Dollar likely to rise, but rally will lose steam later in 2021

MUMBAI/BENGALURU: Economic growth and higher bond yields will keep the US dollar stronger for now, but the rally will lose steam later in 2021 because of a dovish Federal Reserve and rising fiscal deficit in the United States, economists and strategists said.

The dollar rally will be mitigated in the coming months because the Fed’s extraordinary monetary policy won’t result in sustained inflation, they told the Reuters Global Markets Forum.

Fed officials have said the central bank will ignore the price pressures expected to accumulate in coming months and let the economy run “hot” to encourage more hiring.

“The most likely outcome is that after a spring peak (of) around 3.5% for headline CPI and 2.5% for core PCE, inflation will fall back, while remaining above 2% for longer than at any other time over the past decade,” said Gregory Daco, chief US economist at Oxford Economics.

The risk of inflation spiralling out of control was limited because rising prices would in turn restrain demand, and the Fed can eventually rely on its toolkit, including forward guidance and yield-curve control, to control runaway prices.

“The inflation we are seeing is not wage/price spiral stagnation inflation, it is recovery inflation and transitory,” said Jeffrey Halley, senior market analyst for Asia Pacific at OANDA.

Halley expected the dollar to end the year lower, with the Japanese yen topping out at 112.00 to the dollar. It is currently at 108.99.

There is a real possibility that bond yields will keep rising, but the Fed doesn’t have to raise interest rates to combat it, said Kristina Hooper, chief global market strategist at Invesco.

“Operation Twist is most likely,” Hooper said, adding that she expected the Fed to act only if markets became “disorderly” when the 10-year yield reaches 2%.

The benchmark US 10-year yield is currently at 1.6191%.

“But if the 10-year yield rises to even 3% and markets are able to digest the rise in yields, then the Fed will not step in,” she said.

Eric Freedman, CIO at US Bank Wealth Management, likened the communication between the markets and the Fed to “the game of Marco Polo,” where markets sell bonds and wait to see if the Fed is worried about that interest rate level.