. that should see more stimulus. These forces, and positive economic news out of Australia, have helped push the Australian dollar (AUD) higher. As long as markets continue to look through near-term risks toward medium-term optimism, the AUD should remain supported. While one recognizes and understands the consensus view for a weaker dollar, one also has to acknowledge that current levels are unattractive, so expect markets to wait for dips before adding new AUD longs.
Three- to six-month view: Recent price action has been driven in part by the currency’s correlation with global equity markets. Once we are past the pandemic and risk assets start to normalize, the relationship between the AUD and the stock market should fade and give relative monetary policy increased significance. This is important, as the Reserve Bank of Australia (RBA) has committed to catching up with other central banks, ensuring relative accommodation. The RBA’s commitment and capacity to expand relative asset purchases should reduce some of the appreciation pressures.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to remain unchanged at -0.10%
Expectations for rates to remain unchanged at -0.50%
Expectations for rates to remain unchanged at 0.00%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
U.S. Initial Jobless Claims
Expectations for an 830,000 print
U.S. Manufacturing and Services PMI
Expectations for a 56.5 and 53.6 print, respectively
Expectations for a flat month-over-month print
Canadian Retail Sales
Expectations for a 0.4% month-over-month decline
EZ Manufacturing and Services PMI
Expectations for a 54.5 and 44.8 print, respectively
German Manufacturing and Services PMI
Expectations for a 57.4 and 45.0 print, respectively
U.K. Manufacturing and Services PMI
Expectations for a 53.0 and 45.0 print, respectively
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