Tariff Fatigue and Hidden PPI Optimism

Investors experienced a volatile trading session yesterday, with inflation data and trade-related headlines driving price fluctuations across asset classes. The US President has ordered a review of reciprocal tariffs, aiming to address trade imbalances through country-specific levies. The final outcome is expected by 1 April, raising concerns about potential retaliatory measures and prolonged trade uncertainty.

Meanwhile, January’s Producer Price Index (PPI) came in higher than expected, briefly stoking inflation fears. However, key components feeding into the Federal Reserve’s preferred Personal Consumption Expenditures (PCE) index showed declines in areas such as healthcare services and airfares, shifting focus to the upcoming PCE release on 28 February. US government bond yields fell across the curve by nearly the same magnitude they had risen following the Consumer Price Index (CPI) surprise. Equities moved higher in response.

The US dollar continued its decline for a third consecutive day, weakening against all G10 currencies on Thursday. This reflects two key dynamics: (1) investors remain highly sensitive to inflation data as they gauge the trajectory of price pressures, and (2) foreign exchange markets are displaying signs of fatigue regarding tariff-related news.

While Trump’s trade rhetoric and tariff policies will remain major market drivers, investors are becoming more discerning in their reactions. Given Trump’s history of shifting positions on key trade issues, markets are now responding with a more measured approach rather than overreacting to every development.

Euro Gains 1.3% This Week

The euro has strengthened for three consecutive days against the US dollar, breaking above $1.04 and marking a new high for February, solidifying its breakout above the 20-day moving average. After several failed attempts to sustain gains earlier in the week, the pair appears to have made a decisive move, shifting the short-term bias to the upside.

The evolving tariff narrative continues to keep currency traders engaged. However, the delayed implementation of tariffs has allowed the euro to advance this week, a move further boosted by constructive developments in the Russia-Ukraine conflict, despite European and Ukrainian officials reportedly being excluded from negotiations thus far. Nonetheless, bullish momentum for the euro may start to wane if the pair fails to close the week above $1.0450. The outlook for the single currency remains fragile due to weak Eurozone economic performance and firm expectations that the European Central Bank (ECB) will extend its monetary easing cycle, with inflationary pressures expected to sustainably return to the 2% target by year-end.

From a technical standpoint, $1.05 is emerging as the next key resistance level. On the downside, the 20- and 50-day moving averages may now serve as support, but if the pair falls back below $1.0350, the risk of a steeper decline increases, particularly given the lingering negative drivers weighing on the euro.

Digging into the GDP Figures

Sterling’s positive reaction to the UK’s stronger-than-expected GDP figures was short-lived, as the bigger takeaway is that the economy remains stuck in a low-growth trap—an ongoing challenge for both the Treasury and the Bank of England (BoE). That said, GBP/USD has held above its 50-day moving average and remained above $1.25, supported by US dollar weakness amid positive tariff and geopolitical news.

The UK ranked mid-table for growth among G7 nations at the end of last year, outperforming its European counterparts and avoiding a technical recession. Growth was driven by strength in the services and construction sectors, although the manufacturing sector remains in recession. However, a closer look at the data reveals that the primary driver behind the 0.1% expansion in the final quarter of 2024 was a surge in inventories, with businesses stockpiling raw materials and components. These figures tend to be highly volatile, while more telling indicators such as household consumption, exports, and business investment were all flat or negative. Notably, business investment contracted by 3.2%, and the production sector shrank for a fifth consecutive period—both indicators of underlying weakness that could dampen hiring and wage growth. This could also reinforce the disinflationary trend, which may keep the BoE on its easing path—providing a tailwind for gilts but a headwind for sterling.

The BoE expects economic weakness to persist into 2025 and recently halved its growth forecast for this year to 0.7%. Dovish members of the Monetary Policy Committee are increasingly concerned that a slowdown necessitates more substantial rate cuts. Next week’s UK inflation report will offer further insights. While the January figures may not reflect it, upside risks to inflation are growing in the coming months due to the sharp rally in natural gas prices and adjustments to UK energy and water bills.

Dollar Decline Surprises the Market, Not Us

The US dollar weakened yesterday against the euro, despite US inflation coming in hotter than expected and Treasury yields rising across the curve. Equities ended the day in negative territory but managed to recover more than half of their intra-day losses. Consumer prices exceeded expectations across multiple measures, with the monthly figure reaching 0.5% and the core reading at 0.4%, both surpassing forecasts of 0.3%. Headline inflation has now returned to 3% for the first time since June 2024. In response, Federal Reserve Chair Jerome Powell acknowledged that the latest data indicated further work was needed to bring inflation under control.

Markets reacted to the inflation surprise and Powell’s comments by scaling back expectations for interest rate cuts, now anticipating just one reduction this year. However, the dollar failed to capitalise on this shift, confirming its asymmetric reaction function. Instead, geopolitical optimism took precedence. Reports surfaced suggesting that President Trump may be actively working on a peace deal with Ukrainian President Zelensky and Russian President Putin.

This development bolstered risk sentiment, lowered oil prices, and overshadowed the Fed repricing, putting downward pressure on the US dollar. The market reaction aligns with our view that, for now, positive geopolitical developments have a greater influence on foreign exchange markets than concerns about a delay in Fed rate cuts. If this trend persists, the dollar could remain vulnerable despite resilient US economic data.

Euro Strengthens Amid External Factors

The euro appreciated, defying the backdrop of rising US bond yields and revised Fed rate expectations. While US inflation exceeded forecasts—pushing Treasury yields higher and leading investors to price in just one Fed rate cut this year—the dollar weakened due to optimistic geopolitical developments. Reports that President Trump may be negotiating a peace deal with Ukrainian President Zelensky and Russian President Putin shifted market sentiment, reinforcing our view that geopolitical optimism currently outweighs Fed-related concerns.

In Europe, European Central Bank (ECB) policymaker Joachim Nagel further supported the euro by advocating a cautious approach to monetary easing. Speaking in London, the Bundesbank President dismissed the idea of targeting a theoretical “neutral” interest rate, instead urging caution in the ECB’s rate-cutting trajectory. This aligns with our perspective that, while the ECB is set to lower interest rates, expectations of aggressive easing may be overstated. With markets reassessing Fed rate cut expectations and the ECB signalling a measured approach, euro sentiment remains well-supported.

For the time being, investors appear more focused on geopolitical tailwinds than on narrowing nominal interest rate differentials. It is also worth noting that US market-based inflation expectations have been rising for some time, with certain maturities (such as the five-year tenor) reaching their highest levels in years. This theoretically reduces the real rate differential between the US and Europe.

Sterling Rises Above $1.25 Following Strong UK GDP Data

Sterling initially fell sharply against the US dollar following the release of the US inflation report but swiftly recovered as risk appetite improved amid encouraging geopolitical news regarding a potential resolution to the war in Ukraine. As a result, the euro and central and eastern European currencies outperformed, causing GBP/EUR to lose its grip on the €1.20 level. Safe-haven currencies such as the Japanese yen tumbled, with GBP/JPY now up nearly 3% week-to-date.

Meanwhile, GBP/USD has surpassed its 50-day moving average at $1.2475. A daily close above this level would increase the likelihood of a move towards the $1.26-$1.27 range. However, despite stretched US dollar positioning and valuation, there remain numerous dollar-positive drivers that could limit sterling’s upside. Indeed, foreign exchange options traders are taking precautions against a potential decline in the pound. GBP/USD one-month risk reversals are two standard deviations lower than their one-year average, indicating that traders are significantly more concerned about sterling weakening over the next month than they have been on average over the past year. Meanwhile, one-month implied volatility—reflecting the market’s expectations for price fluctuations—has stabilised after hitting two-year highs in January but remains within the 80th percentile of observations over the past year.

On the macroeconomic front, UK GDP data released this morning exceeded expectations, providing a further boost to sterling. Preliminary fourth-quarter GDP unexpectedly expanded by 0.1% on a quarterly basis, defying expectations of a 0.1% contraction. Additionally, December’s industrial production data came in slightly better than anticipated, contracting by 1.9% year-on-year compared with the forecasted -2.1%. These figures highlight the resilience of the UK economy, which should support the pound in the short term as traders reassess expectations for the Bank of England’s interest rate trajectory. Traders now anticipate 55 basis points of rate cuts, down from over 60 basis points priced in at yesterday’s close.

However, we remain mindful that the UK is not immune to global economic headwinds, particularly given the slowdown in trade due to tariffs. Furthermore, while the UK maintains a balanced goods trade relationship with the US, it runs a significant trade surplus in services, which could be vulnerable to tariffs extending beyond goods trade—although such measures are typically more challenging to implement.

GBP/USD

The GBP/USD pair managed to shake off its recent bearish momentum on Tuesday, snapping a three-day losing streak and regaining ground around the 1.2450 level. This recovery came as traders reassessed the US Dollar’s strength, leading to some renewed demand for the Pound. However, despite the rebound, GBP/USD remains constrained below the 50-day Exponential Moving Average (EMA), which hovers near the psychological 1.2500 threshold.

Market sentiment around the pair continues to be influenced by expectations regarding monetary policy from both the Bank of England (BoE) and the Federal Reserve. While the BoE remains cautious about its next steps, recent economic indicators suggest the UK economy may be slowing, which could weigh on Sterling. On the US side, the Dollar has been supported by resilient labour market data and persistent inflationary pressures, leading to speculation that the Federal Reserve may maintain higher interest rates for longer.

Looking ahead, GBP/USD traders will be closely monitoring upcoming macroeconomic data releases, including UK GDP figures and US inflation data. A weaker-than-expected UK GDP print could reinforce concerns about a potential recession, exerting downward pressure on the Pound. Conversely, any signs of cooling US inflation might weaken the Dollar, potentially allowing GBP/USD to push toward the 1.2500 resistance. Technical indicators suggest that while short-term bullish momentum has emerged, the pair needs a sustained break above 1.2500 to confirm a broader trend reversal. Until then, GBP/USD is likely to trade within its recent range, with key support around 1.2400 and further resistance near 1.2550.

GBP/EUR

At the time of writing, GBP/EUR was trading near €1.2009, largely unchanged from Wednesday’s opening levels. The Euro remained subdued on Tuesday amid escalating concerns over transatlantic trade tensions. The latest developments saw US President Donald Trump impose a 25% tariff on all steel and alluminum imports, a move that quickly drew condemnation from the European Union. European Commission President Ursula von der Leyen labelled the tariffs as ‘unjustified’ and vowed to introduce firm countermeasures.

This growing risk of a trade war between the US and the EU has rattled Euro investors, as prolonged tensions could weigh on Eurozone growth prospects. Additionally, the possibility of retaliatory tariffs has fuelled speculation that the European Central Bank (ECB) may be forced to consider further interest rate cuts in the coming months to support the region’s economy.

Meanwhile, the Pound saw limited movement on Tuesday as investors assessed comments from Bank of England Governor Andrew Bailey. While Bailey refrained from discussing monetary policy, his remarks on financial stability clashed with UK Chancellor Rachel Reeves’ pro-growth stance. This divergence in views could add uncertainty to the UK’s economic outlook.

With the second half of the week underway, the focus for GBP/EUR will shift to the UK’s latest GDP data. Analysts expect a 0.1% contraction in Q4 2024, following stagnation in Q3. If confirmed, this could amplify recession fears and weigh on the Pound. Additionally, the Euro’s inverse correlation with the US Dollar means strong US inflation data could weaken the Euro further if it drives demand for the ‘Greenback.’

EUR/USD

EUR/USD showed signs of strengthening as the Relative Strength Index (RSI) climbed to 60, indicating increased buying interest. The pair also closed three consecutive four-hour candles above the 200-period Simple Moving Average (SMA), reinforcing the bullish outlook.

Key resistance levels lie between 1.0390 and 1.0400, where the 100-period SMA aligns with the 50% Fibonacci retracement of the latest downtrend. If this zone is breached, the next upside targets are 1.0440 (61.8% Fibonacci retracement) and 1.0500-1.0510, where another key Fibonacci level aligns with a psychological round number.

On the downside, initial support is expected around 1.0290-1.0300, where the 23.6% Fibonacci retracement aligns with a round number level. Below this, 1.0250 and 1.0200 serve as additional static support zones. Traders will be watching upcoming US inflation figures, as stronger-than-expected data could boost the Dollar and pressure EUR/USD lower, while softer inflation could support further gains for the Euro.

Unpacking a Puzzling Dollar Decline

The US dollar index fell yesterday, struggling to hold above its 50-day moving average and an upward-sloping trendline that has been in place for several months. The dollar weakened against most major currencies, except for the traditional safe havens—the Japanese yen and Swiss franc. This decline was somewhat surprising given the risk aversion in equity markets amid fresh US tariffs and cautious rhetoric from the Federal Reserve, which pushed US yields higher across the curve.

Signs of Tariff Fatigue in FX
US President Donald Trump signed a proclamation to reinstate a 25% tariff on steel and aluminium imports, effective from 12 March. The European Union vowed to retaliate, raising the prospect of an escalating trade dispute between transatlantic allies. The EU may act swiftly by reintroducing duties it first imposed on the US during Trump’s previous term. Tariff risks remain significant, as evidenced by recurring headlines, yet currency markets took the latest developments in their stride, with risk-sensitive FX gaining ground against the dollar.

A review of macroeconomic data does not fully explain the dollar’s decline either. Admittedly, sentiment among small-business owners in the US dipped slightly in January from December’s six-year high, largely due to uncertainty over tariffs and their potential impact on growth and inflation. However, business owners remain largely optimistic about deregulation and tax policies, with 77% believing it is a good time to expand and 47% expecting improved business conditions ahead.

Monetary Policy Rhetoric
Cleveland Fed President Hammack indicated a preference for keeping interest rates steady for the foreseeable future, while Fed Chair Powell reinforced the message of patience on rate cuts during his semi-annual monetary policy testimony to the Senate. Markets remained unfazed, continuing to price in just one additional Fed cut this year.

Perhaps investors are wary that US economic growth could slow due to tariffs, inflation, and tight monetary policy. Alternatively, the dollar’s valuation may simply be stretched. Bullish positioning on the greenback is crowded, and as we have previously argued, with trade risks and the Fed’s pause already priced in, the dollar likely requires evidence of an even stronger US economic backdrop or a sharp deterioration in global risk sentiment to advance significantly.

Euro Searching for Clarity Amid Uncertainty
Market positioning on the euro is approaching levels last seen during the initial wave of the pandemic in 2020. The single currency faces multiple headwinds, ranging from weak Eurozone cyclical dynamics and dovish monetary policy to political and geopolitical risks, particularly in light of Trump’s tariff threats. Rising natural gas prices are another concern.

European gas reserves are being depleted at their fastest rate since the 2022 energy crisis due to a combination of cold weather and declining Russian gas imports. Seasonal price spreads also made it uneconomical to replenish stocks during the summer. As a result, some EU nations have fallen short of their storage targets, and with the bloc’s reserves standing at around 50% capacity in early February—well below the roughly 70% recorded last year—concerns over future supply have triggered a surge in gas prices to fresh two-year highs. This is negative for the euro and supportive of the dollar, adding further downward pressure on EUR/USD.

Since the US election, the correlation between US and euro area interest rates has weakened significantly, reflecting diverging expectations for growth and inflation between the two regions. This widening rate differential is another drag on EUR/USD.

Political uncertainty in Europe could also be a source of volatility, although markets appear relatively relaxed about the upcoming German election. Two-week options on the euro, which encompass the election period, imply a potential 1.5% move in EUR/USD in either direction. From the current spot price, this would still leave EUR/USD above $1.01, but given the array of risks facing the euro, a move towards parity remains a possibility. For now, the weaker dollar is allowing EUR/USD to push above $1.03, with its 50-day moving average in sight around $1.04, though the move may prove short-lived.

That said, several factors could offer support for the euro. A softer tariff outcome, a Ukraine-Russia ceasefire, looser fiscal policy in Germany, a cyclical rebound in China, or a downturn in the US economy could all act as catalysts for a more meaningful euro recovery.

Sterling Records Best Day in Two Weeks
The pound ended a three-day losing streak against the US dollar on Tuesday, recording its best daily performance (+0.6%) in over two weeks, thanks to broad-based dollar weakness. However, sterling also gained against a range of other currencies, notably against safe-haven peers such as the Japanese yen (+1.0%) and Swiss franc (+0.9%), as well as higher-beta currencies like the Norwegian krone and Australian dollar. This suggests that a modest paring of Bank of England (BoE) easing expectations may have also played a role in supporting the pound.

BoE policymaker and noted hawk, Catherine Mann, clarified yesterday why she advocated for a 50-basis-point cut last week. She emphasised that this was not a signal for immediate further cuts but rather an attempt to “cut through the noise” and enhance communication with global markets. She also highlighted the need for continued restrictive monetary policy to tackle persistent inflation. Recent survey data suggests that wage disinflation is expected over the course of the year, though inflation expectations remain elevated and above levels consistent with the BoE’s 2% target.

As a result, traders scaled back expectations for BoE rate cuts this year, now pricing in 60 basis points of easing, down from 66bps at the start of the week. Looking ahead, key economic data releases early tomorrow—including GDP estimates for December, preliminary Q4 growth figures, and industrial and manufacturing output for December—will be closely watched by sterling traders, following today’s US CPI report.