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The Federal Reserve has got some work to do in the year ahead, but it’s the European Central Bank that may call the tune in the coming year for a currency market that’s seen the U.S. dollar enjoy a consensus-crushing 2021 rally, according to some currency watchers.
“Eurozone inflation is now becoming a key EURUSD driver, in our view,” wrote analysts Athanasios Vamvakidis and Abhay Gupta at BofA Securities, in a Friday note, referring to the euro/U.S. dollar
EURUSD,
currency pair.
The ICE U.S. Dollar Index
DXY,
a measure of the currency against a basket of six major rivals, was up 7.1% in the year to date through Friday, on track for its biggest annual gain since 2015, according to FactSet data. At the end of last year, analysts had widely expected the dollar to fall in 2021 as a global economic recovery from the COVID-19 pandemic caught up with the U.S.
Instead, surprisingly strong U.S. growth and higher U.S. interest rates relative to other developed markets kept the dollar supported, while the euro
EURUSD,
the most heavily weighted currency in the DXY gauge, fell sharply, down 7.7% for the year to date.
The euro initially rallied Thursday after the ECB announced it would end its pandemic emergency purchase program, as scheduled, in March, but would temporarily boost the size of its longer running Asset Purchase Program, or APP, in the second quarter, partially offsetting the reduction while retaining flexibility. The ECB gave no end date to the APP. The euro later slumped back toward the low end of its recent range.
“Whether the ECB will actually reach the ‘exit’ or not by the end of next year will depend on inflation,” the BofA analysts wrote. “The ECB revised its inflation forecasts substantially upward, consistent with recent inflation surprises, but they remain below what their forward guidance needs to end QE and start hiking within their forecast horizon.”
That leaves a “likely scenario” in which the ECB gets “stuck” just before the exit, continuing with small monthly asset purchases of €20 billion and negative interest rates for the foreseeable future, unless of course the ECB gives up on its forward guidance, they said. On the other hand, if eurozone inflation continues to surprie
to the upside, market participants will start focusing on ECB policy normalization in 2023.
The analysts argued that assets perceived as risky may eventually have to correct if the Fed is forced to defend its inflation credibility. They see risks to the dollar skewed to the upside in the first half of 2022, looking for the euro to slip to $1.10.
Others see scope for dollar weakness, provided the ECB does the “heavy lifting.”
“We expect the market to focus next year much more on the likely path of the ECB in 2023, much as this year the focus was on the Fed’s potential actions for 2022,” said Javier Corominas, director of macro strategy at Oxford Economics, in a Dec. 10 note.
He contended the Fed, for its part, is likely to be more patient in the year ahead than what’s priced into the market. As investors scale back rate-hike expectations, the dollar will weaken even as the Fed accelerates the process of tapering its bond buying, which has been widely telegraphed, he argued.
The ECB, meanwhile, faces challenges, Corominas acknowledged, and will have to wrestle with the rise in yields in peripheral, or high-debt, eurozone countries as it nears rates liftoff, he said. “A gradual climb of rates back to 0% with some built-in mechanism for yield curve control should spreads not be trading in line with fundamentals might just do the trick,” the economist wrote.
The dollar, meanwhile, has rallied nearly 10% this year versus the Japanese yen
USDJPY,
with the second-largest weighting in the ICE U.S. Dollar Index.
“The lure of U.S. equities and cash kept many Japanese investors in USD assets, and the trade balance has dwindled, creating a perfect storm. This will begin to abate as the yen correction and oil price depreciation has real trade-balance effects while at the same time peak U.S. yields materialize, and Japanese investors begin to hedge more pro-cyclically,” Corominas wrote.
