During the epidemic, the Federal Reserve released massive amounts of water to ease the liquidity crisis, while the U.S. index has fallen nearly 13% since reaching a high of 103 on March 22. The dollar index is down 6.5% this year and is currently at its lowest level since April 2018.
The market is pessimistic about the dollar’s performance in 2021, with some believing the bear market has just begun and expecting the dollar to continue to depreciate by 20% to 30% over the next three years, while other central banks (such as the European and Japanese central banks) have said they will not allow the dollar to depreciate indefinitely because it would significantly impact their own economic “recovery” and put pressure on long-term inflation expectations.
So can we expect a rally in the dollar next January?
First, consider the impact of the Federal Reserve’s monetary policy. Since March, the Fed’s asset size has almost doubled, from $4 trillion in February to $7.4 trillion.
The difference in asset growth between the Fed and the ECB has been narrowing in recent months, and the Fed has been very quiet of late while the ECB has continued to inject new liquidity into the market through its PEPP program. Even though the Fed may still inject another $1 trillion of liquidity into the market in 2021 ($240 billion per quarter), analysts believe that the dynamics of the Fed’s balance sheet largely already reflect the next 12 months and will therefore have less of an impact on the dollar.
The market remains extremely pessimistic about the dollar
The dollar has depreciated significantly this year, and market expectations for the dollar in 2021 remain extremely pessimistic. Historically, however, it is not common for the currencies of the G3 countries (the U.S., Japan and the Eurozone) to depreciate sharply for two consecutive years, and after a steep decline, it tends to rebound briefly.
According to the U.S. Commodity Futures Trading Commission (CFTC) report, investors remain very bearish on the dollar, with 209,000 net short contracts on the dollar, most of which are long the euro against the dollar. While the CFTC data only covers a small amount of OTC volume, it does give us some insight into the current position in the FX market. Therefore, if the dollar starts to appreciate in the coming weeks, extreme positions could lead to significant short-covering.
The dollar will see a seasonal rise in January
Based on the seasonal fluctuations of the U.S. index over the past 50 years, December has been a weak month for the dollar, with an average return of -0.85%, but January has been the best performing month for the dollar, with an average return of nearly 1% for the dollar index in January since 1971.
While the dollar’s past average performance is not indicative of future trends, analysts are still confident that they will be long the dollar in early 2021, especially after the dollar’s sharp 13% depreciation over the past nine months.
Going long the dollar can serve as a hedge
In recent years, we have also seen that going long the dollar can provide investors with a good hedge against sudden rises in price volatility and prolonged market stress.
Since the epidemic, dollar depreciation has generally been accompanied by higher equity markets. As a result, holding dollars can provide a short-term hedge against sudden reversals in risky asset prices.
It remains uncertain how long the new embargo will last, with cases increasing dramatically as soon as European countries begin to lift restrictions. Although three different mutated viruses (England, Wales and South Africa) do not pose a risk to the new crown vaccine at this time, governments will certainly learn from the past few months and implement strict restrictions in the coming months.
Analysts say they remain bullish on equities (large tech FAANG, tech ETFs) as a stricter embargo in 2021 may require high fiscal costs and more liquidity injections should continue to support higher risk asset prices, especially for mega growth stocks. However, when the blockade lasts longer than expected, stocks may see a 10% to 15% consolidation and investors should then be well diversified to hedge against market uncertainty.
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