Oh, Dollar, Where Do You Go From Here?

Coming into 2021, the U.S. dollar short trade has been one of the most consensual trades, and with good reason. As the Federal Reserve carries on with its $120 billion monthly asset purchases, its monetary accommodation mixed with a Congress looking to pass yet another fiscal stimulus bills makes it no wonder that the dollar is forecast to drop.

However, last year all central banks were on the path toward printing more money and easing financial conditions to support their economic recovery, so which currency loses? The thing about currency markets is that it is a relative game; it is all about relative pricing. Currency pairs go through ups and downs depending on whether their central bank is easing more or less than the other one along with other factors such as balance of payments, growth and inflation. It is never just an easy one-way view to call it either way.

Last year during the first-quarter collapse, the dollar rallied a lot versus G-7 and G10 currencies, also seen as a safe haven trade, but then rallied aggressively after the Fed came out with its massive $120-billion-a-month quantitative easing (QE) program that took the dollar down and markets higher across the board.

The dollar, best seen via U.S. Dollar Index (DXY), has been range-bound for the past few months. It has tried to break above $93 and test its lower support level of $90.50, but has not made any progress so far. As the rates of vaccinations pick up and economies slowly reopen, there is less pressure for central banks to provide the same monetary accommodation as they did last year. Also, inflation is creeping higher, if not already at high levels, in a lot of these economies, compelling their central banks to raise rates.

Countries such as Ukraine, Turkey and Brazil are great examples where inflation is already a problem. Just recently the Bank of Canada came out and surprised the market by tapering its QE for the second time. The announcement saw the Canadian loonie jump sharply higher against the dollar. It was a relative trade as one bank was tightening while the other is still in the money-printing mode.

Russia became the latest country to surprise markets when it also unexpectedly raised rates by 50 basis points to 5% last Friday; a move only expected by 13 out of 41 analysts on the sell side. That move saw the ruble move higher versus the dollar as well. So it seems the dollar is rising against a host of currencies and falling against some, leaving the overall index quite flat.

The Fed does not seem too concerned about inflation right now even though it is apparent everywhere in the system, from food prices and grocery bills to steel and construction costs. The average U.S. consumer is facing prospects of lower disposable income, especially if wage income growth does not match this increased inflation.

The Fed uses a muted Consumer Price Index (CPI) measure that takes out all the important relevant real economy inflation indicators. This is its justification to keep the free-money printing train going until either full employment or inflation sustainably above 2% is reached. The goalposts keep moving and it seems the Fed may never be able to reach its target, which has huge implications for fiat currency and the dollar in general. It implies constant devaluation and easing, leading to a lower dollar.

But the real problem is inflation. We can see using a host of broader indicators that a CPI print of 3.5% to 4% is not impossible. If that were to be the case, no matter what Fed says about inflation being "transitory," it will spook the markets and leave them wondering what they do next. It is only a matter of time until the Fed will need to start pulling back from this constant balance sheet expansion and QE, especially if the entire U.S. economy is vaccinated and there is no risk of more closures or lockdowns.

For now, that reality seems to be a bit in the distance with a few unanswered questions about new strains of the virus and lockdowns, but it is one that needs to be monitored. It seems the Fed is hell-bent on getting the desired inflation, even if it means letting the economy run hot for some time. This market has been and will continue to be all about liquidity. How and when the Fed exits this strategy will be crucial as we all know what happened back in the fourth quarter of 2018 when the Fed tried to suggest a mild tapering. All hands on deck for the next Federal Open Market Committee (FOMC) meeting on April 28.