Dollar Dominates as Tariff Wars Begin

February 03, 2025
  • The tariff wars have begun; the currency market reaction has been brutal; Fed officials will be quizzed about the impact of the tariffs on inflation and Fed policy; ISM manufacturing PMI for January will be the highlight; January PMIs will also be reported for Canada
  • Eurozone January CPI ran a little hot; Turkey January CPI also ran hot
  • BOJ released the summary of opinions for its January 23-24 meeting; Australia reported firm December and Q4 retail sales; Caixin reported soft January manufacturing PMI

The dollar surged as the tariff wars begin. DXY is traded near 110 after President Trump reiterated his threat to impose 25% tariffs on Canada and Mexico at 1201 AM ET tonight (see below). The yen is the only currency that’s up today, with USD/JPY trading lower near 154.65 on some haven flows. We view this as a buying opportunity (see below). Sterling is outperforming as the U.K. avoids tariffs (for now) but is still trading lower near $1.2315, while the euro traded as low as $1.0140 on Trump tariff threats before recovering to $1.0250 currently. More and more tariff noise is likely in the coming days and weeks but we continue to look through that and focus on the underlying fundamental backdrop, which remains unchanged. Simply put, the strong U.S. fundamental story of strong growth, elevated inflation, and a more hawkish Fed continues to favor higher U.S. yields and a stronger dollar. Last week’s G-10 central bank decisions and global Q4 GDP data underscored the U.S. economic exceptionalism that favors the dollar and that should continue this week. The tariffs simply turbocharges the move.

AMERICAS

The tariff wars have begun. President Trump announced over the weekend that 25% tariffs on Canada and Mexico as well as 10% tariffs on China will go into effect at 1201 AM ET tonight. No reason was given for the small delay but we assume it’s meant to give a small window for these countries to make some concessions in a last ditch attempt to avoid the tariffs. Trump doubled down on the EU, saying he will “definitely” impose tariffs after saying he will “absolutely” do so earlier this weekend. No further details have been announced but he said “I wouldn’t say there’s a timeline, but it’s going to be pretty soon.”

Retaliation is coming. Canadian Prime Minister Trudeau announced 25% tariffs on over $100 bln of U.S. goods. Mexican President Sheinbaum will reportedly announce both tariff and non-tariff responses today, while China promised “corresponding countermeasures.” Elsewhere, the EU said it will “respond firmly” if tariffs are imposed. The U.S. has pledged to raise tariffs even higher in the event of any retaliation.

It’s no secret that these three countries are the top trading partners of the U.S. Our total trade with Mexico was nearly $750 bln in 2023, followed by nearly $715 bln with Canada and nearly $600 bln with China. According to the Census Bureau, the top U.S. imports from Mexico are vehicles, vehicle parts, and computers. The top imports from Canada are crude oil, vehicles, and vehicle parts. Lastly, the top imports from China are cell phones, computers, and toys.

The currency market reaction has been brutal. USD/CAD surged to a 22-year high near 1.4800, USD/MXN rallied to almost a 3-year high around 21.3000, USD/CNH made a new cycle high near 7.3750 and EUR/USD plunged to $1.0140, the lowest level since November 2022. The foreign currencies have come back a bit but to be quite honest, a weaker domestic currency against the USD is probably the best response these countries have to minimize the drag from the tariffs on their economies. While these currencies are bearing the brunt of the market reaction, every other currency except for the yen has also weakened today. That is because of the ripple effects on the global economy, as well as the fundamental USD uptrend. This remains intact regardless of the tariff implementation as U.S. economic outperformance continues to support monetary policy divergences between the Fed and other major central banks.

Other countries are at risk. We think it's noteworthy that EUR has weakened in sympathy with MXN and CAD. This suggests markets believe Trump will make good on his promise that he will “definitely” and “absolutely” impose tariffs on the EU. Can Japan be far behind? The U.S. runs a big trade deficit with Japan (6th biggest after China, Mexico, Canada, Vietnam, and Germany) and so we'd expect Japan to be an eventual target for tariffs too. In that case, we'd view this drop in USD/JPY as a buying opportunity because the yen is unlikely to be the haven in a trade war.

Fed officials will be quizzed about the impact of the tariffs on inflation and Fed policy. In the past, officials have demurred, saying that they could not make any assumptions because the size and nature of the tariffs were still unknown. Well, that is no longer the case and the Fed will have to start addressing this 800 pound gorilla in the room. We know that inflation will pick up but we don’t know by how much. More importantly, markets need to start thinking about the risks to growth as countries retaliate. Bostic and Musalem speak today.

ISM manufacturing PMI for January will be the highlight. Headline is expected at 49.9 vs. 49.2 in December, while prices paid is expected at 54.8 vs. 52.5 in December. The regional Fed ISM manufacturing surveys point to upside risk. So does the S&P Global manufacturing PMI, which rose to a 7-month high of 50.1 in January vs. 49.4 in December. ISM services will be reported Wednesday. Headline is expected at 54.1 vs. 54.0 in December. The regional Fed ISM services prints point to downside risk. So does the S&P Global services PMI, which fell to a 9-month low of 52.8 in January vs. 56.8 in December.

January PMIs will also be reported for Canada. S&P Global manufacturing will be reported today, followed by its services and composite PMIs Wednesday. Ivey PMI will be reported Thursday. The BOC has warned that a long-lasting and broad-based trade conflict would badly hurt economic activity in Canada and put direct upward pressure on inflation. This complicates the BOC’s job as monetary policy cannot lean against weaker output and higher inflation at the same time. The risk of all-out trade war between Canada and the U.S. can trigger a more pronounced USD/CAD overshoot.

EUROPE/MIDDLE EAST/AFRICA

Eurozone January CPI ran a little hot. Headline inflation came in a tick higher than expected at 2.5% y/y vs. 2.4% in December while core inflation came in a tick higher than expected at 2.7% and was steady from December. Services inflation eased a tick to a still-high 3.9% y/y. Italy also reported and its EU Harmonised inflation came in three ticks higher than expected at 1.7% y/y vs. 1.4% in December. Still, the disinflationary process is well on track and the growth outlook is unimpressive and so the ECB has room to cut rates further. The market has firmed up bets of additional ECB rate cuts last week and now sees the policy rate bottoming near 1.75% over the next 12 months vs. 2.00% previously. December PPI will be reported Wednesday.

Turkey January CPI ran hot. Headline came in at 42.12% y/y vs. 41.10% expected and 44.38% in December, while core came in at 42.65% y/y vs. 41.50% expected and 45.34% in December. Despite the upside miss, headline was still the lowest since June 2023 but the 5.03% m/m gain is worrisome and should keep the bank cautious. At the last meeting January 23, the central bank cut rates 250 bp for the second straight meeting and stressed that it will make its decisions meeting by meeting. Next meeting is March 6 and another 250 bp cut then seems likely, with risks of a hawkish surprise. The swaps market is pricing in 1525 bp of total easing over the next 12 months that would take the policy rate to 29.75%, but this may be optimistic if price pressures remain elevated.

ASIA

Bank of Japan released the summary of opinions for its January 23-24 meeting. At that meeting, the bank delivered the widely expected 25 bp hike to 0.5%. One member felt that “If economic activity and prices remain on track, it will be necessary for the bank to continue to raise the policy interest rate accordingly.” Another felt that “It will be necessary for the bank to adjust the degree of monetary accommodation from the viewpoint of avoiding the yen’s depreciation and the overheating of financial activities. Both of which appear to be due to excessively high expectations of continued monetary easing.” One member felt that “Looking at the current situation of Japan’s economy, a rapid depreciation of the yen, as seen through the first half of last year, would not be desirable.” Lastly, one member felt that “The negative impact that the yen’s depreciation has had on households and firms, through various cost increases, has been caused by the accumulated effects of the yen depreciating in the medium to long term, rather than short-term fluctuations in exchange rates.” The summary of opinions had little impact on BOJ expectations as the swaps market is still pricing in a peak policy rate of 1% over the next two years.

Australia reported firm December and Q4 retail sales data. Nominal retail sales came in at -0.1% m/m vs. -0.7% expected and a revised 0.7% (was 0.8%) in November. In volume terms, retail sales came in at 1.0% q/q vs. 0.8% expected and 0.5% in Q3. However, as the RBA points out, “the extent to which this reflected a sustained recovery in consumer demand, rather than a pull-forward in expenditure in response to emerging patterns of promotional activity, was not clear.” Regardless, softer inflation pressures in Q4 support the case for the RBA to start easing at the next February 18 meeting. Markets have fully priced in a 25 bp cut to 4.10% for then and a total of nearly 100 bp of easing over the next 12 months. Bottom line: RBA/Fed policy divergence and sluggish Chinese economic activity can further weigh on AUD.

Caixin reported soft January manufacturing PMI. Headline came in at 50.1 vs. 50.6 expected and 50.5 in December. Its services and composite PMIs will be reported Wednesday. Services is expected to rise two ticks to 52.4 but we see downside risks. Note that the official PMIs fell sharply in January, with the composite nearing the key 50 boom/bust level. China’s steady drip feed of stimulus has done little to improve the economy’s medium-term outlook, which we believe hinges crucially on addressing the huge debt overhang. Until that has been accomplished, growth will remain well below expectations and a structural headwind for commodity prices. Of note, China returns from holiday Wednesday.

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