Many market participants appear to have forgotten the drama of Trump's first term. It was driven home with the tariff threat on Canada and Mexico, which was postponed at the last minutes. The apparent fascination with his "authenticity" seemed to have overshadowed his ability to dissemble during the election but it has been underscored in the past few weeks, including apparently on what the US Navy will be charged for using the Panama Canal. Key economic officials have denied signals from Trump himself about pressuring the Fed to cut rates or the purpose of the tariff threats on Canada and Mexico. Yet, it is not clear that the power of policy lies with senior officials. It looks like it is being retained within the Oval Office.
Barring more disruptive comments, the greenback will likely be supported by the continued outperformance of the US economy. Even though the US labor market continues to appear to be slowing, increase in average hourly earnings and the decline in the unemployment rate may raise questions about how "materially" restrictive is the US monetary policy setting. A firm January CPI on February 12 will push in the same direction. The first rate cut is not fully discounted until September. US rates may have put in a near-term low last week. The 10-year yield fell to about 4.40%, a new low since mid-December before recovering after the jobs report and further after the jump in the University of Michigan's preliminary February survey of one-year inflation expectations (4.3% vs. 3.3%). Higher US rates should help the greenback recover against the yen from a two-month low seen before weekend.
US
Drivers: The US economic outperformance and widen rate differentials underpin the dollar. Conventional wisdom is that tariffs are supportive for the dollar insofar as they boost inflation, keeping the Fed policy restrictive for longer, and hitting growth prospects in the targeted countries. Still, as a tax on consumption (and investment) the tariffs will act as a headwind to the US economy.
Data: With the January jobs report and benchmark revisions behind us, the market's attention turns to prices. A 0.3% rise in the headline and core CPI measures will leave the year-over-year rates unchanged at 2.9% and 3.2%, respectively, depending on the rounding. On the other hand, producer price inflation may slow. The headline may tick lower to 3.1% from 3.3%. The core rate ease to 3.3% from 3.5%. January retail sales and industrial production will be reported at the end of the week. Dragged down by auto sales, headline retail sales may be flat. The core measure ("control") that is used for some GDP models will likely have slowed after the 0.7% rise in December. The patience that Fed Chair Powell articulated means that barring a significant shock, the central bank will stand pat again at the next meeting (March 19). The Fed funds futures have about a one-in-three chance of a cut at the following meeting (May 7). In the response to the employment report, the market pushed the next cut in to Q3 thought June-July remans a close call.
Prices: The Dollar Index has forged a near-term shelf in the 107.30-50 area. The threat of "reciprocal tariffs helped lift DXY to 108.30 ahead of the weekend, succeeding to do what the second consecutive decline in the unemployment rate and surge in the University of Michigan's one-year inflation expectation survey (4.3% vs. 3.3%) failed to do. The Dollar Index recorded a bullish outside up day ahead of the weekend. A move above 108.60 could see 109.00-30.
EMU
Drivers: The outperformance of the US economy and widening two-year interest rate differential are a drag on the exchange rate. In addition, the US tariffs loom. Germans go to the polls on February 23. While the CDU will likely head the next government, it is not clear if the AfD, which has been polling well, will be invited to form the next government. Still, the domestic challenges and shifting geopolitical consideration suggest that Germany's infamous debt break may be diluted and there may be greater willingness to boost common action, which may include joint bonds for defense spending.
Data: The data highlights include the aggregate December industrial production figures and details about Q4 GDP. Outside of headline risk, following Germany's shocking 2.4% plunge, the impact on the market may be minimal. The swaps market is pricing in another ECB rate cut at the next meeting (March 6). There are nearly 65 bp of cuts priced in by the end of H1, which is to say two quarter-point cuts are fully discounted and about a 60% chance of a third cut by mid-year.
Prices: The euro's recovery from the US tariff threat on Canada and Mexico fizzled out near $1.0440. After testing the $1.03 area on the reciprocal tariff threat, the euro looks heavy to start the new week. A break could spur losses toward 1.0255. The greenback also appears to be supported by the recovery of the US two-year premium over Germany.
China
Drivers: Beijing closely manages the exchange rate. We do not think China wants a weak or a strong exchange rate but one that is broadly steady against the US dollar. This means to slow the yuan's decline in a strong US dollar environment. While the Dollar Index appreciated 10% from the end of Q3 24 to mid-January 2025, the greenback rose half as much against the Chinese yuan.
Data: China is expected to report January lending and money supply figures. It may report direct investment flows, fx settlement, and Q4 24 current account. The exchange rate and equity market do not appear particularly sensitive to these reports. Of note, last year, we tracked the ebb and flow of the yuan's correlation with the yen and the vagaries around the carry-trade. Now we note that the changes in the yuan are more correlated with changes in the euro (~0.70) than the yen (~0.15).
Prices: The dollar posted a four-day high close ahead of the weekend, slightly above CNH7.31. It reached CNH7.3735 amid the tariff announcement at the start of last week. Since returning from the Lunar New Year holiday, the PBOC set the dollar's reference rate in a tight range, little changed from before the holiday. There is near-term potential back into the CNH7.32-CNH7.33 area, though a return to the CNH7.3700 area seems likely in the slightly longer term.
Japan
Drivers: The BOJ's rate hike in late January takes it out of picture in the coming months. The swaps market is not pricing in more than 50% chance of the next move until July, and it is not completely discounted until October. That may give greater sway to the other key driver of the exchange rate, the US 10-year Treasury. The rolling correlation of the changes in the exchange rate and 10-year US yield is slightly below 0.70. It was rarely above 0.75 last year.
Data: Early Monday, Japan reports December current account and January bank lending figures. There is a strong seasonal pattern for Japanese current account balance to deteriorate in December (12 consecutive Decembers through 2023). Japan reported a JPY3.35 trillion surplus in November. A weaker yen and higher interest rates may help flatter the yen value of foreign income. Ironically, although the current account position deteriorates in December, the trade balance typically improves (19 of past 20 Decembers). Although Japan recorded an overall trade deficit in the first 11 months of 2024, it reported a nearly JPY100 bln surplus in November. The trade balance in the last month of a quarter has tended to be the best of quarter going back to Q3 22.
Prices: The 10-year yield fell to around 4.4% last week, the lowest since mid-December, and the dollar fell to its lowest level against the yen since mid-December too. The yield recovered after the employment report and the dollar recovered to around JPY152.40 from a session low slightly below JPY151. We suspect a near-term low is in place and look for the greenback to recover in the days ahead and a move above JPY152.80 would bolster our confidence.
UK
Drivers: After cutting rates last week, the Bank of England is seen likely pausing at next month's meeting (March 20) before cutting again in May (~90% discounted). Except for a day in late November, the UK has offered a premium over the US for two-year month since late August. It is not a at a small discount. The rolling 30-day correlation between changes in sterling and the euro is above 0.85, among the strongest since November 2023.
Data: The highlight of the week is the Q4 GDP and December details. The UK economy stagnated in Q3. The monthly GDP contracted by 0.1% in October and grew 0.1% in November. December may have expanded by 0.1%. In Q4, consumption looks a little stronger, but the real boost came from government spending. The Bank of England projects 1.5% growth this year. The IMF and OECB forecasts are 1.6% and 1.7%, respectively.
Prices: Sterling traded in a $1.2250-$1.2550 range last week and settled near $1.2400 to leave it virtually flat for the week. The momentum indicators are still constructive but getting over extended. A combination of firm US inflation and soft UK GDP may keep the pressure on sterling. A break of the $1.2360-70 area could signal a retest of last week's lows.
Canada
Drivers: The tariff war with the US is poses a significant threat to the Canadian economy. Even prior to the tariffs, the divergence of policy was a weight on the Canadian dollar. Canada's two-year yield reached a discount of almost 167 bp less than the US to borrow for two years before the employment data before the weekend. It settled a little below 160 bp. It is Canada's largest discount in more than a quarter-of-a-century. The tension with the US comes at a difficult time for Canada. Parliament has been prorogued (suspended) until March 24 as the Liberal Party holds its leadership contest. It may limit the ability of provide fiscal support for what appears to a potential significant hit to the Canada economy. Canada's Chamber of Commerce estimates the tariff war could cut Canada's GDP by about 2.6%.
Data: Canada's data in the coming days are second tier reports, such as December building permits and manufacturing and wholesale sales.
Prices: The Canadian dollar looks constructive. The continued strong growth in full-time positions and the unexpected drop in the unemployment rate, while the US tariff threat has been postponed, has lifted the Canadian dollar to January's high. The greenback found support in January near CAD1.4260 and CAD1.4270 last week. The momentum indicators give the US dollar scope to extend its losses in the coming days, with formidable support near CAD1.4200. The odds of a Bank of Canada rate cut at next month’s meeting has been fallen to around 60% from 75% a week ago.
Australia
Drivers: The US runs a small trade deficit with Australia, and this may help keep Australia out of the crosshairs of the new US administration. The Reserve Bank of Australia is widely expected to begin its easing cycle (February 18), and the swaps market is pricing in almost 100 bp of cuts over the next 12 months. Australia's national election, which must be held on or before May 17 is not yet a focus in the market but will more inside the three-month window, which in a common hedging window.
Data: The economic calendar is light in the coming days. There are consumer and business confidence surveys early in the week. Home-loans value for Q4 should not be expected to move the market. The Melbourne Institute February consumer inflation expectations may draw some attention but is unlikely to discourage the speculation of start of the easing cycle. Last February, it stood at 4.5%. Last year's low was set at 3.8% in November. It rose to 4.2% in December before pulling back to 4.0% in January.
Prices: The Australian dollar set a nine-day high ahead of the weekend near $0.6300, but the threat of reciprocal tariffs saw it reverse lower and briefly took out the previous session's low (~$0.6255). A convincing break of $0.6250 could signal losses into the $0.6170-$0.6200 area.
Mexico
Drivers: The US tariff threat and then its postponement saw wide gyrations on February 3. The dollar covered a nearly MN20.30-MXN21.30 range. It spent the remainder of the week below MN20.7150, while the low remained intact. The central bank cut the overnight rate by 50 bp to 9.50% and signaled scope for a similar move next month, though the meeting is after the new tariff deadline.
Data: Mexico's economic data is overwhelmed by the tariff dispute. News in late January that the Mexican economy contracted by a sharper-than-expected 0.6% (quarter-over-quarter) in Q4 likely reduces the sting from weakness December's industrial output (February 11). Given the tariff context, the Mexico's auto production and export figures may attract attention. In December, auto exports exceeded auto production. This seems largely like a year-end distortion, but we cannot rule out that some exports were aimed to beating tariffs.
Prices: The range from February 3 may continue to mark the near-term range for the exchange rate. Within that range, the greenback looks poised to test the MXN20.70-80 area. The peso rose by about 0.4% last week. but settled poorly. Although it traded within the previous session's range ahead of the weekend, the close was slightly below MXN20.60. The momentum indicators are not giving strong signals. When everything was said and done, the implied one-month volatility settled near 14.6%, slight above the previous week's settlement, but well off the intra-week high of a little more than 16%, nearly a three-month high. It was near 12% at the end of last year.
Reviewed by Marc Chandler
on
February 08, 2025
Rating:
