2021 Currencies Forecast: Risk proclivities and inflation breakevens to be the driving force

My FX views in 2021 have 0 to do with central bank monetary policy, although I expect every central bank on the planet to push back on USD strength. But more to do with risk on proclivities and inflation breakevens, which have been the driving force in US dollar depreciation in my view since post-election time in November

Risk assets continued to defy gravity into year-end, with Global equities hitting new records by the week as investors appear to be willing to ride the vaccine and stimulus optimism wave into year-end.

Meanwhile, EM debt spread continued to tighten aggressively, the USD sold off further, which spurred further gains in EM FX. Not even stretched positioning in risk assets, and the USD seems to be an obstacle at the moment.l As the markets continue to view reflation dominating both the real economy and financial markets next year. This might prompt an even larger sell-off in the USD, higher inflation expectations, steeper yield curves, and a rotation into value and laggard sectors in equities and credit.

It feels to me like equity and currency sentiment are at or near peak vaccine. EM will eventually stop appreciating on a not immediate shift in US foreign policy; oil can only rally for so long before OPEC turns on the taps, and FX breadth will become increasingly narrow where only the AUD adn CNH will rally while the EUR and GBP will look increasingly soggy early in 2021

The vaccine narrative is such a big story; it's hard to fade, but I have decided to take a shot at some point in early Q1 2021. If we get a daily close above SPX 3850, I will likely rewrite my FX playbook in early 2021

Still, we remain in a market dominated by risk-on risk-off proclivities and even more so as we reach peak vaccine impulse and uncertain outlook on the US stimulus front. After all, we are still in a liquidy driven environment where all boats seem to be rising with YTD performance of US equities and US dollar lower, all suggesting significant comovement between risk-on asset classes.

So a negative view on any one of these risk-on asset classes will almost inevitably also lead to negative opinions across the entire risk-on spectrum, including cyclical commodity prices like oil.

It would be easy to codify the rise in risky asset classes since the post-election risk premiums evaporated simply as risk-on. But of course, the more significant characteristics has been the rotation within asset classes towards the YTD laggards and 'reopening' sectors across the board.

Perhaps one factor that has been slightly unnoticed is the strong rise in energy prices and cyclical commodity prices triggered by expectations of a hyper reflationary environment over the next twelve months and has resulted in a strong increase in market-based inflation expectations, where this unmistakable reflationary exuberance is getting expressed in FX.

So for 2021, the question is whether this has further room to run. For oil markets, the negative year-on-year base effect will most certainly give way to Q1 exuberance. Still, with much getting priced into the reopen 2021 reflationary surge, any idiomatic reflationary expression will probably vanish just as quickly in Q2. Consequently, there should be very little push for higher inflation and market-based inflation expectations from that angle, and the dollar stops selling.

So back to oil here for a moment. The broad recovery in risk assets and oil prices has not only affected market-based inflation expectations but, of course, also energy-sensitive sectors within asset classes like equities and credit. But again, there will be less exuberance expressed in Q2 for oil assets, given that it's a sector quickly falling out of favor.

By Q2 In G10 FX, the outperformance of some high-beta currencies will have likely run too far. Currencies like the CAD will defer their long-term oil and commodity sensitivities and risk proclivity, where weakness could become more notable in Q2. But given there significant outperformance during the first eight weeks of 2021, this may also pose a greater risk if a correction in risky asset classes unfolds sooner than expected.

Gold is an echo of what the dollar is doing