Analysts are wavering in their conviction that the dollar will continue to weaken as a more optimistic outlook about the US economy challenges a key driver of the greenback slide.

The US currency fell 5 per cent in the final two months of 2020, and many investors and analysts were expecting further declines in 2021. But the past week has brought a 1.2 per cent recovery. Emerging markets currencies that have performed strongly in recent months have also had their march interrupted by the resurgent dollar.

The turnround reflects nagging doubts over whether the Federal Reserve will hold the line with its extremely supportive policy given greater hopes for an economic pick-up in the US.

“Having been vocal dollar bears last year we argue it is time for a consolidation in the dollar lower trend and would take profit on [negative dollar bets against the euro],” said George Saravelos, head of currency research at Deutsche Bank in London.

After the Democratic Senate win in Georgia on January 5, investors are pricing in a larger spending package from the US government than before — a move likely to fire up economic growth. Meanwhile, positive news about the rate of coronavirus vaccinations have boosted hopes for a more robust recovery.

“The Democratic win in Georgia will lead to huge upfront stimulus in coming months, just as the US economy reopens,” Mr Saravelos added.

Line chart of  showing The dollar

The bond market is also braced for more growth-stoking fiscal stimulus. Yields on US government bonds pushed higher, reflecting a drop in prices, on the same risk that the Fed could reconsider its supportive stance sooner than previously thought, said Markus Allenspach, head of fixed-income research at Julius Baer.

“Higher growth translates into better employment, a return of inflationary forces and ultimately lower pressure on the Federal Reserve to keep refinancing rates artificially low,” Mr Allenspach said.

Paul Meggyesi, global head of currency research at JPMorgan said one key driver of dollar weakness was confidence that the Fed would allow inflation to overshoot its target. Now, though, investors are less sure.

“We expect the market to reconsider the Fed’s enthusiasm for an inflation overshoot in the face of a potentially powerful post-vaccine bounce in activity [in the second half of the year],” Mr Meggyesi said.

The pause in the dollar’s declines have stalled the progress of emerging markets currencies, curbing some enthusiasm for placing positive bets on highly risk-sensitive currencies. James Lord, emerging market strategist at Morgan Stanley said the bank had turned neutral on these previously much-liked currencies.

The dollar may have steadied recently, but it is too early to call for a stronger US currency, Mr Meggyesi said, noting that yields are still low and that assumptions about the Fed’s next move are still unproven.

“So long as the global environment remains positive and uncertainty continues to decline, any dollar rally should be limited,” Deutsche Bank’s Mr Saravelos added.