There is great uncertainty for investors and policymakers. The magnitude and timing of U.S. tariffs are not clear. China unveiled DeepSeek, which appears to give other advanced language model AIs a run for their money and calls into question the effectiveness of technology curbs.
While Russia's invasion of Ukraine, the war in the Middle East, and China's harassment of its neighbors have dominated the geopolitical story, the U.S. has entered the fray of wolf diplomacy. President Trump has indicated a desire to take back the Panama Canal and acquire Greenland, explicitly not ruling out the use of force, and telling Canada that tariffs could be avoided if it were to become part of the United States. We offer a historical framework to make sense of these developments.
The post-WWII period was characterized by the evolving freer cross-border movement of goods, services, and capital. There was nothing natural or inevitable about it. As the revisionist power early in the 20th century, the U.S. embraced the spirit of Pax Britannica and dubbed it the “Open Door.” It was specifically articulated by the U.S. Secretary of State at the time and offered an alternative to the carving up of China by European imperialist powers and Japan through political concessions, like Hong Kong or the Bund District, for example.
The U.S. elites were not convinced, and the rejection of the League of Nations and reluctance to replace the UK in international finance signaled that the U.S. “Open Door” was not ready for prime time. However, the WWII experience persuaded Americans that peace and prosperity required it to shape the post-war order. In effect, the U.S. globalized the “Open Door.” The U.S. was instrumental in constructing a multilateral system anchored by institutions like the IMF, World Bank, and GATT. This liberal international order promoted open trade and cooperative conflict resolution, with the U.S. serving as the primary global rule-enforcer. It has veto powers at the IMF and, by tradition, picks the World Bank President.
The end of the Cold War, the rise of China, and arguably growing disparities of wealth and income in the U.S., Europe, and Japan undermined the domestic alliances that embraced the Open Door. The shift appears to have begun around the time of the Great Financial Crisis and been reinforced by the pandemic. In the U.S., the Tea Party predated the GFC, but MAGA and Reform 2025 are much more than the Tea Party envisioned. In Europe, there has long been a segment of the electorate that did not embrace regional integration or globalization, but since the GFC and the sovereign debt crisis, those forces appear to have strengthened.
Despite calls for another Bretton Woods, the material conditions do not exist. Eurasia’s Ian Bremmer calls it the “G-Zero world.” The idea is that international capitalism works best when there is one country strong enough and willing to impose and enforce rules of engagement. That does not exist now, and if that is the case, the Open Door may not be the optimal strategy for the United States.
The abandonment of the Open Door and the return to spheres of influence may offer a useful framework for understanding the changes being ushered in by the new U.S. administration. The need to retake control of the Panama Canal, make Canada a state within the United States, and the “need” to possess Greenland may not have been part of the campaign, but they seem to be a logical extension of eschewing the Open Door.
Trump wants the U.S. to secure its sphere of influence for the 21st century. Embracing spheres of influence also implies that the U.S. may not spend American lives blocking another power from securing a sphere of influence. Trump’s team seems to be willing to concede some (more) Ukrainian territory (in addition to Crimea) to Russia and/or perhaps reduce some deal in East Asia, which the U.S. may now view more in economic competition terms rather than as strategic partners.
The dissolution of the post-WWII order is in the making and is over-determined. It has reached a tipping point. The restoration of the former elite that embraced the globalization of the Open Door after Trump’s first term was given the benefit of the doubt under Biden. Once may be dismissed as an accident, but the U.S. has now withdrawn twice from the Paris Accord and the World Health Organization.
Spheres of influence? Open Door? It is a bit like Heisenberg's "uncertainty principle." The mere fact of "measuring" the world like this makes it so. The U.S. defection from the Open Door will encourage other defections. If the U.S. no longer has the will or strength to defend the global rules of engagement, the tectonic plates of the global chessboard will change.
Near-shoring and friend-shoring of supply chains may have been encouraged before, but now, there are growing incentives for onshoring. Businesses may face greater risk of disruptions, which may speak to the need for some strategic redundancies, robust continuity planning, and trusted advisors that can help navigate through a possible labyrinth of conflicting rules, regulations, and tax authorities.
Last month, the US dollar extended the uptrend that ironically began in late September around the time the Federal Reserve began its easing cycle with a 50 bp cut. However, by the middle of the month, about a week before the inauguration the dollar's gains were pared. It settled lower against most of the G10 currencies.
Three currencies in Bannockburn World Currency Index fell in January. The Indian rupee was the weakest with a 1.2% loss. Sterling and the Canadian dollar both fell by about 1% Together these three account for almost 11% of the Index. Among the G10 members, the yen's 1.3% gain led. The pullback in US yields in the second half of January and a hawkish Bank of Japan helped.
Among the emerging market components, the Russian ruble's 15% appreciation is a distortion, but Russia's GDP (World Bank) gives it only a 2.4% weighing in the BWCI. It was worth about a third of an index point. Still, it had a a greater impact than the Brazilian real (+5.7%), South Korean won (+1.2%) and Mexican peso (+0.7%) put together which accounted for a fifth of an index point.
U.S. Dollar: There appears to be a broad consensus that should the US impose tariffs as President Trump has threatened, the dollar would appreciate. While it is true that exchange rates could be used to offset part of the tariff but there are other forces that drive exchange rates. Tariffs are also understood to be inflationary, which may deter the Federal Reserve from easing policy and also buoy the dollar. Yet, tariffs in Trump's first term did not spur inflation and did nothing to improve the overall US trade deficit. Moreover, the tariffs threatened would be tantamount to a large tax that could potentially stifle growth. The Dollar Index fell for the first time since September. It rallied by about 10% from the late September low through the mid-January high, and has pulled back by about 3% in the second half of the month. We suspect the downside correction is over or nearly so. The pendulum of market expectations briefly considered the possibility of no Fed cuts this year, and some economists have argued the next move is a hike, but by the end of January, the futures market had again converged with Fed officials, where the median projection in December was for two cuts this year.
Euro: The euro's slide that began in late September, around the time of the Federal Reserve's 50 bp cut extended though the first two weeks of the new year. It bottomed a week before Trump's inauguration near $1.0180, its lowest level since November 2022. Subsequently, it staged its biggest recovery since last July-August but stalled in front an important band of resistance in the $1.0560-75 area. The swaps market has a little more tan another 50 bp of ECB cuts priced in by mid-year. With the ECB's rate cut in late January, the policy rate differential with the US is about 160 bp. The US two-year premium finished last year a little below 220 bp and fell to 195 bp by late January, suggest much of the divergence has been discounted. Nevertheless, the euro looks vulnerable in the period ahead. Germany holds national elections on February 23. The CDU is running well ahead in the polls but will not secure a majority. The polls suggest that mathematically the easiest way to put together a majority government may be to break the taboo and invite the AfD into the government. Yet, the defeat of the immigration bill at the end of January warns that this might not be sufficient. Without it, the CDU will have to negotiate with two and possibly three other political parties. At the same time, a consensus appears to be emerging that the debt brake has outlived its usefulness, and the challenge posed by Russia, China, and the United States may qualify as the type of crisis that can lead to greater European integration.
(As of January 31, indicative closing prices, previous in parentheses)
Spot: $1.0360 ($1.0310) Median Bloomberg One-month forecast: $1.0335 ($1.0345) One-month forward: $1.0375 ($1.0320) One-month implied vol: 7.4% (8.7%)
Japanese Yen: Helped by rising US 10-year yields in the first part of January, the dollar reached a six-month high slightly below JPY159. As US rates pulled back, so did the greenback and it set the month's low in late January near JPY153.70 along side decline in the US 10-year yield. The correlation between changes in the exchange rate and 10-year US yields is near 0.70 over the past 30 days and nearly that high for the past 60 days. This is higher than the correlation with the 10-year yield differential. Japan's headline and core inflation measures are distorted by the government's energy subsidies for households. The measure that excludes fresh food and energy finished 2024 at 2.4% year-over-year. It was at 3.7% at the end of 2023. The headline measure stood at 3.6% at the end of 2024, up from 2.6% at the end of the previous year. Energy subsidies have been reintroduced for the first three months of 2025. After raising the overnight target rate by 25 bp to 0.50% in late January, the Bank of Japan is likely on hold until late this year. The swaps market is pricing in a terminal rate near 1% in 2026. Japan records an overall trade deficit but runs a bilateral surplus with the US of about $74 bln in 2023 and $57 bln in the first nine months of 2024. Autos and parts are among Japan's biggest exports to the US and are vulnerable to US tariffs as the Trump administration seeks to re-shore the auto production.
Spot: JPY155.20 (JPY157.25) Median Bloomberg One-month forecast: JPY154.15 (JPY154.95) One-month forward: JPY154.70 (JPY156.80). One-month implied vol: 9.6% (10.5%)
British Pound: Sterling's slightly less than 0.6% decline in January gave it the dubious honor of being among the weakest G10 currency. Growth disappointed and the budget deficit was larger than projected by the Labour government, which has seen it support steadily erode last summer's election. It may be punished in the spring local elections. Price pressures have moderated and the mini-Gilt meltdown has passed, the Bank of England is set to resume its easing cycle with a quarter-point cut at the February 6 meeting. The swaps market has the next cut discount for toward the middle of the year. Sterling tested $1.21 in mid-January, culminating a roughly 10% slide since the end of last September. It was the weakest sterling has been since November 2023. The recovery stalled in late January near $1.2525. Scope for additional gains looks limited without better domestic news or a broader pullback in the dollar.
Spot: $1.2395 ($1.2425) Median Bloomberg One-month forecast: $1.2400 ($1.2490) One-month forward: $1.2400 ($1.2420) One-month implied vol: 7.9% (8.6%)
Canadian Dollar: The Bank of Canada delivered a quarter-point rate cut in late January and culminating the 200 bp campaign beginning last June. It does not meet again until March 12, by which time it will have more data in hand and the tariff threat from the US may be clearer. We suspect the bar to a cut is relatively high, all else being equal, but would recognize that the imposition of tariffs would be a sufficient economic shock to prompt a policy response. The Liberal Party leadership contest March 9. And even then, it is unclear whether the Liberal Party leader can sustain a confidence vote in parliament without a majority. The Bank of Canada's policy reaction function would at first instance likely see broad US tariffs as a threat to growth. The 25% tariffs would likely spur a federal government response to the economic shock. The Canadian dollar looks vulnerable, and the divergence of policy has lifted the US two-year premium over Canada to a new high since H1 97. The dollar is approaching the upper end of where it has traded in a couple of decades. The highwater mark was seen in early 2016 and approached again in the early days of the pandemic, a little below CAD1.47.
Spot: CAD1.4540 (CAD 1.4450) Median Bloomberg One-month forecast: CAD1.4425 (CAD1.4355) One-month forward: CAD1.4525 (CAD1.4430) One-month implied vol: 8.5% (6.9%)
Australian Dollar: The downtrend that began from almost $0.6950 at the end of last September, saw the Australian dollar approach the edge of a technical abyss in the middle of January ($0.6000-$0.6100). It recovered nearly a quarter of the loss before stalling a little above $0.6300. The softer than expect Q4 CPI reported in late January clears one of the remain hurdles to the beginning of the central bank's easing cycle at its February 18 meeting. Outside of the the Bank of Japan, Australia is only G10 central bank that has not cut rates. The market expects its to play a little catch-up, with at least three cuts are discounted in the futures market for this year. Important technical support is seen in the $0.6000-$0.6100 area. A break of it leaves nothing on the charts before the pandemic low near $0.5500. Australia may be vulnerable to some product specific US tariffs, but it has an overall trade deficit with the US.
Spot: $0.6220 ($0.6215) Median Bloomberg One-month forecast: $0.6255 ($0.6285) One-month forward: $0.6215 ($0.6220) One-month implied vol: 9.6% (10.5%)
Mexican Peso: Within the first 24 hours of his second term, Trump renewed his threat of 25% tariffs on imports from Mexico and declared a state of emergency at the US southern border. Still, the dollar peaked against the peso on January 17, the session before the inauguration near MXN20.94, and subsequently has held below MXN20.90. The Mexican economy is vulnerable to US tariffs. Exports to the US account for around a quarter of Mexico's GDP, even though an estimated 40-50% of the exports are from affiliates of US companies. Trump has threatened tariffs on Mexico as early as February 1, but also instructed the cabinet to review the trade and migration flows by April 1. Late last year, the central bank suggested that it could accelerate the pace of interest rate reductions. After five quarter-point rate cuts, the risk is of a 50 bp cut at the February 6 meeting. The swaps market has about 150 bp of cuts discounted for this year, though we fear that a sharp depreciation of the peso would temper the central bank's hand for fear of imported inflation.
Spot: MXN20.68 (MXN20.63) Median Bloomberg One-month forecast: MXN20.71 (MXN20.67) One-month forward: MXN20.76 (MXN20.7565) One-month implied vol: 14.7% (12.3%)
Chinese Yuan: The yuan fell by around 4.5% from late September through mid-January. Many observers feared that Beijing would allow the yuan to decline in the face of US tariff threats. To the contrary, the PBOC opportunistically lowered the dollar's reference rate from around CNY20.19 at the end of 2024 to slightly below CNY7.17 by the end of January. By lowering the fix, the PBOC brought the dollar's 2% cap down. Although there are some signs that the implosion of the property market is easing, and despite efforts to support equities, the CSI 300 lost nearly 3% after rising a little more than 1% in November-December 2024. Although Q4 24 GDP and the details were mostly stronger than expected, January's composite PMI fell 4% to 50.1, the largest decline since April 2023, raising questions about the economic momentum at the start of the year. The stream of reforms, most recently, "cash-for-clunkers," a subsidized auto trade-in program, which ironically is likely to help expand the China's used-car market, continues, seems to confirm Beijing is still not content. That said, the PBOC chose to rely on a new facility ("outright reverse repurchases agreements") to provide liquidity over the Lunar New Year and suspended its bond purchases, seemingly signaling it wants to avoid a further slide in yields. Lastly, China's trade practices and "wolf diplomacy" has been the source of much criticism, in recent weeks, China's technological achievements engendered a sense of awe, like DeepSeek, fusion technology, creating oxygen in space.
Spot: CNY7.2445 (CNY7.3215) Median Bloomberg One-month forecast: CNY7.5025 (CNY7.3285) One-month forward: CNY7.2425 (CNY7.1870) One-month implied vol: 4.8% (4.8%)
Reviewed by Marc Chandler
on
February 01, 2025
Rating:
