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Euro seen benefiting from further dollar weakness in 2020 as trade tensions ease

U.S. dollar weakness could have further to run in 2020, even after it posted the worst quarter in two and a half years, as easing trade tensions, improving macro sentiment and the expansion of the Fed’s balance sheet continues to damp demand for the dollar.

The Dollar Index, which measures the dollar against a basket of its developed-market peers, declined 1.9% during December, capping off a rocky three months that saw the currency retreat by 3.01%, its biggest quarterly decline since second quarter 2017.

"The dollar retreat has further to run," Jeremy Stretch, head of G10 FX strategy at Canadian bank CIBC, said in an interview, citing the de-escalation of trade tensions and a moderate reduction in Brexit risk, both of which are expected to benefit the euro, as well as more favorable non-U.S. growth dynamics.

The U.S. and China are slated to sign a "phase one" trade agreement on Jan. 13 in Washington, putting an end to almost two years of tit-for-tat tariff increases and rolling back some of the levies that had already been put in place. Boris Johnson's crushing victory in U.K. parliamentary elections in December 2019 have ensured that the country will leave the EU on Jan. 31, almost a year after the original deadline.

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UBP’s Global Head of FX Strategy Peter Kinsella also sees the euro as a key beneficiary of dollar weakness in 2020, but points more toward the Federal Reserve's activity in the repo market as it sought to damp volatile short-term rates.

The Fed pumped half a trillion dollars into the repo market since mid-September 2019 after a shortage of cash sparked by a corporate tax payment deadline and a larger-than-usual issuance of Treasury securities led to a spike in short-term borrowing costs.

"Usually [Fed injections into the repo market] carry a lagged negative pass-through to the US dollar spot level, when the U.S. dollar liquidity outlook improves as substantially as seen in recent months," Nordea Global FX/FI Strategist Andreas Steno Larsen wrote in a research note. "Judging solely from USD liquidity, the USD looks vulnerable through Q1, broadly speaking."

There are also signs that foreign investors are returning to the euro area, despite manufacturing remaining in contraction territory, Larsen said. “Investors have started to buy into the euro-area case again slowly but surely," he wrote in the note. "For the first time since the Euroboom of 2017, we see inflows to unhedged EUR ETFs again."

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While the dollar slumped in the fourth quarter, it ended 2019 0.2% higher after rallying earlier in the year and remains relatively strong. The Dollar Index closed the year at 96.389, 9.1% above its 10-year average of 88.379.

Currencies that respond best to global growth saw the largest increases against the dollar in December 2019. The New Zealand dollar added 5.2%, its biggest monthly advance since November 2018; the Norwegian krone advanced 4.8% gain, followed by the Australian dollar with 4%. The weakest G10 currency performance against the dollar in December was the Japanese yen, which gained a modest 0.8%.

Middle East tension

The biggest threat to expectations of a weaker dollar is the recent spike in tensions in the Middle East following the assassination by the U.S. of Iranian general Qassem Soleimani, which contributed to a 0.5% jump in the dollar index on Jan. 2, the biggest one-day gain since Nov. 5.

"Both US Treasuries and the dollar have started the year on the front foot as the escalation of tensions between the U.S. and Iran has prompted renewed safe-haven demand," Jonas Goltermann, a senior economist at Capital Economics, wrote in a research note.

The research group also expects prevailing tensions between the U.S. and China and a stronger-performing U.S. economy to cause the dollar to appreciate against most currencies in 2020. "We forecast the dollar to rise by about 4% on a broad trade-weighted basis in 2020."