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In this last piece for 2021, a series of factors that affect USD valuations will pass in review. At the start of the year, proponents expecting a strong USD were a clear minority. The consensus calls for the main EURUSD pair aligned for a swift break of 1.23 and an attack towards 1.30 over the medium term. On Friday, EURUSD closed at 1.1240, representing a USD appreciation of about 8% over the year. A proper USD exposure of 25% across a diversified balanced portfolio over 2021 would have contributed 2% to performance, irrespective of asset allocation. Measured exposure to foreign currencies holds diversifying benefits and can constitute a tailwind. That was clearly the case over 2021. We’ll discuss the behaviour of the main reserve currency against the Euro, the DXY index (USD versus 6 main DM currencies) or the EMCI index (JP Morgan Emerging Market Currency index). We take stock of changing global trade dynamics, relative money supply dynamics, compare central banks’ reaction functions, EURUSD breakeven points end 2022, 2023 expressed through forwards and behavioural factors.
Global trade fell by 8.9% over 2020, still less than was the case over 2008-2009. The pandemic has affected services more than goods trade. Services trade (about 25% of global trade) fell by 20% over 2020, about 4 times the decline in goods. Volatile, but in general harsh, restriction measures dampened recovery of services over 2021. Goods trade has seen a sharp recovery as factory shutdowns were limited. The surging (pent-up) demand over 2021 caused heavy bottlenecks across supply chains. Overall, global trade has been scarred. The pandemic delivered a negative blow on the ability for global trade and overall growth dynamics to occur in a synchronised fashion. Lack of harmonious trade patterns across regional trading blocks, calls for continued USD strength. Over the past 5 years, global trade took insult with Trump dialling back and installing protectionist strategies. Insult was followed by injury through the global health crisis, the nature of which becomes more and more persistent.
End of 2020, early 2021, the dollar index (DXY) prepared for a synchronised global growth spurt as highly effective vaccines came to market. However, the correction to 89 by February this year was short-lived. The rise of corona variants became evident. Today, delta gives room to omicron, a variant that catapults us back towards lockdowns. A revisit of the 103.00 DXY index level cannot be ruled out. That level would represent a 6.5% strengthening of the USD versus 6 main DM currencies (EUR, JPY, GBP, CAD, SEK and CHF). The DXY index closed at 96.57. Effectively, the Great Financial Crisis over 2008-2009 marked a long-term bottom for the DXY-index at 70. The USD future, as the global reserve currency par excellence next to solid portfolio protective characteristics in times of stress, is bright. Moreover, whilst the FED took a responsible and leading role over March 2020 by pushing and providing ample USD liquidity across world trade channels, they changed tack by the end of summer and mean business when it comes down to anchoring inflation and inflation expectations.
The Powell pivot end of September announcing the end of QE has put the brakes on the USD money supply impulse. Doubling the pace of QE taper towards USD 30 billion a month last Wednesday will provide a tailwind to USD strength. US M2 YoY money supply growth topped at a massive +25% end of Q1 2021. Today, we pencil in 13% and expect a continued drop towards a 5%-10% bracket over H1 2022. The brakes on ECB M2 growth might be hit less intense over 2022 as the QE intensity will remain at EUR 40 billion a month after March 2022, the moment active FED QE drops to zero. These money supply trends are not conducive to fuel a synchronised global trade recovery. Over March 2020, the EURUSD made lows in the neighbourhood of 1.0650. Apply respectful odds for a possible revisit over 2022. Turning towards emerging economies, it’s fair to state that the US FED will guarantee USD swaplines for countries in need. Still, some developing countries will face more challenges under a resurgent strong USD episode than others. Sound country selection next to a relative high yield of close to 6.00% for local currency emerging market government debt solutions should provide decent protection the moment the EMCI index slips further. In short: EM carry should defy EMFX risks.
Last week a great deal of central banks provided grades of visibility across their respective reaction functions. The FED stood out. The BoE made a reluctant start by hiking the bank rate from 0.10% to 0.25%. The ECB is still on autopilot but prepared participants for a protracted taper with a message that reinvestments of principal and coupons would continue till end of 2024. As the dust settles, the clear winner in FX is the USD (and the Powell FED whose credibility got a lift). With a lot of information embedded in policy rate normalisation paths, one should look at what forwards the EURUSD pair prices by the end of 2022 and 2023. These levels give you a breakeven point on an unhedged basis i.e., if we stay below, it pays to invest in USD today. By Christmas 2022, the EURUSD is priced at 1.1360. End of 2023 the EURUSD forward finished the week at 1.1560. For information, the 5-year EURUSD forward sits at 1.2150 whilst the 10-year forwards closed at 1.3070. Consensus is attracted towards these levels because predicting such levels carries less (reputational) risk. The only game in town of course is to call the correct path. End of 2023 US policy rates, as priced by futures markets, will finish around 1.50%-1.75%. The message for a more prudent allocation to USD should be a 2023 task, not a 2022 worry.
I want to end with some notions present in behavioural theory and finance. The basic tenet of behavioural finance rests on the belief that our emotions and biases colour our decisions. However, energy levels also play an important role. Indeed, less mentioned, but proper energy conservation (not being tired) next to the capacity to capture many scenarios – be less time constrained (have the aptitude, time to memorise different ideas) will lead to less biased decision making. The group you work and live in also makes an important difference. The more diverse the group the better, as less biased decision making will result. The higher the psychological safety the higher the quality and independence of decisions. The more the ability to change habits the less threat comes from biased decision making. It serves to pause a while on the above statements.
An instrument to combat our biases lies in formulating different diversification strategies. When solving investment equations, quant colleagues can help you a great deal in avoiding certain biased thoughts and behaviours. Yet, successful active managers are also aware of the need for energy conservation next to avoiding time constraints. Be aware of the pitfalls of too narrow group think. This applies across asset classes. But FX often is an easy prey. USD predictions are all around. The above piece conveys confidence in the greenback.
Confidence based on its long-term credentials as a unit of exchange, of account and store of value. I hear you…don’t cryptocurrencies have that as well. Best answer is maybe. With crypto currency you might be able to buy certain goods (unit of exchange) at a given price (unit of account but extremely volatile) and as store of value through ‘trustful’ crypto wallets. But I deviate. We will revisit such musings over 2022.
In the meantime, I wish you all a happy and safe holiday season with friends and family.