In recent weeks, while Russia's war on Ukraine continues and Beijing continues to harass its neighbors, the U.S. tariff threats and doubts that its defense commitments will be sustained, have emerged as the most significant challenge for businesses, investors, and policymakers. These tariffs are aimed at protecting domestic industries, forcing a re-shoring of production, and raising revenue. If, and when implemented, the tariffs can be expected to impact economic growth, inflation, and various industrial sectors. It signals a further break from the multilateralism of the past.
If the past few weeks are anything to go by, the transition away from the US traditional approach to trade and defense are unsettling as transitions often are. In the first instance, it has meant greater volatility, which in the capital markets, means risk. It also means uncertainty, and the lack of visibility is often associated with cautiousness on the part of business in making investment decisions.
Ironically, the changes that are being ushered in by the new US administration are most disruptive to US allies that have relied on the American market and military protection. So far, the Dollar Index, a basket of major currencies, peaked on January 13, a week before President Trump’s inauguration. It had rallied nearly 10% from the end of last September through mid-January. Profit-taking kicked, and even when the 25% tariffs on Canada and Mexico looked imminent in early February, the Dollar Index was unable to set a new high.
Instead, “tariff fatigue" emerged as a dominant narrative as the Dollar Index fell 3.6% from the January peak. The tariffs were seen to be bluster and a negotiating tactic. However, as February drew to a close, Trump reiterated his intention to impose the 25% tariff on Mexico and Canada (except its energy exports), announced another 10% tariff on China (including Hong Kong), and indicated he was still moving toward tariffs on the EU, and industry specific tariffs, on steel, aluminum, copper, autos, semiconductors, pharma, and lumber. The Dollar Index finished February on a firm note and reached a two-week high on the last day of the month.
We are still in the early days of Trump's second term. We suspect there is a profound shift taking place. We see the tariffs as part of a broader implementation of Trump's world view that is predicated on the US being a victim, which has been a common theme in both the mainstream and social media in the US. The US traditional allies are seen, in this framing, as having harmed it the most. In late February, for the first time since 1945, the US voted with Russia and against Europe at the United Nations on a European security issue. Some of Trump's advisors want to eject Canada from the Five-Eyes intelligence sharing group.
We argue that grand shift of the geopolitical and economic tectonic plates. The next 4-6 weeks risk even greater disruption. The 25% tariffs on Canada and Mexico for border issues (undocumented migration and fentanyl) were postponed until March 4. On March 12, the U.S. has threatening 25% tariff on steel and aluminum imports. Reciprocal tariffs could come into effect in early April, but more likely will have a later start date. President Trump also has signaled that tariffs on auto imports may could be announced on April 2. As of now, the only tariff that has been imposed was an additional 10% levy on all imports from China and Hong Kong).
The economic consequences of tariffs are multifaceted and complex. Sometimes, as we have seen in the past, they do a poor job of boosting the competitiveness of US industries, while creating space for domestic companies to raise prices. Yet, rising prices to end-users is only one, albeit common, result. Profit-margins of either the domestic producer or the foreign producer can absorb some of the higher tariffs.
The exchange rate could also bear part of the burden, but there are various forces that impact the currency market. The Mexican peso, and Chinese yuan, for example finished February stronger than they were at the end of last year. The Canadian dollar is the only G10 currency lower on the year as of the end of February, and that is a minor 0.25% decline.
Economists often argue that tariffs have contradictory economic impulses. They can be both inflationary in the first instance, and the higher prices weaken aggregate demand in the next. There is also risk of two shocks from the labor market. The first are what appears to be 1000s of government workers let go. The impact may begin showing up in the data in soon but may be more of a Q2-Q3 story. Government jobs traditionally stabilize the economy during recessions by providing steady employment and income. The loss of thousands of federal workers reduces disposable income, adversely affecting local economies and businesses that depend on consumer spending.
The second is the impact of the cooling of immigration that began in the middle of last year., while the policies of the new administration may extend and accelerate the trend. In the 12 months since January 2024, foreign born employment rose by 1.9 mln (to 31.8 mln), while domestic born employment rose by 766k (to 130.6 mln). The increase in the labor force has been an under-appreciated tailwind to the economy. Growth, after all, is a function of aggregate hours worked and productivity.
For its part, cognizant of the criticism of its post-Covid response that it was slow to recognize the persistence of supply-shock price pressures, Federal Reserve officials have indicated that they will be particularly sensitive to it now. Nevertheless, many officials anticipate being able to resume easing policy later this year. As February wound down, investors appear to have grown more concerned about an economic downturn than inflation. The derivatives market has around an 88% chance of the next Fed cut in June and at least one in H2 25. As recently as February 12, the market had the effective Fed funds rate a little above 4%. It finished the month a little below 3.75%.
By the time the Fed cuts again, the swaps market is discounting at least two more quarter-point cuts by the European Central Bank, and at least one cut by the Bank of England, the Bank of Canada, the Swiss National Bank, and the Reserve Bank of Australia and the Reserve Bank of New Zealand. The market suspects Sweden's Riksbank may be done cutting until Q3, while Norway's Norges Bank is expected to begin its easing cycle in March, with another cut likely in Q3.
Emerging market constituents did not fare as well. Three of the six fell and they account for a little more than 27.5% of the BWCI. The onshore yuan eased by around 0.55%, though the offshore yuan appreciated by about 0.45%. The Indian rupee fell by around 1%, and the Korean won slipped approximately 0.5%. With Trump having the US seem to side with Russia (accusing Ukraine of starting the war and must accept more territorial loss given the lives Russia lost trying to take it), it is little wonder that the Russian ruble was the strongest currency in that Bannockburn World Currency Index, rising a little more than 11%. The Japanese yen's nearly 3% gain was the largest of the G10 currencies, helped by fall of US rates and the BOJ's commitment to continue to normalize monetary policy.
U.S. Dollar: After the dollar's Q4 24 rally carried into the first part of January, it peaked before the Trump's second inauguration and trended lower through most of February. The postponement of the tariffs on Canada and Mexico supported the priors of those who believe the tariffs were a negotiating tactic and arguably encouraged a complacency that concluded that until implemented the tariffs were not to be believed until actually seen. Nevertheless, in late February, as Trump renewed his tariff threat on Canada and Mexico for March 4, the Dollar Index rallied the most in three weeks and settled February at two-week highs. US interest rates trended lower from mid-January. The dollar's recovery in late February took place even as US rates continued to decline. The US two-year yield settled below 4% at end of February for the first time in four months. The 10-year yield slipped below 4.20% and traded through its 200-day moving average for the first time this year. Growth concerns were highlighted by Atlanta Fed's GDP tracker warning of a 1.5% contraction. In the middle of February, it was still tracking around 2.3% annualized growth. And this is before tariffs (except on China) are implemented and before the large-scale federal government lay-offs expected. Another wild card is the US debt ceiling on March 15. This could lead to a government shutdown. The economic impact is a function of breadth and duration. As of the end of February, none of the 12 appropriation bills have been signed. Only four times has the federal government been shut for more than one business day. During Trump's first term, when the GOP had a majority in both houses, the federal government was shut for a record 35 days in late 2018 and early 2019.
Euro: The euro recovered from the spike low in early February to almost $1.0140 when US tariffs on Canada and Mexico looked imminent. When they were postponed, and disappointing January US retail sales and a contraction in manufacturing output saw the euro recover but was unable to take out the January high near $1.0535. The risk is that the broad sideways movement of the past couple of months has alleviated the overbought technical condition and euro is poised to weaken. The momentum indicators are set to turn lower, and the US tariff threats may re-emerge as a key issue in the coming weeks. Europe is at risk of becoming marginalized by the US-Russia accord and the broader reversal of US traditional policy thrust. Europe, it is often said, grows by crisis, and the crisis spurred by the change in the US political discourse is of historic proportions. It may be sufficient for Germany to eschew its debt brake, and for the EC to consider joint bonds for defense spending. The market is highly confident that the European Central Bank will cut rate key rates by 25 bp in early March and again before the end of Q2. The current deposit rate target is 2.75% and the swaps market has near 1.80% at the end of the year.
(As of February 28, indicative closing prices, previous in parentheses)
Spot: $1.0375 ($1.0360) Median Bloomberg One-month forecast: $1.0300 ($1.0335) One-month forward: $1.0395 ($1.0375) One-month implied vol: 7.6% (7.4%)
Japanese Yen: A combination of softer US 10-year interest rates and higher Japanese rates helped lift the yen by over 3% in February. The US dollar peaked on January 10 near JPY159. It trended lower in most of February and traded to almost JPY148.55 in the last week of February, its lowest level since last October. The (50%) retracement of the dollar's rally from the middle of last September (~JPY139.60) was near JPY149.20. The next retracement (61.8%) is around JPY147.00. Still, the dollar proved resilient in late February despite the slide in the US 10-year yield. Moreover, the 10-year JGB yield has fallen in only two weeks since mid-December. The yield reached almost 1.45% in the second half of February. It has not been higher since 2009. Japan's January CPI stood at 4% compared with 3% in the US. The last time Japan's CPI was above the US was in 1997-1998. The BOJ is committed to continue normalizing monetary policy. Although market surveys show a preference for a July hike, the swaps market does not have the next hike fully discounted until early Q4.
Spot: JPY150.65 (JPY155.20 Median Bloomberg One-month forecast: JPY152.00 (JPY154.15) One-month forward: JPY150.10 (JPY154.70). One-month implied vol: 10.8% (9.6%)
British Pound: Sterling extended its recovery from $1.21 seen in mid-January and reached almost $1.2715 on February 26, its best level in two months. It overshot the (38.2%) retracement of its decline from the $1.3454 area seen late last September, which was found a little above $1.2600. We suspect the upside correction is over, and that sterling can pull back toward $1.2300-$1.2400 in the coming weeks. The Bank of England meets on March 20, but it is too soon to expect another rate cut, especially given the acceleration of wage growth and firm core (3.7%) and services inflation (5.0%). The swaps market has about an 80% chance of a May cut and another cut in H2 discounted. The British economy eked out 0.1% growth (quarter-over-quarter) in Q4 24 after it stagnated in Q3 24. Growth in Q1 looks a bit better around 0.3%. The UK will pay for its increased defense spending by further cutting its foreign aid program. It has offered peace-keeping troops after a ceasefire in Ukraine. The UK may escape of harshest US tariffs. According to its figures, it records a small bilateral trade surplus with the US, while US data suggests it has a small bilateral trade surplus. Also, Trump does not like the European Union and claimed on February 26, that it was formed "in order to screw the United States,” which actually had been encouraged by the United States, under both Republican and Democratic presidents.
Spot: $1.2575 ($1.2395) Median Bloomberg One-month forecast: $1.2400 ($1.2400) One-month forward: $1.2580 ($1.2400) One-month implied vol: 7.5% (7.9%)
Canadian Dollar: The US dollar spiked to almost CAD1.48 in early February before the American 25% tariffs (10% on energy) were postponed for a month, its highest level in more than two decade. Subsequently, the greenback's gains were unwound, and by mid-February traded down to a two-month low near CAD1.4150. The downside momentum stalled, and the US dollar looks poised to trade higher in the coming weeks. Canada is vulnerable to the new US tariffs in the coming weeks. The 25% tariff for undocumented migration and fentanyl may still be implemented on March 4. A couple of weeks later, the US has threatened 25% tariffs on steel and aluminum. In early April, tariffs on auto and lumber are threatened. Tariffs on lumber and copper would also adversely impact Canada. The Bank of Canada estimates that 25% tariff on Canada's exports to the US (10% on energy) could cut Canada's GDP by 3% over the following two years. The Bank of Canada meets on March 12, and the swaps market is pricing about a 50% chance of a cut, which is fully discounted at the April 16 meeting. Between now and the end of the year, the swaps market has two cuts fully discounted and about 40% chance of a third cut. Meanwhile, the Liberal Party's leadership contest comes to a head on March 9. Former Bank of Canada and Bank of England Governor Mark Carney is well ahead. Potentially facing a confidence vote shortly after parliament reconvenes on March 24, there is speculation that Carney could call for a snap election (possibly April 21).
Spot: CAD1.4460 (CAD 1.4540) Median Bloomberg One-month forecast: CAD1.4400 (CAD1.4425) One-month forward: CAD1.4440 (CAD1.4525) One-month implied vol: 7.6% (8.5%)
Australian Dollar: The threat of US tariffs in early February drove the Australian dollar to a new five-year low slightly below $0.6100. It recovered to briefly poke above $0.6400 on February 21, which practically met a technical retracement target from the Australian dollar's slide from last September (~$0.6940). The rebound was extended even after the Reserve Bank of Australia began its easing cycle with a 25-bp cut on February 18. However, the correction looks to have run its course. As the market's worry turns to growth, the Australian dollar (and New Zealand dollar) under-performed. The central bank made it clear that would remain cautious and the futures market does not have the next cut fully discounted until July. The market has about 60 bp of cuts discounted for the remainder of the year. Australia must have a national election by May 17. Incumbent parties in most high-income countries faltered last year, and the fate of the Labor government may be the same. It is trailing behind the Liberal-National coalition.
Spot: $0.6210 ($0.6220) Median Bloomberg One-month forecast: $0.6300 ($0.6255) One-month forward: $0.6215 ($0.6215) One-month implied vol: 9.9% (9.6%)
Mexican Peso: When 25% tariffs on exports to the US looked inevitable on February 3, the dollar spiked to almost MXN21.30, a three-year high. However, the one-month postponement saw the greenback's gains unwind and the month's low was set near MXN20.20 on February 19. The tariffs for undocumented migration and fentanyl may still come into effect on March 4. Also, Mexico is vulnerable to sectoral tariffs, especially on steel and autos, which could be forthcoming in the coming weeks. Mexico's economy is weak. It contracted by 0.6% in Q4 24 and appears to have little momentum to start the new year. Yet, with inflation back within the 3% +/- 1% target range, the central bank has scope to continue to cut its overnight rate. After five quarter-point cuts in 2024, Banxico delivered a 50 bp in February. It kept door open to another 50 bp cut at the March 27 meeting. By then the US tariff picture would be clearer. As the peso recovered in recent weeks, the benchmark three-month implied volatility has fallen from almost 15% to around 12.5%, the lower end of where it has traded over the last eight months. For the right type of exposure, options may offer an attractive alternative to the forward.
Spot: MXN20.55 (MXN20.68) Median Bloomberg One-month forecast: MXN20.75 (MXN20.71) One-month forward: MXN20.75 (MXN20.76) One-month implied vol: 13.3% (14.7%)
Chinese Yuan: Chinese officials do not appear to have tried offsetting the 10% US tariff imposed in early February by depreciating the yuan. The onshore yuan fell less than 0.2% in February, while the offshore yuan appreciated by about 0.75%. The PBOC set the dollar's reference rate in a narrow range in recent weeks, though it has crept up in late February. Beijing's efforts to support the equity market is not generating strong results, as the CSI 300 is off 1.1% year-to-date, while the MSCI Asia Pacific Index's is up about 3%. However, the index of mainland shares that trade in Hong Kong is up almost 15.5%. China's 10-year yield discount to the US has fallen from a record near 320 bp in mid-January to less than 250 bp at the end of February. While the fall in house prices is slowing and disinflation forces among consumer prices is lessening, the Chinese economy appear to require more stimulus if the economy is to grow around 5% this year. The National People's Congress runs from March 5 through March 11 and may lay the groundwork.
Spot: CNY7.2785 (CNY7.2445) Median Bloomberg One-month forecast: CNY7.3500 (CNY7.5025) One-month forward: CNY7.1855 (CNY7.2425) One-month implied vol: 4.8% (4.8%)
Reviewed by Marc Chandler
on
March 01, 2025
Rating:
