In 2021, the foreign exchange market was heavily impacted by the coronavirus pandemic. Currencies were often bought and sold based on tradersí desire to increase or decrease their exposure to riskier assets rather than on individual fundamentals. This Year, tradersí attention will slowly shift towards individual fundamentals although the pandemic will remain a major factor.
The U.S. Dollar Index, which measures the strength of the U.S. dollar against a broad basket of currencies, lost plenty of ground in 2020 as the Fed cut rates while the U.S. government provided an unprecedented amount of stimulus to the economy.
After reaching the 103 level back in March, the U.S. Dollar Index declined towards the 90 levels. On the way down, the U.S. Dollar Index made only one serious attempt to rebound in September.
The pressure on the U.S. dollar is strong, and the market consensus is that the dollar will continue to move lower. While this yearís downside move may look significant, the U.S. Dollar Index may have more room to fall.
Back in 2008, the U.S. Dollar Index touched 71 levels before rebounding to 88. In 2011, the U.S. Dollar Index tested the 73 levels.
Put simply, current levels cannot be seen as low for the American currency so it may easily gain additional downside momentum if the situation in the world economy improves and traders increase purchases of riskier currencies. The main risk for the bearish thesis is that shorting the dollar may become a very crowded trade.
Australian Dollar is set to finish the year 2020 on a strong note. The main reason for this strength is the recent strength in the commodity segment, especially in the iron ore market.
The dovish policy of the Reserve Bank of Australia had little impact on AUD/USD because other central banks were dovish as well.
The market consensus is that interest rates in the developed countries will stay at the bottom for the next several years, so the Reserve Bank of Australia may have an opportunity to put more pressure on bond yields without hurting the Australian dollar.
This year, Australiaís relations with its main trading partner, China, have worsened, but the interdependence of these countries is strong enough to prevent their relations from serious deterioration. I do not expect any major risks on this front.
Currently, the outlook for the Australian dollar looks bullish, but its future trajectory will depend on the continuation of the rally in the commodities segment.
EU and UK have just managed to negotiate the Brexit trade deal so the main risk for GBP/USD was not realized.
In recent months, GBP/USD was moving higher as traders bet on the successful outcome of Brexit negotiations (and these bets paid off), but now GBP/USD traders will have to find additional reasons to be bullish on the pound.
Currently, the UK struggles to contain the new strain of coronavirus which may put additional pressure on the countryís economy. In addition, the economy may take a hit from Brexit, although the size of the blow will not be as serious as in the case of a no-deal Brexit.
The fundamental situation looks challenging for the UK economy in the first half of 2021 which may put some pressure on GBP/USD which needs additional upside catalysts after the end of Brexit negotiations. While the pound may have some more room to run, GBP/USD bulls will likely need some help from general U.S. dollar weakness.
Just like other major central banks, the Bank of Canada will be forced to provide material support to the economy until inflation shows some signs of life. Canada is also suffering from the second wave of the virus although the situation has stabilized in December. It remains to be seen whether this second wave will put additional pressure on the Canadian economy.
Oil price dynamics will remain an important catalyst for USD/CAD in 2021. If WTI oil manages to settle above the $50 level and gain more upside momentum, commodity-related currencies like the Canadian dollar will get an additional boost.
At this point, the outlook for the Canadian dollar looks favorable. The main risk for Canadian dollar bulls is the sudden general strength of the U.S. dollar.
The European currency showed material strength at the end of this year. In recent years, EUR/USD was under pressure because of dovish policy of the European Central Bank and disappointing growth rates in the Euro Area.
However, the pandemic provided significant support for euro as traders turned their attention to the problems of the U.S. dollar. In 2021, the main question for EUR/USD is whether it will be able to settle above 2018 highs at 1.2500.
While ECB may be disappointed by the recent increase in the value of euro which will put more pressure on economic growth, thereís little that it can do to stop the euro from moving higher.
The interest rate is already at the bottom, the asset purchase program is working, and while ECB likes to reiterate that it has not run out of options to support the economy, there are limits to any central bankís power.
Traders know this, so EUR/USD bulls will likely try to test new highs at the very beginning of 2021. If this early test shows that demand for the euro remains high, EUR/USD will have a good chance to develop a strong upside trend against the U.S. dollar in the next year.
This year was very interesting for foreign exchange market traders, and the next year will likely bring more volatility.
The marketís attention will be focused on the fate of the U.S. dollar which may find itself under more pressure if the Fed continues to print money while the world economy recovers from the blow dealt by the pandemic.
Commodity-related currencies like the Australian dollar and the Canadian dollar may enjoy more support if demand for commodities continues to grow together with the economy.
It will be very interesting to see whether the British pound will be able to continue its upside move after Britain successfully negotiated a trade deal with the EU.
For the euro, it may be another year of strength against the U.S. dollar despite the current problems of the European economy.