FX Quarterly Outlook for First Quarter 2021

January 14, 2021
In the latest FX Quarterly, our strategists highlight the key risks driving global economies, including the ongoing COVID-19 crisis and the transition to a new administration in the U.S. We also provide our outlook on developed and emerging markets in Q1 2021.

Major Market Global Overview

In many ways, the outlook is relatively consistent with last quarter.  Countries around the world continue to fight the virus with lockdowns even as the vaccine rollout advances. Despite the ongoing risks, markets have priced in stronger global growth this year coupled with easy monetary and fiscal policies. This is the perfect cocktail for risk assets. Indeed, we believe the Blue Wave trade is likely to remain in vogue for Q1, meaning higher equities, higher bond yields, and a weaker dollar.

The unexpected Blue Wave adds to the downward pressure on the dollar. For DXY, we continue to target the February 2018 low near 88.25 but with the unexpected showing for the Democrats, we need to start thinking about the next target that comes in somewhere near late-2014 lows near 85. Likewise, we believe the euro is on track to test the February 2018 high near $1.2555. Following that is the late 2014 high near $1.29. Due to a variety of reasons, sterling is lagging and has yet to break above the recent cycle high near $1.3705 and it will likely struggle to break above the April 2018 high near $1.4375. As a result, EUR/GBP is likely to continue climbing. USD/JPY has largely traded in the 103-104 range since early December. Within the weak dollar environment, the pair remains heavy and should remain on track to test the March low near 101.20. 

It’s worth stressing that we've never been in the ultra-bearish dollar camp. For now, we believe the dollar is in a cyclical dollar downturn, not a structural one. The groundwork has been laid for a robust U.S. recovery later this year, especially with more fiscal stimulus coming.  Surely, equity and bond markets are already looking ahead to this and the dollar should eventually carve out a bottom late in Q1 or perhaps early Q2. However, we have a lot of work to do in terms of controlling the virus so that the economy can reopen properly. Until that plan has been firmly established, we fear the U.S. will lag other major economies in terms of recovery.

Looking ahead, what could derail this Goldilocks scenario? One warning sign is the rise in U.S. long rates and TIPS breakeven inflation rates. Higher U.S. rates will impact equity valuations as well as spread products such as local currency EM debt. For now, Fed policymakers are sanguine about the recent rise in rates and inflation expectations, but the pace has been picking up. The mutation of the virus poses another risk. While pharmaceutical companies believe that their vaccines will remain effective against the new strains, it’s still too early to be certain.


Recent developments at the U.S. Capitol change nothing from a fundamental standpoint. Simply put, Joe Biden will be inaugurated President on January 20 and it looks likely that the Democrats will hold both houses of Congress. While official results have not yet been declared as of this writing, both Warnock and Ossoff have virtually insurmountable leads. This means that a 50-50 tie will be seen in the current Senate, and incoming Vice President Harris will cast the tie-breaking vote. 

Chuck Schumer would become Senate Majority Leader and Democrats would head up the key committees. This will allow the Democrats to set the legislative agenda and so the Senate may actually vote on a host of bills that never made it past outgoing Majority Leader McConnell.  Our understanding is that McConnell was able to prevent many votes purely by procedural tactics, and this will change under Schumer. We also suspect the partisan divide may ease, allowing for bipartisan passage of some important bills.

What kind of stimulus can we expect going forward? At a minimum, we believe $1.5 trillion will be proposed. That amount along with the $900 billion passed last month would take the total up to $2.4 trillion, which is the last real compromise the Democrats offered. Could it be larger? A $2.5 trillion price tag would take the total up to $3.4 trillion, which is what the Democrats passed back in May but died in the Senate. How about $2 trillion as a solid compromise? This is of course all guesswork and we will have to wait and see how the new Congress and new administration frame the issue. President-elect Biden has already said the price tag will be big, but no specific numbers have been discussed yet. We also expect a separate infrastructure spending bill of at least $1 trillion this year that both parties can support.

Stimulus lies at the heart and soul of the so-called Blue Wave trades. That is, another round of significant stimulus will be seen this year, and that’s positive for U.S. equities. Yes, there will be some sectoral and company-specific risks, especially in tech. However, we believe the improved U.S. growth outlook is overall positive for equity markets. The stimulus will be funded with increased debt issuance, and that’s negative for bonds. 

The U.S. curve continues to steepen. At 104 basis points (bp), the 3-month to 10-year curve is the steepest since March and the year’s high comes in near 120 bp on March 18. The 10-year yield of 1.12% is also the highest since March 18, while the 10-year TIPS inflation breakeven inflation rate of 2.10% is the highest since October 2018. Clearly, the rise in the long end is driven in part by rising inflation expectations. However, we also believe that supply concerns are playing a part since the next round of stimulus will have to be funded by increased debt issuance.

So far, Fed officials do not seem concerned with the steepening curve. Kaplan recently said he expects yields to rise due to an improved economic outlook, adding that the Fed should not intervene to prevent this from happening. Bullard expects longer-term rates to rise as the economy recovers, adding that rising bond yields also reflect hopes for an end to the pandemic. Bullard added that the ingredients for higher inflation are in place and that negative rates are not a good option for the U.S. These two are both non-voters in 2021. That said, Vice Chair Clarida echoed these sentiments. We know from the December FOMC minutes that “a couple” of Fed officials were concerned about rising long rates. 

The Fed will keep rates on hold in 2021. And 2022. And most likely in 2023.  With so much slack in the labor market, the Fed will see no need to tighten its policy settings for the foreseeable future. Some officials have started to talk about tapering asset purchases while stressing it won’t happen anytime soon. We think this is a 2022 story, if not later. We believe the risks are tilted towards increased QE in 2021, not decreased. Why?  The Fed may have to address a significant steepening of the yield curve with some policy changes. The first line of defense is jawboning, followed by shifting asset purchases more to the long end, but keeping the total amount unchanged. Next would be an increase in the total amount of monthly QE that would likely be more weighted to the long end. The final (we think) line of defense would be Yield Curve Control. We continue to believe negative rates are a non-starter for the Fed.

Graph showing the fluctuation of the U.S. Dollar Index (DXY) ranging from January 08 to January 20.


Deflation risks are likely to remain high. Headline inflation for the eurozone ended the year at -0.3% y/y. This is the cycle low and well below the 2% target. The most recent ECB projections from December 2020 see inflation rising to 1.0% in 2021, 1.1% in 2022, and 1.4% in 2023. If anything, these forecasts are on the optimistic side and so we can expect accommodative policy to be maintained into 2024, if not later. Similarly, growth is expected to accelerate to 3.9% in 2021, 4.2% in 2022, and 2.1% in 2023. These too are likely to disappoint.

Graph showing the Central Bank Balance Sheets in USD Trillions ranging from February 07-February 19 for Fed, ECB, BOJ, and BOE.

The ECB launched a strategy review last January, and it was supposed to have been wrapped up by year end-2020. Obviously, the pandemic has had an impact on the timing and the ECB now aims to complete the review in the second half of 2021. Its last review was carried out in 2003 and things have changed since then, to put it mildly. In launching this review, the ECB acknowledged that it is in a fundamentally different environment of historically low interest rates and low inflation. It recognizes that there are limits to what policy can do in this situation and so must look at other methods of stimulating the economy. Judging from various official speeches and comments, the ECB appears likely to follow the Fed down the path of average inflation targeting. 

The ECB remains concerned about the strong euro. President Lagarde had a change of heart in recent months and appears to be paying more attention to the exchange rate. Recently, Governing Council member, Rehn echoed her stance and said that while the ECB doesn’t target the exchange rate, “that does not mean that the appreciation is not important,” since it leads to a loss of competitiveness and impacts the outlook for growth and inflation. He noted that “We monitor exchange rate developments very closely and we will continue to do so in the future.” That said, there is not much the bank can do right now besides jawbone. 

After introducing its Pandemic Emergency Purchase Program (PEPP) last March, the ECB increased the program in June and December and currently stands at EUR 1.85 billion. The duration of PEPP was extended through at least the end of March 2022. For the early part of this year, the ECB is likely to remain on hold to see how the recovery develops. With the vaccine rollout turning out to be slower than expected and virus numbers rising across Europe, we believe the recovery will be uneven and will likely require further stimulus. Given the cautious nature of the ECB, the next increase in PEPP would most likely come around mid-year.


We can finally move on from the Brexit drama. After the last-minute deal was struck last week, the U.K. Parliament passed the deal on January 13 handily with Labour’s support. E.U. government leaders unanimously endorsed the deal on a provisional basis, with formal ratification by the European Parliament to take place in early 2021. As of January 1, the U.K. has officially left the E.U.

We are not the first (nor will we be the last) to note that this is the first free trade agreement that leads to more barriers to trade, not less. Yes, under the terms of the deal, most goods won’t face new tariffs or quotas. However, U.K. exporters will face regulatory hurdles that will make it more costly to trade with the E.U. These include rules of origin, testing, and certification of certain goods. While these are not obvious barriers to trade, they nonetheless lead to frictions at the border.

The more important services trade was largely left out of the agreement. There was no decision on so-called “equivalence” that would allow U.K. financial companies to sell their services unfettered in the E.U. The two sides will continue talks, but it’s clear that other financial centers across Europe are stepping into the vacuum. Services account for around 80% of U.K. GDP, with financial services making up the lion’s share. 

As widely expected, U.K. Prime Minister Johnson announced a national lockdown. It will likely remain in effect until mid-February. U.K. is entering its third lockdown as progress on the vaccine has not been fast enough to mitigate rising hospitalization rates. Primary schools, secondary schools, and universities will close, with the exception of vulnerable children and the children of key workers. All non-essential retail, hospitality, and personal care services must close too. The key issue is the widespread concern about the new variant of the virus, thought to be as much as 70% more contagious. The good news is that the new strand doesn’t seem to lead to a more severe outcome for those infected, and vaccines should remain effective.

The economic implications of the lockdown are very negative. The economy is likely to contract in Q1 as a result and this will further delay the overall recovery even more. No wonder Chancellor Sunak just announced a £4.6 billion emergency rescue package to U.K. business in the form of grants to help them cope with the renewed lockdowns. More assistance will probably have to be provided for workers. The extended job furlough scheme expires at the end of April. With the recovery delayed by this current lockdown, the labor market will still be in bad shape and so another extension seems very likely.

All of these developments point to larger budget deficits ahead. That in turn suggests a greater likelihood of more QE from the Bank of England, as the increased gilt issuance will require additional mopping up. The next policy meeting is February 4. While this is likely too early to see any action, it’s possible that the bank starts to prepare markets for the next slug of QE that will probably come at the March 18 or May 6 meetings. While the end of the Brexit drama removed a major headwind for sterling, this latest lockdown puts another headwind back on. While we remain negative on the dollar, we believe sterling will lag the other major currencies in the coming weeks. That suggests EUR/GBP is likely to be higher in Q1.  


Prime Minister Suga declared a state of emergency for the Tokyo region. It is expected to last one month but that is clearly open to question. The head of the government’s advisory panel admitted “Stronger measures might be needed.” This simply adds to the headwinds facing the economy. There is fiscal stimulus in the pipeline, however, and so the Bank of Japan is likely to remain on hold for now. Next policy meeting is January 21.  .

Suga’s popularity has fallen sharply as a result of the government’s handling of the virus. As a result, general elections are likely to be called later in the year to give Suga time to increase his standing. We would not rule out yet another stimulus package near mid-year to give the economy another boost ahead of the vote. 

Japan policymakers are concerned with the strong yen. Senior officials from the Finance Ministry, BOJ, and the financial regulator met earlier this month and represents the first step in the escalation ladder. The Finance Ministry’s top official on currency matters said afterwards that “The stability of financial markets is extremely important. The government and Bank of Japan will work together as needed while carefully watching markets and the economy.” Of course, we all know that “financial stability” is code for a strong yen. That said, Japan policymakers are in a similar predicament as the ECB and nothing beyond jawboning is likely. We are in a weak dollar environment, so FX intervention would do nothing beyond an initial knee-jerk reaction.

The Japanese economy  will continue to struggle despite the regional recovery. Like the U.K., widening lockdowns will weigh on Japan growth in Q1. Headline inflation fell a tick more than expected to -0.9% y/y in November vs. -0.4% in October, while core (ex-fresh food) came in as expected at -0.9% y/y vs. -0.7% in October. The core reading is the worst since September 2010. The most recent BOJ projections from October 2020 see targeted core inflation rising to 0.4% in FY2021 and 0.7% in FY2022. If anything, these forecasts are on the optimistic side and so we can expect policy to be maintained into FY2023, if not later. Similarly, growth is expected to accelerate to 3.6% in FY2021 and 1.6% in FY2022. These too are likely to disappoint. FY2023 forecasts will be added at the beginning of FY2021 this April. 

Bank of Japan kept policy unchanged in December, but unexpectedly announced a policy framework review. It extended its emergency lending and liquidity programs for six months whilst keeping rates and asset purchases unchanged. However, it pledged to review the sustainability of its policy framework. The bank stressed that there was no need to scrap its yield curve control as part of the review, but the announcement does suggest there will be tweaks coming that will seek to maintain its accommodative stance for even longer. The bank did say it would likely announce the findings in March. Governor Kuroda said that “Our intent is to keep short- and long-term policy interest rates at their present or lower levels, and we won’t be reviewing negative interest rates.”

Emerging Markets

Chart showing the risks to Emerging Markets.

We subscribe to widespread optimism towards Emerging Markets (EM) going into 2021, but weigh our preference towards catch-up trades, especially for commodity-linked assets. High-beta EMs have already posted a solid outperformance in recent months, but we see plenty of room for further gains. Latin American assets look especially attractive as they combine commodity exposure with higher potential for currency appreciation. Additionally, anecdotal reports suggest positioning by global asset managers is comparatively light vis-à-vis EM Asia. There is not much carry to speak of (for now at least), but from a real exchange rate perspective, Latin America is now in a vastly more competitive position than they were at the start of last year.

Graph showing the Real Exchange Rate 1-Year Change divided in sections for Latin America, EMEA, and Asia. The graph highlights the 28 ppts difference between Brazil and Philippines.

This is not to say that we have a negative outlook on Asia’s emerging markets, but the drivers are different, and likely to play out over a longer period. The speed and intensity of the change policy direction in China will be the dominant marginal variable going forward for the region. China's renewed efforts to rebalance a domestic growth engine, investment in tech infrastructure away from US components, and redrawing of global supply chains are all long-term positives for the region. Also, a stronger yuan (our base case) will drive China's growing import demand. With China aside, Asia will be far less scared by the virus than Western countries, translating to continued growth outperformance.

Despite our positive outlook for Emerging Markets, there are plenty of variables at play. First, long EM trades are as consensus as you can get at this juncture. Similarly, markets are convinced there will be a continued decline of the dollar, a view based on continued support from the Fed, more fiscal expansion, and portfolio diversification away from U.S. assets, and we agree. Yet let's not forget that Europe, the U.K., and Japan are not doing that well, posing a risk to the weak dollar view. In addition, inflation expectation continues to rise in the U.S., with 10-year breakevens above 2% after the Georgia elections, helping drive the nominal 10-year higher. With the Fed having just established its Average Inflation Targeting framework, the risk of a sudden reversal – a new Taper Tantrum – is increasing. Ultimately, the risk to EM comes from a steepening U.S. curve driven by inflation expectations, not growth. On the geopolitical stage, we think the U.S.-China conflict will continue; it's just a question of how severe and disruptive it will be. Markets may be somewhat complacent as Biden will be under pressure from his left flank to act on any perceived human rights violations by China.

Chart showing the factors that drive Emerging Markets.

Domestically, we are monitoring any fiscal hangover leading to deteriorating fundamentals. The combination of weaker growth (and fewer tax revenues) plus increased spending could lead to long-lasting downgrades to the outlook. Many countries may find themselves unable/unwilling to pare back social assistance for political reasons. For example, the difference in stimulus between Mexico (comparatively low) and Brazil (high) will have a long lasting impact on the relative ratings of these countries. Another complicating factor is the simultaneous global borrowing binge over last year, which could mean several maturity walls down the line. One can easily imagine a world where U.S. yields are rising, and EM had a much harder time competing for funding or rolling over their debt. Local debt curves already reflect this reality to some extent, forcing some governments to reduce the maturity of their rolled over debt.

Graph showing the Selected Local EM Sovereign Curves for Brazil, Mexico, South Africa, India, and Indonesia.

What we are watching in EM:

Russia and Saudi Arabia: The Biden administration will (theoretically, at least) stand in opposition to Russia, Saudi Arabia, and the U.S. oil industry while reproaching Iran. Biden has enough reasons to stand up against Russia as it is, but with the results of Georgia, we think the balance of risk has shifted for the worse. Democrats are likely to want some payback from perceived Russian interference in the U.S. elections, the recent hacks, as well as many other actions taken by Putin on the geopolitical stage. Tensions between Germany and Russia following Alexey Navalny's poisoning and the 2019 murder in Tiergarten can serve as a bridge for cooperation between the U.S. and Europe on reprehending Russia. Meanwhile, maintaining a good relationship with Saudi Arabia will be harder under Biden for at least two reasons: The Democratic party's greater emphasis on human rights (see the Jamal Khashoggi case) and Iran. Biden is expected to take up Obama's mantel over Iran and reduce sanctions. Not only will this increase the global oil supply, but will anger the Saudi, pushing it closer to Russia and possibly China.

Turkey: Trump’s decision to impose sanctions on Turkey before the elections served as a positive development. The very light-handed measures reduce the likelihood for stronger action by the incoming Biden administration. In fact, it could lay the base for a rekindling of the U.S.-Turkey relationship, especially if this can be articulated in opposition to Russia. This upside risk, along with the recent shift towards economic policy orthodoxy, should materially improve the outlook for Turkey's asset prices in the near-to-medium term. There is still a lot to dislike about Turkey's fundamentals (and even more if oil prices continue rising), but the country should get a pass for now, at least as far as financial markets are concerned.

Brazil and South Africa: Both countries share many positive and negative factors, with high risk-reward profiles, but we favor Brazil over South Africa. Both are firmly in the high-beta category and are commodity exporters. Both countries face very complicated political outlooks and deep-rooted fiscal challenges, neither of which are likely to be resolved in the foreseeable future. And the fiscal outlook is now highly dependent on how the pandemic develops, with more transfers likely if the numbers spike. Despite ZAR's impressive recovery over the last 6-months, both are still underperforming in the EM space compared to pre-pandemic levels, but BRL has far more catch-up potential.

Chile: Local assets remain in flux from pension fund withdrawals and supported by the skyrocketing price of copper. But, next year, the Constitutional Convention Election (April) can be a risk. This is when we will find out the composition of the assembly in charge of drafting the constitution, which will determine the scope and how unfriendly to the market the outcome is presumed to be.

China: The country will continue benefiting from economic outperformance and sustained inflows. We expect the yuan to continue appreciating and relatively high interest rates for its local bond market to remain advantageous, making it one of the best carry trades out there. When adjusted for volatility, a long yuan position against the dollar is on par with the Mexican peso and South African rand in terms of carry. From a fundamental perspective, the "dual circulation" strategy will accelerate the rebalancing from external to domestic demand, and a stronger currency would help the process. But, as always, we need to remind ourselves that the yuan is as much an economic instrument as it is a political one, meaning that trajectory won't be without speedbumps. Lastly, we expect Biden’s policy towards China to be stabilizing in the short term because (1) it will be slower moving, seeking consensus, and advice, (2) it will re-weight concerns more towards human rights and away from trade; and (3) less erratic than under Trump. In the medium-term, however, a sustained policy against China under Biden can gain a lot more traction globally and be more effective in de-coupling the sphere of influences around the two countries.

Graph showing Volatility- Adjusted Carry for South Africa, Mexico, Brazil, and China ranging from January 2020- January 2021.

Currency Forecasts

This table shows the Currency Forecasts for Major Markets and Emerging Markets in US Dollar Terms and in Euro Terms. The chart shows the dollar value currently and forecasted dollar value in Q1 2021, Q2 2021, Q3 2021, and Q4 2021.

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