Tariffs, AI Disruptions, and the Fed: A Market Caught in the Crossfire

Overshadowing a Federal Reserve (Fed) rate decision is no easy feat, regardless of how uneventful a particular meeting may seem. Yet this week, a relentless wave of tariff rhetoric from President Trump and the disruptive "DeepSeek shock" in the AI sector have managed to divert attention. Tuesday’s trading session underscored just how volatile politically driven markets can be. A single comment from Trump, advocating for steeper tariffs than those proposed by his officials, was enough to send investors flocking to the U.S. dollar, which strengthened against all G10 currencies. With the February 1st deadline approaching, the first round of tariff rollouts is imminent, including new levies on chips, pharmaceuticals, and steel.

Despite these distractions, Wednesday’s Fed decision remains pivotal in shaping global monetary policy in the coming months. Policymakers are expected to hold rates steady, pausing the easing cycle that began in September. This decision unfolds against a complex backdrop of escalating trade tensions and AI-driven market turmoil, which has triggered a sharp equity sell-off. However, the Fed’s room to maneuver remains limited. Markets have fully priced in an unchanged rate stance, and with the labour market showing resilience, any deviation could be risky. Inflation has trended favourably over the past year, but the recent slowdown in disinflation gives the Fed little incentive to make an aggressive shift.

With a strong U.S. economy and looming tariff uncertainties, it would likely take a major global market downturn to push the Fed toward a dovish stance in early 2024. The balancing act between risk sentiment and monetary policy was evident this week, as equity market turbulence marginally increased expectations of future rate cuts. Moving forward, the Fed’s ability to navigate these competing forces will determine whether this pause turns into a prolonged hold or a return to rate easing later in the year.

Euro Struggles as Markets Bet on Aggressive ECB Rate Cuts

Traders are increasingly betting on significant rate cuts from the European Central Bank (ECB) this year, driven by concerns over the Eurozone’s sluggish economic outlook. Growth remains fragile, business sentiment is weak, and consumer spending lacks momentum, fueling expectations of policy easing to support demand. However, persistent inflationary pressures—both domestic and global—complicate the ECB’s decision-making.

Although inflation has cooled from its peak, underlying price pressures, particularly in wages and services, remain sticky. Inflation expectations, after reaching a low, have started to rise again. At the same time, global risks—including supply chain disruptions, volatile commodity prices, and potential trade tensions—pose fresh challenges, limiting the ECB’s ability to ease aggressively.

For now, EUR/USD remains heavily influenced by U.S. market developments. After peaking around $1.0530 earlier this year, the euro has slipped into the low $1.04 range amid selling pressure ahead of the Federal Reserve meeting. The currency now awaits further direction from central bank decisions and looming tariff risks. So far, its performance aligns with expectations of a bottoming phase, with little room for significant upside. This is further supported by declining bond market risk premia, as the French-German yield spread narrows from over 90 basis points last year to 72 basis points, signalling renewed investor interest in French bonds.

Rachel Reeves’ Fiscal Strategy in Focus as Markets Seek Clarity

Amid recent instability in UK assets and a growing disconnect between sterling and gilt yields, Rachel Reeves’ speech today has captured market attention. With limited fiscal headroom, she faces mounting pressure to tighten spending plans while simultaneously identifying new investment avenues to stimulate economic growth. Investor sentiment will be crucial—a well-received strategy could strengthen sterling, while uncertainty may trigger further volatility in UK markets.

A key proposal under consideration is the "surplus release" plan, which would unlock corporate pension scheme surpluses—worth tens of billions of pounds—for reinvestment in British businesses and infrastructure. Additionally, markets anticipate government backing for major infrastructure projects, including a potential third runway at Heathrow Airport. These initiatives aim to revitalize the UK economy by attracting investment and fostering long-term growth.

Sterling and gilt movements will depend on how effectively Reeves conveys her economic vision. If her proposals are viewed as both pro-growth and fiscally responsible, gilt yields could rise in an orderly manner, signalling confidence in the UK’s long-term prospects. Such a scenario could push GBP/USD above $1.25 and GBP/EUR toward €1.20. However, a lack of clarity or doubts over policy execution could weigh on investor confidence, putting renewed pressure on the pound.

Dollar Poised for Rebound Amid New Tariff Push

Following its steepest weekly decline in months due to softer tariff rhetoric, the dollar appears set for a recovery. Treasury Secretary Scott Bessent announced plans to advocate for new universal tariffs on U.S. imports, starting at 2.5% and increasing gradually. This policy shift is expected to sustain uncertainty, dampen risk sentiment, and boost the USD alongside heightened market volatility.

Nvidia, a leading beneficiary of AI chip investments, saw its shares plummet by approximately 17%, erasing nearly $600 billion in market value—the largest single-day loss for any company. Traditional safe-haven currencies, such as the Japanese yen and Swiss franc, climbed nearly 1% against the US dollar as risk aversion spread from equities and bonds into the FX markets. Persistent concerns over AI investments, compounded by Trump's latest tariff threats, have continued to weigh on risk sentiment.

Euro Rises Amid AI Disruption and Positive Economic Signals

Cautious optimism is emerging among euro buyers as the currency benefits from a mix of AI-driven market upheaval and improving European economic data. The “DeepSeek shock”—an announcement of a ground-breaking AI spinout from Zhejiang University, featuring an open-source model outperforming industry leaders at lower costs—sparked a broad sell-off in U.S. equity markets.

Typically, such risk-off sentiment would drive investors toward safe-haven currencies like the Swiss franc and Japanese yen, both of which gained against the euro. However, EUR/USD defied expectations on Monday, climbing above the $1.05 mark for the first time this year. Investors appear to be rethinking the “U.S. equity exceptionalism” narrative, redirecting flows away from the dollar despite falling stock prices.

Adding to the euro’s momentum, European macroeconomic data continues to show signs of stabilization. Recent indicators, including PMIs and the Ifo index, have exceeded forecasts over the past two sessions. The Ifo Current Conditions Index notably rose to 86.1, its highest reading since August 2024.

Despite these encouraging developments, the euro’s potential for further gains remains limited. Weak economic growth prospects and escalating trade tensions could constrain its upside in the near term.

Pound Weakens Amid Risk Aversion and Domestic Inflation Concerns

The British pound, a risk-sensitive currency, has faced renewed selling pressure this week against safe-haven peers such as the USD, JPY, and CHF. GBP/USD recently broke above the downtrend line that had guided trading since last October but encountered resistance at its 50-day moving average. While the pair remains about 3% above its 1-year low, it is over 7% below its 2024 peak.

On Monday, both the pound and the euro gained ground against the dollar despite the "DeepSeek shock" disrupting market sentiment. However, by Tuesday, renewed tariff threats from Donald Trump caused both currencies to underperform the dollar.

Domestically, UK food prices surged at their fastest pace in nine months at the start of 2025, according to British Retail Consortium data. This development intensifies inflation concerns ahead of next week's Bank of England meeting, keeping stagflation fears alive. This has contributed to a recent decoupling between rising gilt yields and the pound’s performance, further weighing on the currency.

Pound Sterling Poised for Further Gains Against the Euro

GBP appears set to extend its recovery against the Euro in a week shaped by the European Central Bank (ECB) interest rate decision and Germany’s inflation data.

As markets anticipate Thursday’s expected ECB interest rate cut, the Pound to Euro exchange rate (GBPEUR) has climbed to 1.19—a two-week high—breaking above the 200-day exponential moving average (EMA).

Should GBPEUR sustain multiple daily closes above the 200 EMA, it would signal the end of a brief downtrend, paving the way for a potential return to levels of 1.20 and higher in the weeks ahead.

The GBP/EUR pair is now trading above the nine-day EMA, with the Relative Strength Index (RSI) pointing higher, signalling positive short-term momentum for the coming hours and the next two to three days.

A test of 1.1950 is anticipated ahead of Thursday’s European Central Bank (ECB) decision and Friday’s German CPI inflation release—two key events in an otherwise quiet week for UK data. The ECB is expected to cut interest rates by 25 basis points while maintaining guidance similar to previous meetings. This guidance will emphasize data-driven rate decisions without committing to a preset path for further cuts.

Lower rates are aimed at stimulating growth in the Eurozone, though inflation remains stubbornly above the ECB’s 2.0% target. Last week’s unexpectedly strong PMI data offers a glimmer of optimism, suggesting the Eurozone economy may have bottomed out. This could lead the ECB to adopt a cautiously optimistic tone, pushing back against calls to accelerate rate cuts and offering a temporary boost to the euro.

However, the ECB is unlikely to make sufficiently "hawkish" statements to sustain a meaningful rally for the euro, and traders may consider fading any GBP/EUR dips following the announcement.

Friday’s German CPI inflation data is expected to show a flat monthly rate of 0% for January, down from 0.5% in December. This would confirm that inflation is under control in the Eurozone’s largest economy, reinforcing the case for lower interest rates and countering any hawkish interpretations from the ECB’s earlier comments.

Will History Repeat? Examining the US Dollar Under Trump’s Presidency

Reflecting on Donald Trump’s first presidential term, the US dollar weakened in 2017 following a strong rally in 2016. As Trump begins his second term, early signals suggest a potential repeat of history. Last week, the Greenback suffered its worst performance in five months, weighed down by selling pressure after Trump expressed a preference for avoiding tariffs on China and urged the Federal Reserve to cut interest rates.

While interest rate differentials typically support the dollar, market sentiment and short squeezes could counteract this effect. Hedge funds and large speculators currently hold their most significant long-dollar positions since 2019. Furthermore, the dollar appears historically overvalued, having returned to 1985 levels when adjusted for inflation differentials. Trump might leverage this by pressuring trading partners to strengthen their currencies, possibly using tariffs as a bargaining tool. However, the US economy remains robust, as underscored by Friday’s strong PMI data showing the manufacturing sector’s first expansion since July 2024.

The week ahead will be pivotal, from the US driven by key themes such as inflation, trade politics, and central bank decisions. Wednesday’s FOMC decision will set the tone for currency markets, followed by Friday’s PCE data, which is expected to show an acceleration in December’s inflation rate (m/m).

Can Europe’s Economy Defy Investor Pessimism?

Investor sentiment toward the European economy has been predominantly negative, driven by fears of recession, sluggish growth, and geopolitical tensions. However, much of this pessimism is already priced into the market, creating a low bar for positive surprises. This means any unexpected improvement in economic data could spark a strong market reaction in the coming year.

Recent economic data supports this outlook. The Eurozone composite PMI rose from 49.6 to 50.2, surpassing expectations, while the UK’s PMI climbed to 50.9 against a forecast of 50.1, marking two years of consistent monthly private-sector growth. These indicators suggest that Europe’s economic momentum may have bottomed out.

The euro has gained support from recent positive developments, including a softening in Trump’s tariff rhetoric and the expansion of Eurozone private-sector activity. These factors have helped reduce the risk premium embedded in the euro, diminishing expectations for EUR/USD to reach parity.

Nevertheless, uncertainty over Trump’s trade policies toward the EU could cap further gains. Structural challenges, such as slowing growth and shifting monetary policies, may also weigh on the euro in the weeks ahead. The $1.02 level is expected to provide strong support, while the European Central Bank is anticipated to cut rates in the coming week, with at least three additional cuts likely by year-end.

Japanese Yen Swings After Rate Hike

The Bank of Japan (BoJ) implemented a widely anticipated 25 basis point increase in interest rates earlier this morning, alongside issuing significantly higher inflation projections. The core CPI estimate for 2025 was revised upwards to 2.4% from the previous 1.9%. Markets have already priced in an additional 32 basis points of easing by the end of the year.

Initially, the yen gained strength but later reversed course following Governor Ueda’s press conference. The USD/JPY’s recovery prior to the press conference suggests that Tokyo traders perceive Ueda as hesitant to raise rates again in the near term. While this does not diminish the yen’s potential for longer-term appreciation, it offers yen bulls a reason to exercise caution this Friday.

The GBP/JPY has declined by 2% since the beginning of the year but has risen by over 1% this week, edging closer to the 192 mark.

Dollar Set for Largest Weekly Decline in Months

The US dollar has faced renewed selling pressure after President Donald Trump called for the Federal Reserve (Fed) to cut interest rates immediately. The US dollar index is on track for its steepest weekly drop in five months, reflecting a continued decline in US Treasury yields.

Speaking at the World Economic Forum in Davos, Trump remarked, “With oil prices going down, I’ll demand that interest rates drop immediately, and likewise they should be dropping all over the world.” Attention now shifts to next week’s Fed monetary policy meeting. Following 100 basis points of rate cuts, the Fed has indicated that further reductions would require evidence of economic slowdown and softer inflation data. While Trump’s low-tax, deregulation policies bode well for economic growth, his immigration restrictions and trade tariffs pose upward risks to inflation, suggesting further rate cuts may be a long way off.

On the data front, initial jobless claims in the US increased by 6,000 to 223,000 for the week ending 18 January, slightly exceeding the forecast of 220,000. Continuing claims, representing individuals still receiving benefits, surged to 1.9 million—the highest level since November 2021—highlighting extended job search durations.

Euro Nearly 2% Stronger This Week

The euro has rallied to nearly $1.05 against the US dollar as of Friday, poised for its largest weekly gain in over a year. This surge has been driven by renewed dollar weakness as investors await greater clarity on President Donald Trump’s policy agenda. Flash PMI data will be closely monitored to assess whether the euro’s recovery can maintain momentum.

In the early days of his presidency, Trump refrained from implementing stringent trade penalties, easing concerns about protectionist policies stifling global growth and driving US inflation higher. His pro-business measures lifted investor sentiment, though tensions remain as he criticised the EU and hinted at potential tariffs. European Central Bank (ECB) President Christine Lagarde urged Europe to prepare for possible trade measures, commending Trump’s decision to delay blanket tariffs as “very prudent.”

On the monetary policy front, the ECB is expected to continue its accommodative stance, with markets anticipating a 25 basis point cut to the deposit rate next week. Meanwhile, consumer confidence in the Euro Area improved slightly to -14.2 in January 2025, in line with market expectations. Consumers remain optimistic about further ECB rate reductions this year.