US dollar’s strength is more responsible for the EUR/USD weakness than the weak euro. So what caused the dollar to rally in 2021?
The US dollar rallied in 2021 despite almost all investment houses having a bearish forecast for the greenback at the end of 2020. Or, perhaps, precisely because of that.
The rally is even more impressive if we look at the EUR/USD pair. It started the trading year above 1.23 and just traded below 1.13 this week. The one-thousand pips drop is not that usual for the most important currency pair on the FX dashboard, and most of the dollar’s strength is related to events from the United States and not Europe.
Sure enough, the dovish ECB stance helps, but other euro pairs are not down as much as the EUR/USD is. For example, the EUR/JPY cross pair is higher on the year – it opened 2021 at 126 and now trades around 130. Therefore, while the euro did trade with a bearish tone, the EUR/USD’s decline reflects the dollar’s strength more than the euro’s weakness.
So what caused the dollar’s rally?
US economic strength
One thing contributing to the dollar’s strength, and perhaps the most important one, is the US economic strength. The US economy, the largest in the world, was the first one in the developed economies to recover from the COVID-19 pandemic.
Moreover, it grew well above estimates, outpacing even the most optimistic scenarios. As a result, the economy grew above the pre-pandemic trend, while the Euro area economies lag.
Therefore, one of the explanations for the dollar’s strength against the euro is the old classic economic performance; the divergence in favor of the US dollar could not be left unnoticed by traders and investors.
Another thing that explains the dollar’s strength is the divergence between the two central banks – once again, favoring a strong dollar. While the Fed started to taper its asset purchases and signals at least one rate hike next year, the ECB puts a lot of effort into making sure the markets understand that no rate hike comes in 2022.
Therefore, the monetary policy divergence also favored a stronger dollar, particularly in the second half of the year. As long as the two divergences explained above persist in the period ahead, the US dollar’s strength will likely be here to stay. Thus, the EUR/USD will have a hard time bouncing from its lows.