Dollar defies the doubters as hopes for economic rebound rise

Like many new year resolutions, convictions about the future direction of currencies can crumble fast.

The majority of strategists and investors set about trading in 2021 with a rock-solid conviction that the dollar would weaken, pushing the euro higher. With most of the year still ahead, this previously popular view might still become true but so far it’s not so good.

The euro has lost 1.2 per cent against the dollar since the start of January, slipping from its multiyear highs of $1.2349 in early January to hovering around $1.20 on Wednesday. The dollar index, which measures the value of the US currency against a basket of its peers, is up 1.2 per cent this year.

The dollar had been widely expected to weaken given the scale of the US Federal Reserve’s efforts to keep interest rates low through bond buying and extremely loose monetary policy. In addition, the currency was forecast to suffer from worries over growing debt levels in the US that might restrict further options to stimulate growth.

That would have caused a growing headache for the European Central Bank. A stronger euro weighs on the region’s economy by making exports less competitive, while lowering the price of imports — at a time when the eurozone is experiencing deflation.

But the US economy is gunning faster than anticipated and bond yields have been rising as investors were jolted into pricing in a faster return of rate increases than they had previously expected.

Rather than focusing on the abundance of dollars sloshing around in the global economy, investors are increasingly zooming in on the pace of economic growth following the pandemic. But doing this means abandoning bets on a weakening dollar and instead wagering on the return of “US exceptionalism” — American growth outstripping other developed economies.

“Markets are transitioning through narratives,” said Mark McCormick, global head of currency strategy at TD Securities. “What started as a global liquidity trade . . . shifts to a more significant focus on regional dynamics.”

Doubts about the viability of the weak dollar narrative started to pick up in January after the victories by the Democrats in the Georgia’s Senate run-off elections that gave the party control of the upper chamber. The results have made it possible for new president Joe Biden to pass a larger-than-expected spending package to combat the impact of coronavirus, raising hopes of a faster economic rebound.

Rather than becoming a burden for the dollar, the huge spending package could turn into a boon if it translates into bumper growth.

“It’s a bit of a dilemma for everyone at the moment: do you focus on growth or debt?” said Ugo Lancioni, head of currency management at Neuberger Berman.

Economic growth expectations for the US have had a 1 percentage point upgrade since January, while consensus forecasts for the EU’s economic performance had slipped, Lancioni noted, adding that even with rates at near zero, investors were better off holding US assets than European ones.

By betting on growth, investors would tilt towards a stronger dollar, as long as they believed that the US economy would outpace its peers during the rebound from the pandemic. Such an outcome would be highly supportive of the dollar, especially if the Fed was pushed into raising rates.

The euro faces no such threats. Analysts expect no change in the ECB’s policy any time soon and interest rates in the EU are already the most negative in the world, bar Switzerland. That makes the euro one of the least attractive currencies to hold.

These features have tentatively pushed the euro back to a role it first played in the years running up to the start of the pandemic. Then the US’s interest rates outstripped its developed market peers and allowed investors to cash in on the difference by buying US assets with their euros — a so-called carry trade.

“Our sense is that partially funding carry positions using the euro makes sense given that the ECB is unlikely to tighten policy anytime soon,” said Francesca Fornasari, a portfolio manager at Insight Investment.

Paul Meggyesi, head of global FX strategy at JPMorgan, said the bank had been recommending using the euro as a funding currency since the election results in Georgia, as the euro tends to decline when US rates rise.

The prospect of a rate rise might still be some way away. But as the year progresses, we might see a divergence between the big central banks’ signals on future monetary policy. That could support a carry trade. But still, in a world where rates remain low, returns might be modest.

eva.szalay@ft.com