Recent price action in the markets feels very much like it did at the end of 2020. Equities are reaching new historic highs, the U.S. dollar is down, emerging market currencies are up, foreign exchange volatility is down, U.S. yields are falling, and oil prices are higher.
The likely driving force behind these recent market moves is the combination of vaccine catch-up in Europe and a dovish Federal Reserve. In the first quarter of 2021, the foreign exchange markets were trading on the divergence in vaccination, with the U.S. and the U.K. — and thus the U.S. dollar and British pound — leading the way. With expectations now being for Europe to catch up on vaccinations during the second quarter, the euro is higher, while the U.S. dollar and British pound are lagging their peers. Meanwhile, the Fed continues to maintain its dovish tone despite strong U.S. data.
The above narrative notwithstanding, the outlook remains positive for the U.S. dollar for the rest of the year. However, short-term risks are clearly for further U.S. dollar weakness. Data shows that investor flows, especially real money, have turned negative for the dollar. Whether or not the current trading regime will last for long will depend on two key developments.
First, will the EU be able to vaccinate its population fast enough to save the summer tourist season? Currently, the plan is to reopen in July, which is similar to last year’s plan. Therefore, vaccinations not only need to move fast enough to reopen by July but also need to reopen to a greater extent than last year while the rest of the world shows an increased willingness to go on holiday to Europe. This isn’t an impossible scenario to achieve, and the increased pace of European vaccinations gives some optimism, but more work needs to be done.
Second, will the markets start testing the Fed, and/or will the Fed become less dovish as U.S. data continues to improve? Recent data has surprised already optimistic expectations, and expectations are for upcoming data to be even stronger due to vaccine outperformance, massive fiscal stimulus and pent-up demand from excess savings. Markets will be hard-pressed to ignore a critical mass of positive U.S. data, especially if Europe remains closed. The Fed has indicated it will give an early warning to markets before any policy changes. The question then is when this signal will come and whether the markets will have it priced in at that time in response to strong U.S. data.
On a broader level and beyond the short term, there are two key concerns that will affect foreign exchange markets. The first is the effect of U.S. fiscal stimulus and whether or not it leads to overheating risks and what the Fed’s reaction to this would be. The second concern is when will the pandemic end? The World Health Organization warned that mass vaccinations do not guarantee the end of the pandemic. Even if advanced economies vaccinate most of their adult populations by the end of the year, it could take significantly longer before the rest of the world does the same. Meanwhile, new strains that challenge vaccine effectiveness continue to pop up. Bottom line, it is still unclear when and how the pandemic will end, with the market’s current view possibly too optimistic.
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