The dollar had quite a day yesterday – it gapped higher at the market’s opening, only to give the gains back toward the end of the North American session.
For bulls, yesterday was as painful a day as it can be, as the reversal was sharp, with little or no pullbacks. For example, the EURUSD dropped from 1.2250 to 1.2130 and then climbed back to the initial level. The same happened to the AUDUSD or GBPUSD – basically, the dollar ended the day more or less flat.
With so many sellers of the world’s reserve currency, let us have a look at the most popular reasons why the dollar decline is poised to continue in 2021.
The Change in the U.S. Administration
The highly anticipated change in the U.S. administration may add fuel to the fire when it comes to the decline of the dollar. The market expects more fiscal stimulus in the form of an infrastructure bill worth over one trillion dollars.
The Change in the Fed’s Strategy
Out of the three, this is the one that has the strongest impact on the dollar. The Fed’s shift to an average inflation targeting was in full display last Wednesday during the press conference that followed the December meeting. The Fed is willing to let inflation fly high if only would have a chance to see higher prices.
The pace of the quantitative easing program, $120 billion/month, suggests it will. The only difference from the classic 2% inflation-targeting framework is the Fed’s willingness to react. In fact, the expected lack of action is what has the potential to drive the dollar even lower next year.
Average inflation targeting means that the Fed will not raise the federal funds rate or taper the quantitative easing program until there is sharp evidence that inflation averages more than 2%. The big unknown comes from the period that the Fed will consider – how many years back in time will the Fed go to average an inflation of 2%?
Strong growth in economic activity is expected if the vaccines against the COVID-19 pandemic do their job. Already 500k+ people received their first shot of the jab in the United Kingdom – so it begins.
Strong recovery means a lower USD as funds will pour into emerging markets and other places in search of higher yields.
Will these three themes dominate 2021? Or will the dollar have a strong comeback, given that the narrative explained in this article represents the general market consensus?