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Looking ahead to 2021, we at UBP expect the dollar to continue to be affected by the Fed’s policies announced in the final months of 2020. Not only does the Fed intend to leave rates on hold until at least 2023, but it has also adopted a medium-term inflation target.
Even before the pandemic, the US was one of the few economies generating inflation. If they continue to do so after the pandemic, without a policy response from the Fed, periods of accelerating inflation will reduce the purchasing power of the dollar, which is then likely to weaken progressively.
The Fed (its last monetary policy meeting for 2020 is expected tonight) has other arrows in its bow that it can use to further ease financial conditions, including explicitly controlling the yield curve. This strategy, currently followed by the Bank of Japan, would bring bond yields within narrow ranges along the yield curve, preventing them from rising due to rising inflation expectations, and in doing so the dollar would weaken further.
In the absence of a political agreement on fiscal stimulus, the Fed could also activate its private credit lines, which would result in a guarantee programme for consumers and small businesses, like the one adopted in the UK. This would cause a further expansion of its balance sheet and thus a depreciation of the greenback.
One of the main causes of the dollar’s weakness next year will be the rapid deterioration of the US current account balance. The deficit is close to 3% of GDP, and is likely to widen rapidly in 2021.
As the US budget deficit is set to remain very high, close to the current 13% of GDP, a further economic recovery is likely to cause the current account deficit to widen sharply.
As the dollar is fully valued by most standards, it could easily depreciate substantially over the next 12 months.
In the past, similar scenarios have seen it leave between 20% and 30% of its trade-weighted value on the ground in subsequent years. Therefore, it is a given that when US growth is moderate and global growth is recovering – which is the most likely scenario in 2021 – the dollar is generally weak.
The risk of dollar appreciation could emerge in two scenarios.
The first is if US growth far outpaces growth in the rest of the world, but this seems unlikely given that the Chinese economy is already moving from recovery to expansion and that concerted fiscal stimulus measures in Europe would materialise in early 2021.
The second scenario would occur should risk aversion reach extreme levels, as it did during the 2008-09 global financial crisis or in the early stages of the Covid-19 pandemic (January-March 2020). Given the proactivity of global fiscal and monetary policy, this risk is likely to be modest and transitory.
But the dollar is also affected by important political factors. The political and monetary authorities will use all their influence to keep the dollar low, as an appreciation of the dollar tends to have deflationary effects and there is a close correlation between an overly strong dollar and the default rate of emerging market debt.
A stronger dollar would further widen the US trade deficit, which is already considerable even after the elimination of oil imports. In a world where demand is low, nobody would benefit from an appreciation of the dollar.
According to Volker Schmidt, manager of Ethenea, we have a recipe for disaster. Below-average economic growth, the massive budget deficit, the still unclear relationship with the EU and an even more expansive monetary policy all point to a further depreciation of the pound against the euro. Although the Bank of England has so far rejected the idea of introducing negative rates, we believe that it will eventually break this taboo and follow in the footsteps of the ECB. This would put even more pressure on the British currency, causing it to depreciate further.
The double shock of Brexit and the pandemic has hit the British economy particularly hard. Rising unemployment, falling sales and job losses, especially in the retail and entertainment sectors, have pushed Britain’s gross domestic product down more than in any other industrialised country. The estimated -11.3% in 2020 is the worst figure in three centuries.
Added to this is the fact that the UK is far more dependent on trade relations with the EU than the EU is on the UK, with around half of all UK imports and exports of goods and services trading with the EU. Even the most favourable possible deal on Brexit would require London to make significant investments in converting its production and supply chain, as well as adjusting to new border controls and documentation requirements.
“A situation that will further burden the British economy and put further downward pressure on the pound,” Schmidt points out, “while UK government bonds should continue to be considered a safe haven.”
The Bank of England has already lowered its reference rate twice this year, from 0.75% to 0.1%, and recently increased its purchases of government bonds by a further GBP 150 billion to GBP 875 billion. The demand created in this way should stabilise the bond market on the one hand and keep interest rates low on the other, thus facilitating public financing. In addition, investors can be virtually certain that they will be able to sell the government bonds they have bought back to the central bank if they need to.
The pound will remain under pressure as, with one month to go until the end of the Brexit transition phase, there is still no acceptable agreement on the future trade relationship between the EU and the UK.
The Central Bank will do all it can to mitigate the negative repercussions of leaving the EU and the coronavirus pandemic. Further bond purchases have already been announced and other measures are being discussed. So far the Bank of England has refused to adopt negative reference rates, but may soon change its mind.
“Finally, if the deadline of 31 December 2020 is postponed once again and negotiations continue into the new year, we would be sliding into an endless nightmare, probably the worst of all possible scenarios due to continuing uncertainties. Coupled with the coronavirus, this would put the UK economy in even more difficulty,” Schmidt concludes.