FX Update: Not looking for a smooth ride for USD bears in 2021
Head of FX Strategy
Summary: The market narrative is overwhelmingly positive for a reflationary rebound and for a weaker US dollar in 2021, an outlook we are largely sympathetic to, but plenty can still go wrong, and the speculative fervor of the momentum is the most clear and present danger for a correction sooner rather than later. Elsewhere, the Brexit deal was the dampest of squibs for sterling.
FX Trading focus:
Markets are positioned for very aggressive assumptions about 2021
The US dollar is near its cycle lows as 2021 comes into view, driven by the anticipation that a reflationary recovery in 2021 is in the offing, with a Fed intent on keeping the pedal to the metal with a blind eye to inflation as long as unemployment hasn’t normalized to pre-Covid-19 levels and pent-up savings ready to be unleashed on travel and entertainment once we begin rounding the corner on the vaccine roll-out by the second half of next year. It all sounds great and hopefully this is the way it will pan out, but the market feels extremely aggressive here in stating its case – too aggressive, in fact.
I recently outlined a pre-FOMC list of the “last few hurdles” for USD bears that included concerns about the status of stimulus talks in US Congress and the FOMC meeting itself. The latter, of course, provided no real hurdle, while the news yesterday that Trump has finally caved on his hold-out for larger stimulus checks clears away another obstacle for USD bear.
The last major risk I outlined is one that remains unresolved; namely long US yields and whether these are poised for a breakout that could support the USD fundamentally to a degree, but more importantly could trigger a consolidation in global risk sentiment. This is clearest and most present danger for markets (and for USD bears) in the near term as we have simply reached a remarkable degree of speculative excess, with participants having extrapolated expectations too aggressively and having become too leverage up and one-sided in its positioning. A consolidation could even take the shape of a mini-crash.
If this is indeed what unfolds, the Fed and other central banks will have only themselves to blame, having so thoroughly conditioned the market that the central bank put strike price simply gets set higher and higher, encouraging the aggressive risk taking that can make the market so fragile and crash prone and then in need of the next round of policy response. It’s an unhealthy and destructive cycle and needs to end before the policy response required is larger than what they can deliver.
Brexit deal is “thin”, as are the shouts of joy from sterling bulls here
A Brexit deal was finally struck just before Christmas that settled the most immediately disruptive issues linked to trade in physical goods, but as a number of good breakdowns of the remaining opening questions about the post-Brexit period remind us, the tougher aspects of the post-Brexit landscape may only reveal themselves slowly in the months and years to come, particularly the fall-out for the UK financial services industry, which was long the “crown jewel” of the UK economy that helped spark massive capital inflows to offset the UK’s huge external deficits in traded goods. The status of that industry and in general of capital inflows into the UK will be the dominant driver of sterling over the next few years and the currency and UK assets are very cheap. Sterling will only begin to look less cheap if a reflationary recovery brings vicious negative real rates to the UK that erode the currency’s fundamental value relative to its peers. Have a look at something like GBPNZD as a pair that looks a bit silly in the long run below the level of 2.00.
Chart: EURGBP weekly
It was tempting to put up a GBPUSD chart rather than a EURGBP chart today, as the former has breached a very important chart level at 1.3500 again, but because almost all of that development is down to the weak US dollar of late, it is more important to measure the effects of the Brexit deal on sterling via EURGBP, where the price action is underwhelming, particularly given the collapse in short-term implied volatility in the options market on the clearing away of near term uncertainty. The lack of a reaction is a significant red light for sterling bulls and a reminder that longer term uncertainties remain for sterling, especially the fate of its very important financial services industry, where the outlook and the final shape of post-Brexit reality are uncertain. That said, sterling is still cheap in this pair and I would prefer to look toward 0.8500 rather than 0.9500 as an eventual direction in 2021, even if not ready to start in that direction right away.