Morgan Stanley Turn Bullish on U.S. Dollar Outlook

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Economists at Wall Street bank Morgan Stanley are backing the Dollar to make gains in 2021, having entered the year expecting the currency to make losses.

"Our view on the USD in 2021 has evolved from bearish at the beginning of the year to neutral in mid January, and now takes a bullish skew," says Matthew Hornbach, Global Head of Macro Strategy at Morgan Stanley.

Surveys of economist forecasts made in late 2020 and early 2021 showed the vast majority of analysts expected the Dollar to decline, however this consensus has since deteriorated given the currency's strong showing over recent weeks.

In a research briefing out this week Morgan Stanley says the bullish skew recognises that strong U.S. data are increasingly dominating how the U.S. Dollar behaves, whereas previously the Fed’s dovish communication was able to hold back the tide.

"The unstoppable force of the US economy is overpowering the immovably dovish communication from the Fed, and causing some cracks to emerge in the FX market, leading to USD strength," says Hornbach.

The Dollar has been one of the best performing major currencies of the past week, going 1.58% higher against the Euro and pushing the Euro-to-Dollar exchange rate back below 1.20 to a low at 1.1835 in the process.

The Pound - which is one of 2021's better performers - has also been unable to resist the Greenback's advance, as the Pound-to-Dollar exchange rate dipped back below 1.40 to register a low on Monday at 1.38.

The Dollar's come as investors bet on a strong U.S. economic recovery, which will in turn stimulate inflation over coming months.

As a result, investors have dumped government bonds - particularly longer-dated bonds - and in the process the yield paid on those bonds has risen.

Money market pricing meanwhile indicates that investors are bringing forward the date they expect the first Federal Reserve interest rate rise to take place.

All this is driving demand for the Dollar, say analysts.

"The data – and expectations about future data – are starting to dominate in the FX market in part because the Fed has signalled that it is not concerned enough about the rise in bond yields to do anything about it, inviting market participants to push bond yields higher still, pressuring the USD," says Hornbach.

Morgan Stanely forecast the Euro-Dollar exchange rate at 1.23 by the end of June 2021 and 1.25 by year-end.

While the forecasts for EUR/USD don't necessarily reflect the stated view that Morgan Stanley now expect Dollar strength in 2021, against the Pound this strength is obvious in the forecasts.

The Pound-Dollar exchange rate is forecast at 1.35 by the end of June 2021 and 1.32 by year-end.

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While consensus still expects the Dollar to weaken in 2021 more in the analyst community are pushing back against the view.

Ben Randol, Senior Analyst, G10 FX Strategy at Bank of America Merrill Lynch says fundamental support for the Dollar is emerging.

"We continue to see a bottoming process playing out as capital flows & positioning shifts precipitate USD appreciation in 2021," says Randol. "The re-pricing of global rates markets on diverging economic prospects is emerging as a key source of USD support."

Bank of America expect this process to continue as the magnitude of relative Fed normalisation increases and timing becomes more proximate.

The foreign exchange playbook suggests that when a central bank hikes rates at a faster rate than its peers the currency it issues appreciates in value.

Therefore, a faster 'normalisation' of U.S. rates (i.e. interest rate rises at the Fed) will therefore be a positive for the Dollar.

"A steeper, more proximate path of Fed normalisation relative to global central banks is broadly beginning to support the US dollar, our analysis shows. This evidence supports our bullish USD thesis based on fundamental growth and interest rate decoupling this year, particularly as FX sensitivity is asymmetrically poised to increase in the months ahead. We remain contrarian USD bulls and expect this process to continue to play out," says Randol.

The analyst cites OIS markets which have priced in an additional two hikes by G5 central banks this cycle, with considerable differentiation across the global landscape.

This differentiation is expected to result in exchange rate movements.

The market has priced in three additional hikes from the Federal Reserve beyond the nearly three hikes already priced at the turn of the year, pushing the Fed Funds rate in four years' time above 1.4%.

Above: 3-month OIS paths for the G5 central banks.

For the Bank of England, the market has priced in another 66bp for a total of three hikes cumulatively.

For the Bank of Canada, the market has priced in 100bp on top of the 3+ hikes previously priced, bringing the terminal rate four years from now to about 1.9%. Pricing for the ECB and BoJ has understandably lagged.

For the ECB, the market has only priced in an additional +28bp for a return of rates to just under zero, whereas for the BoJ, pricing has been only +15bp for a return of rates to just over zero.