Tariff Fears Weigh on Peso and Loonie
Investors were on edge yesterday as global markets began the week with a mix of optimism and uncertainty following Donald Trump’s inauguration for a second term. Reports and comments from the president himself about the United States considering steep tariffs on Mexico, Canada, and China sent ripples through financial markets, raising questions about how global trade dynamics might shift in the months ahead. Foreign exchange traders reacted swiftly, with the price of options products betting on further Canadian dollar weakness climbing to its highest level in two years.
In Europe, investors took some solace in the fact that no immediate tariffs had been introduced, though concerns about the future persist. Meanwhile, Chinese officials sought to reassure markets about economic stability as growth remains fragile. Despite these uncertainties, equity benchmarks across the developed world managed to edge higher, supported by robust corporate earnings, which helped offset fears surrounding trade policy. Longer-term bond yields continued to decline, offering welcome relief to currency markets, which had been contending with a stronger dollar until last week.
The US Dollar Index is already on track to decline for a second consecutive week, a trend last observed in September 2024. As the year progresses, markets are bracing for heightened volatility. With trade policy, central bank decisions, and geopolitical risks all in play, investors are navigating a complex macroeconomic landscape where any policy surprise could trigger sharp market movements.
Animal Spirits Push the Euro Beyond $1.04
Investor sentiment towards the European economy has been overwhelmingly negative, with fears of recession, weak growth prospects, and ongoing geopolitical risks dominating the narrative. However, much of this pessimism is already reflected in asset prices, creating an environment where the bar for positive surprises is exceptionally low.
This was underscored by yesterday’s ZEW investor survey, in which zero percent of participants described the Eurozone economy as being in good shape. The German sentiment index fell more than expected, remaining in deeply negative territory. This asymmetry in expectations means that any upside surprise in economic data—be it stronger-than-expected growth, resilient consumer spending, or even a modest improvement in business confidence—could provoke an outsized market reaction this year.
Such developments could have significant implications for the euro in the medium term. For now, however, its rally is being driven by market sentiment and dollar weakness, as investors respond to Trump’s decision to delay immediate tariff hikes. EUR/USD extended Monday’s gains, pushing beyond the $1.04 mark, with last week’s lows of $1.02 already fading into memory. Nevertheless, as the pair climbs higher, selling pressure is likely to increase, given the Eurozone’s continued vulnerability to potential US tariffs.
Sterling Still Stuck in a Downtrend
The British pound is currently 2% higher than its recent one-year low against the US dollar. Its recovery from $1.21 faltered just below the $1.24 threshold, leaving the downtrend that began in October intact. Although sterling has benefited from this week’s broadly weaker dollar, ongoing concerns about UK stagflation—characterised by persistently high inflation and stagnant economic growth—continue to weigh on the currency.
On Tuesday, data revealed that wage growth accelerated to a six-month high in the three months to November, aligning with expectations. However, the unemployment rate unexpectedly rose to 4.4%, alongside the steepest drop in payroll numbers since November 2020, hinting at potential softening in the labour market. While higher wages prompted traders to slightly scale back rate expectations, the likelihood of a rate cut at the Bank of England’s (BoE) February meeting remains above 80%. Sterling appears to be caught between a rock and a hard place. Its current negative correlation with rates and yields reflects concerns about the UK’s slowing economic growth and rising government debt burdens. Yet, stronger signals from the BoE about the need for interest rate cuts would likely further weaken sterling due to its impact on yields.
For the pound to stage a sustainable recovery against its peers, including the euro, UK economic data will need to show improvement alongside greater confidence in fiscal policy. This morning’s data, indicating that the UK government borrowed more than expected in December, highlights the significant challenges facing Chancellor Rachel Reeves.