ECB Cuts Interest Rates Amid Economic Uncertainty and US Tariff Threats

The European Central Bank (ECB) has lowered interest rates across the 20-member eurozone for the second time this year in an effort to stimulate economic activity. The move comes as Europe braces for potential economic fallout from Donald Trump's plan to impose damaging tariffs on EU exports to the US.

The Frankfurt-based central bank reduced its benchmark deposit rate by 0.25 percentage points to 2.5%, aligning with expectations from City economists. This decision coincides with Trump’s preparations to implement 25% tariffs on all EU imports, mirroring previous actions against Canada and Mexico.

“The disinflation process is well on track,” the ECB stated, adding that inflation trends remain in line with previous forecasts.

Despite six rate cuts in the past year, ECB officials are cautious about further reductions amid global economic volatility. Inflation eased slightly in February, dropping to 2.4% from 2.5% in January, while services inflation fell to 3.7%—the lowest since April 2024. However, rising energy prices linked to geopolitical tensions, including ongoing “peace talks” regarding Russia’s invasion of Ukraine, could disrupt expectations that inflation will reach the 2% target by early 2026.

The ECB also reduced its main refinancing rate, which banks pay when borrowing weekly from the central bank, by 0.25 percentage points to 2.65%. The marginal lending facility rate, charged for overnight borrowing, was cut from 3.15% to 2.90%.

In addition to economic concerns, the ECB faces pressure to manage eurozone government borrowing costs. German chancellor-in-waiting Friedrich Merz has vowed that Germany will “do whatever it takes” to bolster its defence capabilities, adding further uncertainty to the region’s financial landscape.

GBP/EUR trading 0.5% lower following the cut, with interbank at 1.1911, EUR/USD 1.0820.

GBP/USD Surges to 4-Month Highs Amid US Dollar Weakness

The ongoing decline of the US dollar has propelled GBP/USD to fresh four-month highs, surpassing the $1.29 mark. The pair has broken through key resistance levels, including the closely monitored 200-day and 200-week moving averages, signalling a bullish trend. Additionally, short-term risk reversals in the FX options market, favouring further sterling strength, have reached their highest levels in nearly five years.

Investor expectations of US dollar outperformance due to trade war tensions are waning, as concerns over stagflation in the US take centre stage. Instead of seeking the USD as a safe haven, traders are focusing on weaker US economic data compared to improving UK and European data, boosting the pound. Interest rate differentials are also shifting in favour of the UK and Europe, as rising bets on Federal Reserve rate cuts contrast with surging German bund yields. The UK’s 10-year yield saw its largest jump in over a year, lifting UK-US yield spreads to an 18-month high, further fuelling sterling’s rally.

Despite a near 7% climb from January’s $1.21 low and a 2.6% rally this week, GBP/USD is now in overbought territory, according to the 14-day relative strength index. This suggests a possible consolidation or pullback, with the psychological $1.30 level now acting as the next resistance. Meanwhile, GBP/EUR has dropped 1.5% this week, experiencing its sharpest single-day loss in five months as stronger euro inflows take precedence.

Germany’s Bold Spending Shift Fuels Euro Strength

Germany is set to make a historic shift in its fiscal policy with a multi-billion-euro commitment to boost infrastructure and defence spending. To fund these initiatives, the government plans to amend the constitution, enabling it to borrow substantial sums. This move has sent German 10-year bond yields soaring—a key indicator of debt costs. Incoming Chancellor Friedrich Merz emphasized the urgency, stating in Berlin on Tuesday, “In view of the threats to our freedom and peace on our continent, the motto ‘whatever it takes’ must now apply to the country’s defence.”

The surge in bond yields is attracting global investors seeking higher returns, leading to strong capital inflows into the euro. This has strengthened the single currency, causing GBP/EUR to suffer its steepest single-day decline in five months on Wednesday, bringing the week's total drop to 1.55%.

For years, economists and analysts have argued that Germany’s rigid debt controls have stifled economic expansion, particularly in times of economic hardship. The newly proposed measures, backed by both the conservative CDU/CSU bloc and the ruling Social Democrats (SPD), aim to change this. Key reforms include exempting defence spending exceeding 1% of GDP from debt restrictions and establishing a €500 billion infrastructure fund to modernize critical sectors and stimulate economic growth.

This shift in fiscal policy marks a decisive move away from austerity and toward greater investment—an approach analysts predict will bolster the euro and European assets. European defence stocks have already surged, contributing to the Eurozone’s equity market outperforming the U.S. in 2025. Meanwhile, the European Union is preparing to raise up to €150 billion through special bond issuances to finance military spending. By leveraging the EU’s top-tier credit rating, member states can access funds at significantly lower interest rates than if they borrowed individually.

Germany’s strategic pivot signals a new era of fiscal flexibility, positioning the euro as an increasingly attractive prospect for global investors.

Trade War Intensifies as New Tariffs Shake Markets

The US administration implemented fresh tariffs yesterday, raising duties on most Canadian and Mexican imports to 25% and doubling the tariff on Chinese goods from 10% to 20%. The response was swift—Canada unveiled a phased tariff plan affecting roughly $100 billion in US exports, Mexico is expected to introduce similar measures by week’s end, and China imposed tariffs of up to 15% on select US products.

Investors had previously downplayed tariff risks, reassured by Trump’s repeated delays and policy adjustments. However, this latest escalation signals a worsening in trade relations, amplifying concerns over a potential US recession. Investors have taken note, increasing the odds of the US economy contracting for two consecutive quarters this year from 23% last week to 37% today. Fixed-income markets reflect this shift as well, with traders now fully pricing in three Federal Reserve rate cuts before year’s end.

GBP

The British pound is climbing sharply against the US dollar as weaker US economic data erodes the narrative of American economic superiority. This shift has narrowed the performance gap between the US and other economies. GBP/USD has surged past both its 200-day and 200-week moving averages, approaching the $1.28 mark this morning—right in line with its five-year average and nearly 6% above its January low of $1.21.

With key resistance levels breached, market sentiment around GBP/USD has flipped from bearish to bullish. A pullback was initially expected before a rebound, but Trump-era trades appear to be unwinding faster than anticipated, and the dollar's tariff-related risk premium is rapidly diminishing. Investors are now shifting their focus from inflationary concerns to potential growth risks in the US. Meanwhile, expectations for UK interest rates suggest they may remain elevated longer than previously thought. Bank of England Governor Andrew Bailey recently projected four rate cuts in 2025, but persistent consumer price pressures and private sector wage growth could delay the timeline.

EUR

The Federal Reserve’s shift toward a more accommodative stance has propelled the Eurozone-US real rate differential to its highest level since September—an impressive rebound from its one-year low in December, just weeks before EUR/USD hit a two-year low. This changing landscape suggests the euro may have further upside potential in the coming weeks, moving closer to its fair-value range based on real rate differentials. Adding to the momentum, reports from Brussels indicate that the EU’s plans to increase defence spending could bolster economic growth prospects and temper expectations for aggressive European Central Bank (ECB) rate cuts.

As the ECB convenes on Thursday, markets have already priced in a 25-basis point rate cut. However, policymakers may tweak their messaging, signalling that additional rate reductions beyond March are no longer a certainty. Such a shift could prompt markets to reassess their outlook on future cuts, strengthening the euro’s position and fuelling further gains.

The saga continues

The US dollar is likely to face continued pressure throughout the remainder of the week. Market participants are closely monitoring trade developments, economic indicators and geopolitical tensions with on-going peace talks with the Russia/Ukraine conflict, all of which could influence the dollar's trajectory in the short term.

Tariffs and DOGE Shake Market Confidence, Fuelling Fed Rate Cut Bets

Tariffs and DOGE are undermining market confidence and increasing expectations that the Federal Reserve will need to cut interest rates further. The U.S. Dollar fell nearly 1% after President Donald Trump confirmed that tariffs on Mexico and Canada would proceed, signalling that markets view the move as detrimental to the U.S. economy. The Dollar also registered similar losses against the Euro and Yen.

In response, Canada and China imposed reciprocal tariffs after Trump announced an additional 10% increase on February’s existing 10% tariff on Chinese imports. The U.S. Dollar Index, which measures the Dollar’s broad value, dropped 0.80% on the day of the announcement—its largest decline in four weeks. Previously, the Dollar had shown resilience amid tariff escalations, but this shift suggests a weakening trend as the trade war continues.

Signs of an economic slowdown in the U.S. are becoming evident, prompting financial markets to anticipate more aggressive rate cuts from the Federal Reserve. Money markets indicate that investors are pricing in 75 basis points of cuts by the December meeting—equivalent to three 25bp cuts—up from a single expected cut in early February. This is weighing on U.S. bond yields, which, in turn, is pressuring the Dollar.

Economic indicators reflect growing concerns. Monday’s Services PMI for February highlighted that DOGE spending cuts are affecting private sector spending decisions, while the latest Manufacturing ISM report emphasized the uncertainty surrounding tariffs. The February headline index stood at 50.3, a slight decline of 0.6 points from January.

This morning GBP/USD rose above 1.2800, a new two-and-a-half month peak.