It's a matter of growth

Chart of the week

The days when risk sentiment was all that mattered in currency markets may be ending: A fast U.S. recovery and a sluggish Eurozone looks set to boost the U.S. dollar.

Ever since the Covid-19 pandemic started, there has been a persistent pattern in foreign-exchange markets. At any given time, the relative movement of various currency pairs mostly depends on general risk appetite, as judged, for example, by stock-market sentiment. The U.S. dollar remains a safe haven of choice, as are the yen and the Swiss franc. Whenever there is a disruption in equity markets, the dollar tends to gain. The reverse is also true. In recent months, stock-market strength was accompanied by dollar weakness.

One reason for this pattern is the comparative absence of another typical driver of foreign-exchange markets. The interest-rate differential between the United States and the Eurozone has narrowed sharply since the start of 2019, reflecting sharp declines in U.S. Treasury yields compared to those of German-Bund yields. And it is precisely this interest-rate differential that returns into focus for this currency pair in the coming months. Interest rates partly reflect growth prospects, which in turn are related to the pandemic, but also to U.S. politics.

Joe Biden's inauguration has ushered in a new era, and not just in foreign policy. Domestically, the new U.S. administration plans more stimulus spending to combat the consequences of the pandemic. In total, we currently expect another 1.1 to 1.3 trillion dollars, to be approved by Congress by the end of March. That is less than Biden has in mind, but still an enormous fiscal impulse, which has already moved markets. For example, U.S. inflation expectations have risen. Meanwhile, the bailout package in Europe has been off to a slow start and the recovery looks set to be less dynamic here than in the United States.

As our Chart of the Week shows, there is a growing gap between the economic growth forecast by the consensus in the United States and the Eurozone for 2021. In addition to the greater fiscal impetus, the more dynamic outlook for the United States reflects other sources of strength. For example, the dynamic of the U.S. labor market has typically recovered faster during previous crises, admittedly at the cost of temporary spikes. This time around, a bigger factor may be the slow start of vaccination campaigns within European-Union countries (though the U.K. has done a lot better). Compared to the delivery bottlenecks and other mishaps in the Eurozone, even the United States is doing quite well. That should boost the U.S. dollar against the euro. All told, it might take a while yet until currency markets start paying attention again to other fundamentals, such as the amount of government debt piled up during the pandemic on both sides of the Atlantic. At the moment, nobody seems to be interested.

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Sources: Bloomberg Finance L.P. and DWS Investment GmbH as of 2/3/21

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