Dollar Index formed a top in March 2020 and until then it fell more than %8. But the market sentiment is still bearish despite last year’s big fall. In this article, we will talk about the Dollar and what to expect in 2021.
Dollar Index
Dollar Index is calculated by 5 currency pairs’ performance against the dollar. The most major of them all is the euro. Because of %57.6 weight, Dollar Index’s value is not only about the US but also about Europe’s economy. To decrease the dependency on the euro, we could use the Bloomberg Dollar Index which is calculated with 10 pairs instead of five and weighting changes annually according to trade volumes, but still, we will use the standard Dollar Index because it is more widely accepted.
Money Supply
In 2020, one of the major reasons for the bearish outlook of the dollar was the creation of a substantial amount of money supply. M2 money supply increased by %25 relative to all American history only in 2020. FED’s assets increased by more than %70. This insane amount of money increase caused bearishness for the dollar which will likely to continue in 2021.
Inflation
Inflation decreases the value of a currency. In 2020, despite the Covid-19 slowdown, a massive amount of money supply limits the reduction of inflation. As we start in 2021, inflation expectations are over %2 for the first time since 2018. Especially in the second half of 2021, the economy may start to recover and grow faster which is combined with inflation expectations and high money supply, inflation, the sleeping giant since 2008 may decide to wake up. That may cause a lot of different changes to the economy but a direct impact on the dollar will be bearish.
Another thing about inflation and the Dollar Index relationship is the US-Europe CPI difference. Because of the dependency of the dollar to EURUSD, a high CPI difference may be in favor of the euro instead of the dollar. Europa’s negative inflation is increasing the bearishness of the Dollar Index.
Market Sentiment
Dollar positions are most negative since 2011 (which was the start of 4-year of upward move for the Dollar Index). Most analysts have a negative outlook for the dollar and market sentiment is aligned with them. But this may be bullish for the dollar because as the chart shows, whenever positions most against the dollar like this time Dollar Index made a bottom in the coming weeks and start an uptrend.
What Can Affect Dollar in 2021?
• Blue Wave: As Georgia senate elections are coming to a close, Democrats will gain two senators. This means the senate will have a 50-50 democrat – republican balance and Vice president Harris will tip the balance in favor of democrats. This means in the first quarter a new fiscal stimulus package will be most likely. With this package money supply and inflation expectations will rise which will affect the dollar negatively. But a blue wave most probably bring a high-tax high-spending cycle and if in the middle of the year the US started to get close to herd immunity economy will heat up and demand for the dollar may increase which will be positive for the dollar. Another positive impact of a blue wave is the possibility of repairing trade relations after Trump’s havoc.
• Covid-19: TheUS may be one of the worst countries how to handle Covid-19. Reluctance to take necessary steps cause the US to suffer from the Covid-19. In the first quarter of 2021, it may turn to worst because the hospital’s capacities are nearing maximum. A possible capacity crisis or an intense lockdown to avoid it may affect the dollar negatively in the short-term.
• Rising Inflation Risk: Rising inflation expectations, entering a high tax – high government spending cycle, high levels of money supply may wake up the inflation in the second half of the year. Rising inflation will negatively affect the dollar. But despite some of the FED members saying that %3 inflation will be a good thing. FED may have to decrease the asset purchase speed which will be overwhelmingly positive for the dollar if that happens.
Summary
Dollar Index is near its 30-year average. First-quarter may still be negative for the dollar, more so if 88.250 support breaks to the downside. But in the second half, if inflation starts to pick-up, FED may be cornered and have to slow down the dovishness. This may lead to a positive year for Dollar Index.
