The year 2020 has been a challenge for the forex industry. In 2021, exchange rates are likely to be driven more by how fast confidence is renewed in what will hopefully be a post-pandemic global recovery, though aggressive fiscal and monetary policy support packages have been helpful. The FX markets were also affected before the pandemic by the US protectionist policies, but the dollar is expected to decline about five to ten per cent from current levels against most currencies, though the legacy of Covid-19 globally may not make this is simple as it sounds.
Bullish outlook
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There is a bullish outlook for the forex industry thanks to the US Federal policy decisions which support expected inflation rises whilst keeping interests remain low, and the dollar typically selling off in the early stages of a recovery cycle. However, the challenges of Covid-19 and an upcoming winter in the northern hemisphere could impact this outlook.
The three-year diversion in the US
The global financial markets and the dollar were driven in 2018/19 by US President Donald Trump’s large tax cuts and protectionism, while 2020 has been dominated by Covid-19. Both made the dollar stronger for a brief time. The ending of Trump’s protectionist policies should help other global currencies, with Biden expected to return to a rules-based international order, with liberalisation seeing USD/CNY reach 6.30, with more balanced global growth. The biggest risk to any forecasts relates to the control of Covid-19, yet few policymakers are currently mentioning austerity, but instead discussing growth and inflation to drive down public debt burdens.
Returning economies to pre-pandemic levels
In Europe, policymakers are dealing with the impact of deflation and returning economies to pre-Covid-19 levels, which makes them less tolerant of a strong euro. It is expected that there will be a move from precautionary USD holdings into emerging markets in 2021 that will keep the dollar weak with a EUR/USD at 1.25.
In the UK, the EU:UK trade deal (Brexit), as long as it is not a “no-deal” Brexit, is likely to support the GBP. Scandinavian currencies are expected to recover first, whilst in the Central European region, CZK is favoured, backed by one of the few central banks ready to tolerate currency strength.
The year 2021 is also expected to see higher commodity prices, with Canada’s expected recovery in oil prices having the potential to reach USD/CAD at 1.23. AUD and NZD should also stay supported. In LATAM, the Colombian peso is favoured because it is backed by relatively stable politics. The Korean Won (KRW) is also expected to do well.
FX markets
Some currencies have completely reversed their March losses and now stand stronger against the dollar on the year, including the EUR, CNY and KRW. However, many emerging currencies are still well down on the year due to the collapse in commodity prices, some like Brazil have struggled with fiscal challenges or balance of payments weaknesses, such as TRY and ZAR.
US Federal policy
All global policymakers are aiming for reflation. If US policymakers are successful with reflation, the dollar should weaken. US Treasury 10-year yields at one or even 1.25 per cent should provide a moderate investment environment long as the pandemic is under control.
Interest rates
In developed markets, many central banks are dealing with rates near zero or slightly negative. While the Bank of England and the Reserve Bank of New Zealand are threatening to take rates into negative territory, most central banks and policymakers want to convince investors that economies are back on track and that inflation will return to more normal levels, such as 2.6 per cent in the US in the summer of 2021 and an average inflation target of between 2.00 and 2.20 per cent. Lower real interest rates and weaker currencies are a desirable policy outcome in early-stage recovery cycles.
Carry trades
Carry trades are expected to be popular in 2021. This is a trading strategy that involves borrowing at a low-interest rate and investing in an asset that provides a higher rate of return. This should lead to lower levels of FX implied volatility. The highest real interest rates are typically the emerging market currencies including Vietnam and Egypt. It is also one of the factors that could drive EUR/USD higher in 2021.
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