The US monetary policy should remain highly accommodative in 2021, despite large-scale fiscal stimulus and an expected economic recovery starting later this year. Against a backdrop of recovering global demand and ample liquidity, many emerging-market currencies that depreciated significantly in 2020 should appreciate this year. However, currency markets should remain sensitive to local economic conditions, and demand must favour countries with comparatively rapid vaccination rollouts.

In the first few months of 2020 the US dollar index surged to an all-time high as the first wave of the coronavirus (Covid-19) pandemic prompted a flight to safety and a shortage of US dollar liquidity. The currencies that fell most were those of emerging markets and commodity exporters (including advanced economies, such as Australia, New Zealand, Canada and Norway) that experienced particularly sharp depreciations amid collapsing commodity prices.

The US dollar gave up most of these gains in the second quarter, when the Federal injected about US$3 trillion of liquidity in financial markets and concerns that the pandemic would spark a financial crisis eased, reducing precautionary demand for dollars. The dollar depreciated further against the euro and other major currencies in the second half of the year, as the Chinese economy reopened, the euro zone agreed to a concerted pandemic relief package, and the results of clinical trials showed that some coronavirus vaccines were effective.

The outlook for the US economy changed substantially when the Democratic Party won the Senate (upper house) elections in Georgia on January 5th, thereby gaining control of both houses of Congress and making large-scale fiscal stimulus more likely. Although a new pandemic relief package is likely to be smaller than the US$1.9 trillion initially announced by the president Joe Biden, it will nonetheless be a significant addition to the US$900 billion stimulus package already adopted in December 2020. In addition, the US vaccination campaign is progressing faster than in most other countries, and economic restrictions should ease relatively quickly, setting the scene for an economic recovery in the second half of the year.

By contrast, in the euro zone social distancing and other containment measures are likely to remain in place into the third quarter. Nonetheless, the US dollar should appreciate only modestly (by less than 2%) against the euro, the yen and the renminbi in the second half of 2021. The reason for this is that the Fed is likely to accommodate fiscal stimulus with continued asset purchases, in line with its shift to a more expansionary monetary policy framework in August last year, which it reaffirmed in its communications in early 2021.

In the medium term, the US dollar could receive a stronger boost from the Biden administration’s ambitious infrastructure spending plans. Receding risk aversion in global financial markets, rising prices for many commodities and continued monetary policy accommodation in advanced economies should support many emerging-market currencies in 2021 as investors search for higher yields. With some notable exceptions, including Brazil, Latin American currencies will broadly benefit from this trend, reversing some of the heavy losses recorded over the past year.

Emerging economies in central Europe should record appreciations of their currencies against the euro in real terms. However, some regional central banks would rather avoid excessive exchange-rate strength. The National Bank of Poland, for instance, has recently started to intervene in the currency market to prompt a depreciation of the zloty against the euro, but an expected robust economic recovery and a wide current-account surplus will probably force a modest appreciation against the euro in 2021.

Many developing countries should also continue to face an uncertain outlook in the early stages of the post-pandemic recovery. Low-income countries should be unable to compete with advanced economies in the vaccination race and should instead depend on assistance through the World Health Organisation (WHO)-led COVAX facility, which aims to ensure equitable access to vaccines.

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