The US dollar will strengthen throughout 2021 for 5 key reasons, Bank of America says

The US dollar will strengthen throughout 2021 for 5 key reasons, Bank of America says
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  • Bank of America on Tuesday lifted its forecast for the US dollar's strength against the euro.
  • After weakening through much of 2020, several factors stand to support the greenback through the ongoing economic recovery.
  • Detailed below are the five reasons why BofA expects the US dollar to strengthen in 2021, from risk-off positioning to stimulus.
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Uncertainties surrounding the US dollar's path in 2021 are fading and bulls might finally have their day in the sun, Bank of America said Tuesday.

Strategists led by Athanasios Vamvakidis boosted their forecast for the US currency on Tuesday, expecting it to strengthen to 1.15 dollars per euro by the year-end. The forecast compares to Wall Street's consensus of a 1.25 exchange rate.

A higher euro-dollar rate means a weaker greenback, as more of the US currency can be purchased with a single euro. The currency pair already trades at the bank's first-quarter forecast of 1.20, down from roughly 1.23 at the start of the year. The team already expected upside for the dollar later in the year, but now sees several reasons why such strengthening can arrive sooner.

Detailed below are the five reasons Bank of America expects the dollar to strengthen in 2021.

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The Fed-ECB gap

After taking several actions to pump dollars into the struggling US economy, the Federal Reserve is starting to near the end of its ultra-easy policy stance. Some officials have started talking about tapering the central bank's asset purchases. The Fed quickly rebuffed concerns of premature tightening, but the mixed communication suggests policy normalization could arrive early next year, the strategists said.

It's a different story on the other side of the Atlantic. The European Central Bank has taken on more intense rhetoric against Euro strength in recent weeks. A strategic review of how the bank can reach its inflation target will likely reveal new tools for adding Euros to the economy.

"The bottom line is that the ECB will be moving towards more easing, while the Fed will be looking towards policy normalization," the team said.

Stimulus boost

The Biden administration continues to move toward passing its $1.9 trillion stimulus proposal without Republican support in a bid to supercharge the US economic recovery. While such a large fiscal relief package does weaken the dollar somewhat, it also increases the risk of earlier policy normalization by the Fed, the strategists said. In all, the measure should support the dollar's strength, they added.

Fiscal policy in the European Union, however, is "not as supportive and if anything could be tightened too early," the team said.


Faster growth

The global economy is expected to rebound in 2021 as widespread vaccination brings an end to the coronavirus pandemic. Still, Bank of America's strategists expect US growth to handily outpace that of the EU.

The team projects growth of 6% in 2021 and 4.5% the following year, exceeding the consensus estimates of 4.1% and 3.5%, respectively. EU growth is estimated to reach 2.9% this year and 3.4% in 2021, the strategists said.

Inflation in the US is projected to similarly come in above price growth in the EU.

The US's decoupling from the EU economy should support the dollar as US spare capacity fades and the rates market prices in early Fed normalization, the team said.

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Dollar shorts

The dollar could be the next asset to face a massive short squeeze following the GameStop phenomenon in January, Bank of America said. The market continues to short the dollar despite the currency's recent rally.

If the team's projections are right and the US economy outpaces the EU's, selling of the euro-dollar trade will likely cut into long positions and strengthen the dollar, the strategists said.

Return of the safe haven

The risk-on party that's lifted stocks through the year-to-date won't last forever, and a reversal stands to push more investors into cash positions, the team said. Bank of America expects positioning in risk assets to peak in the first quarter before policy support hits its limit the following quarter. A 10% market correction is forecasted to arrive sometime this year and shake investors' appetite for stocks, they added.

Starting the year with assets at record highs "does not leave much room for further upside," the bank said. The relatively slow pace of global vaccination means it could take years to fully emerge from the COVID-19 crisis. Realization of the long path to recovery should prop up the dollar in the near term, according to Bank of America.

"A more challenging outlook for risk assets this year also suggests a less clear foreign-exchange picture and upside USD risks," the strategists said.


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