| 2021 started with a strong consensus that last year’s trends would continue, if not accelerate. Last year, risk assets rallied on strong macro policy support and expectations that the COVID-19 shock would be temporary. Risk-on and U.S. dollar weakness were the main G10 trends in FX. Furthermore, vaccine developments late last year reinforced the market’s expectation for a strong global economic recovery in 2021 as macro policies remain supportive. All in all, a strong rebound of the global economy and a dovish Federal Reserve were seen as a recipe for further U.S. dollar weakness. |
However, with just a little over one month in the books, this strong consensus is already facing challenges, with the markets showing signs of adjusting and looking at more individual currency drivers rather than just trading on risk sentiment and the U.S. dollar.
The first big change has been in the Fed’s tone. Last year, the Fed was unequivocally dovish. However, a number of Fed speakers did start to talk about tapering in early January. Since then, the Fed has pushed back firmly on such rhetoric, but mixed communication suggests that the Fed normalization, while not imminent, is closer than what was previously expected.
The economic outlook has also become more uncertain compared to initial expectations. New and more infectious COVID-19 strains and a slow start to vaccinations, particularly in Europe, have pushed back the timetable on when countries around the world were hoping to move out of lockdowns. This likely means that severe lockdowns should remain in place for all of the first quarter, and possibly longer, as the more infectious COVID-19 strains and slow vaccinations should lead to a more gradual removal of restrictions this year and delay the move back to normality.
On the positive side, U.S. fiscal policy is now more supportive. Last December saw the U.S. add another $900 billion in stimulus on top of already historically large support. Since then, the Biden administration has proposed another $1.9 trillion in spending, with further spending expected to come through an infrastructure package later this year.
Even if negotiations weaken the total amount of Biden’s fiscal proposal by 50%, the total amount of pandemic fiscal support in the U.S. will still be roughly three times that seen in Europe and will be spent now as opposed to over seven years, as is the case with Europe’s response.
As such, the U.S. dollar’s response to such massive fiscal stimulus is not as straightforward anymore. Last year, fiscal stimulus was positive for risk and negative for the U.S. dollar. This year, massive fiscal spending increases the risks for earlier-than-expected Fed normalization which has a supportive impact on the U.S. dollar.
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