• A new hope for the UK economy: good vaccination pace, the completion of an UK-EU trade agreement, and economic resilience will likely push Sterling higher – but limited progress on new trade deals and coronavirus-related scarring could undermine the currency.
• The pandemic strikes back in Europe: a comparatively slow vaccine rollout and strengthened lockdowns could weigh on the Euro and regional growth, but questions remain around the longevity of those trends.
• Return of the Fed eye – and US fiscal stimulus: the Fed is unlikely to taper asset purchases until it sees improvements for the most vulnerable, and with large-scale fiscal stimulus now more likely after a Biden victory, we see US dollar weakness remaining a key theme.

While we don’t yet have full-year numbers, it’s clear 2020 saw an unprecedented fall in UK growth (we estimate -10% of gross domestic product, or GDP), materially worse than what was seen in the US and slightly larger than declines in the Euro area.

But the good news is that a recovery from that low base, even if delayed until the spring due to further lockdowns in Q1, means the UK should be able to achieve impressive growth rates as we move through the year – as vaccination momentum builds, lockdowns ease, and households put some of their extra cash to work (we estimate 3.7% and 7% GDP growth in 2021 and 2022, respectively). All of this should be broadly supportive of Sterling in the medium-term (especially with the window for negative interest rates in the UK now firmly shut).

Recent data lend further reason for optimism:

• Monthly growth for November showed a less severe fall than expected: once the most heavily affected sectors are stripped out (hospitality, leisure, retail), service sector declines were relatively modest (especially compared with previous lockdowns), pointing to more resilience than we initially thought.
• Labour market data for December showed a rise in the number of employees for the first time since the pandemic began: while it may be too soon to say whether this is a pivotal turning point, the fact that there weren’t further declines should lead to greater optimism.
• Inflation remains low: we will likely see that step-up with the scheduled reversal of the VAT cut in April, and energy price base effects – the UK’s energy regulator, Ofgem, was aggressive with price caps last year, but those should ease in 2021.

At the same time, the UK-EU Brexit trade deal secured over Christmas, though perhaps not as comprehensive as some had initially hoped, will nevertheless help ease politics & media-driven market jitters that punctuated Sterling movements in the years preceding the agreement. Because of that, we think the risk premium will be lower going forward – in other words, investors will accept a lower Sterling exchange rate to compensate for greater certainty around the outlook.

However, if Brexit-related concerns do persist – particularly if the trade balance comes under pressure due to limited further trade deal progress – and if coronavirus-related scarring is more severe than estimated, that could undermine the currency in the long-term.

In the UK and elsewhere, the vaccine rollout is the key driver of the economic & FX outlook. The UK government has raised vaccine expectations – and appears to be meeting them. Some of this is supportive of Sterling because the UK was quick off the blocks, but also because the UK was among the hardest hit by the pandemic, so it’s safe to expect equal sensitivity to vaccine movements going forward – in the UK and elsewhere.

That said, vaccine supply hiccups and newly strengthened lockdowns in Europe have weighed on the Euro and cloud the medium-term economic outlook in the region. We think some of media & market pessimism here may be overblown, but beyond the headlines, Sterling-Euro pricing will fundamentally hinge on a recovery in Europe – so it’s worth looking out for possible distortions to the shape of that recovery.

Relative growth will be a key rate driver. We think Sterling-Euro could hit 1.15 or higher as the year progresses, depending on the extent to which the pandemic strikes back. Sterling-US Dollar could drift up to 1.40 and stay there for much of the year – partly due to a stronger pound and partly a weaker dollar. But where the rate lands will ultimately depend on relative growth in both countries, the speed of the vaccine rollout, and whether the Fed changes its outlook & approach to pandemic support.

In the last two months of 2020, the US dollar weakened significantly – mostly due to negative vaccine news and investors’ defensive positioning against a surprise US presidential election outcome (a Trump victory).

But with the election out of the way (including a Senate run-off in January that handed the Democrats a razor-thin majority) and more progress on the vaccine front, the dollar has begun to strengthen and interest rates at the long end of the US Treasury yield curve rose – raising questions about whether the Fed would start to pull back from its quantitative easing (QE) programme.

The question on everyone’s mind for 2021 is: how long will the combination of a stronger dollar and higher interest rates last? We think it’s too early to abandon the view that the dollar will continue to weaken, for several reasons:

• A Biden victory significantly increases the odds of large-scale fiscal stimulus: as we’ve written elsewhere, an initial support package of $1.9 trillion has been proposed, though we think a figure closer to $1-1.5 trillion is more realistic (but still substantial).
• The Fed’s unlikely to taper asset purchases any time soon: its mandate includes both inflation and employment, and Fed Chair Powell has made it clear financial conditions will remain easy until they see more sustained improvement on the latter – particularly for low-wage workers, who have been hit the hardest by the pandemic (in January, we saw the first decline in non-farm payroll since April 2020). We expect the Fed to keep a close eye on how the pandemic affects the most vulnerable.
• The dollar’s status as a global safe haven means a stronger US economy doesn’t necessarily equal a stronger currency: much like what’s been said about Europe and the UK, that vaccine progress helps service-oriented economies recover more quickly (and catch up with manufacturing-oriented economies) certainly holds true for the US. But the dollar’s supremacy in global trade & commerce means a stronger US economy could be of greater benefit in the near-term to smaller, growth-oriented economies (and their currencies), and may not necessarily lead to strengthening if it isn’t accompanied by a broad-based global recovery.

There may be near-term challenges to our dollar view – the path of interest rates, fiscal stimulus, investor positioning, and more recently, concern from other central banks about strength of their own currencies – but we still see a weaker dollar on the horizon.