There is no doubt that it was a challenging 2020 for the US dollar, with the currency weakening to levels not seen for more than two years. The emergence and continuing presence of the global coronavirus pandemic did not spell good news for the dollar.As a currency that thrives in a risk-off environment, the dollar was down almost 6% in December 2020, compared to the previous year, representing its worst yearly performance since 2017.The Covid-19 pandemic dealt a major blow to the dollar in 2020, prompting unprecedented policy responses from the US government and the Federal Reserve.Prior to this, the dollar had been a pillar of strength, being much more resilient than other currencies, offering a stable safe haven of certainty for investors.However, after reaching its ceiling in the first quarter of 2020, the dollar began to weaken throughout the year, continuing its downward trajectory into the new year.Despite these developments, analysts at Bank of America have outlined five reasons why the dollar could in fact strengthen in 2021.
President Joe Biden has ambitious plans for a generational transformation of the US economy as part of a $1.9 trillion stimulus package. Indeed, the dollar would initially be weakened by such a large fiscal relief package. However, Bank of America strategists believe that the fiscal stimulus will support the dollar’s strength in the medium-to-long term. This is because it will increase the likelihood of a normalisation of monetary policy from the Federal Reserve in the form of monetary tightening.
Safe Haven Return
According to the experts at Bank of America, there is likely to be a reversal of the risk-on market mode, which is where traders favour riskier assets, normally to the effect of expanding corporate earnings. However, this position is not expected to remain the case indefinitely, and investors will return to safe havens in due course. With the global vaccination programme making slow progress, the experts are predicting that a gradual path to recovery should support the dollar in the short term.
Another theory put forward by market analysts is that the dollar could soon face a short squeeze, within the same context as the GameStop phenomenon that occurred back in January. Projections around the US economy outpacing the EU’s could mean that the dollar could be strengthened. This is because the selling of the euro-dollar trade could be cut into long positions, to the benefit of the dollar.
It is expected that the global economy will begin to make small steps towards a recovery in 2021. The introduction of mass vaccination programs will signal the beginning of the end in terms of the coronavirus pandemic, while the easing of lockdown restrictions by national governments will stimulate economic growth. The US economy’s decoupling from the EU is expected to support the dollar, as US spare capacity begins to diminish.
Federal Reserve Stance
The Federal Reserve is beginning to draw a close to its ultra-easy policy stance, moving away from injecting money into a struggling US economy. Policy normalisation could be on its way in the near future, but is more likely to arrive early in 2022. There may not be any premature tightening, but it is certainly the case that the Federal Reserve’s position is less intense than the rhetoric regarding the euro coming out of the European Central Bank.