Dollar Soft as Trade Wars Begin

March 04, 2025

Win Thin

The trade wars have begun; retaliation has been swift; the growth outlook is getting cloudier; February ISM manufacturing PMI was disappointing
Fiscal stimulus is coming in Europe; OPEC+ announced it would go ahead with its planned output increase next month
Japan finds itself in the spotlight now; Japan reported mixed January labor market and soft Q4 capital spending data; RBA published the minutes to its February meeting

The dollar is soft as the trade wars begin. DXY is trading lower for the second straight day near 106.167 as tariffs and retaliatory tariffs go into effect (see below). The yen is outperforming after Trump complains about the weak yen (see below), with USD/JPY trading near 148.40 after testing 151 yesterday. The euro is trading higher near $1.0530 after reports of massive fiscal stimulus (see below), while sterling is trading higher near $1.2730. Recent softness in the U.S. data is concerning and has weighed on the greenback. We are not ready to push the panic button yet but if the data continue to soften, the strong USD fundamentals of strong growth, elevated inflation, and a more hawkish Fed will come into question. Data this week will be key. Lastly, tariffs should help keep the dollar firm but so far today, the reaction has been the opposite. Perhaps this is a bit of buy the rumor sell the fact price action, as the prospects of higher inflation from tariffs should keep the Fed on hold for now.

AMERICAS

The trade wars have begun. Tariffs on Chinese imports will double to 20% went into effect today. So did 25% tariffs on Canada and Mexico imports (with a reduced 10% rate for Canadian energy). Trump said further China tariffs will depend on retaliation. He added that the U.S. would penalize any countries weakening their currencies with tariffs. The funny thing is, most exchange rates are floating. It's the market that is weakening the currencies of those countries that are getting tariffed, not the countries themselves.

Retaliation has been swift. Canada announced late last night 25% tariffs on CAD30 bln of U.S. goods, with another CAD125 bln to be subject to tariffs in three weeks. Prime Minister Trudeau said “Our tariffs will remain in place until the US trade action is withdrawn, and should US tariffs not cease, we are in active and ongoing discussions with provinces and territories to pursue several non-tariff measures.” Elsewhere, China will impose starting March 10 an additional 15% tariff on U.S. chicken, wheat, corn and cotton products, as well as an additional 10% tariff on sorghum, soybeans, pork, beef, seafood, fruits, vegetables, and dairy products. China is one of the largest agricultural importers and so the prospects of lower demand have pushed prices lower.

A trade war has long been one of the exogenous shocks that we fear could detail the economy. According to the non-partisan Budget Lab policy research center at Yale, the effects of the tariffs on China, Mexico, and Canada will lower US real GDP growth by -0.6 ppt in 2025. To make matters worse, the PCE price level is estimated to rise between 1% and 1.2% in the short-term.

Indeed, the growth outlook is getting cloudier. The Atlanta Fed's GDPNow model is now tracking Q1 growth at -2.8% SAAR vs. -1.5% previously. Next update will come Thursday after the data. As we have noted, the Q1 growth estimates so far are basically based on one or sometimes two months of data and so the early numbers can bounce around quite a bit as more inputs are reported. This week brings a load of February data and should give a clearer picture of the U.S. economic outlook. Elsewhere, the New York Fed's Nowcast model is doing better and has Q1 growth at 2.9% SAAR. It will be updated Friday and the model will also give us its first estimate for Q2 growth.

For now, the Fed is on hold. Most officials view the economy as resilient and so feel steady rates are required to move inflation back to the 2% target. Indeed, St. Louis Fed President Alberto Musalem summarized it well yesterday, highlighting that “Payroll growth averaged 237,000 from November to January - exceeding estimates of the break-even pace—and the unemployment rate ticked down to 4%. Job openings and quits rates have declined, but layoffs have remained low. A recent National Federation of Independent Business survey found a sizable net percentage of small businesses are expecting to add jobs in the coming three months. Recent surveys conducted by several Federal Reserve banks also show increases in the percentage of firms planning to add jobs in the months ahead.” However, now that tariffs have come into effect, Fed officials will have to start calibrating policy accordingly to this new normal. Williams speaks today.

February ISM manufacturing PMI was disappointing. Headline came in at 50.3 vs. 50.8 expected and 50.9 in January. However, this was one of the rare cases where the details were much worse than the headline. New orders plunged to 48.6 vs. 54.6 expected and 55.1 in January, employment fell to 47.6 vs. 50.1 expected and 50.3 in January, and production fell to 50.7 vs. 52.5 in January. Most importantly, prices paid jumped to 62.4 vs. 56.3 expected and 54.9 in January and was the highest since June 2022. It's worth noting that prices paid rose sharply and we really haven't gotten the bulk of the tariffs yet. Supplier deliveries rose to 54.5, the highest since August 2022 and suggestive of some supply chain issues. Similarly, backlog of orders rose to 46.8, the highest since September 2022. ISM services will be reported tomorrow and is expected to fall a tick to 52.7.

Canada also reported a very weak manufacturing PMI. S&P Global manufacturing PMI headline fell to 47.8 vs. 51.6 and is the lowest since July 2024. Its services and composite PMIs will be reported tomorrow, while Ivey PMI will be reported Thursday.

EUROPE/MIDDLE EAST/AFRICA

Fiscal stimulus is coming in Europe. Reports suggest the EU will activate a program that would allow member counties to spend an extra EUR650 bln on defense over the next four years without triggering any budgetary penalties. Reports also suggest the EU will propose EUR150 bln in loans to boost defense spending. EU President von der Leyen said “We are in an era of rearmament. Europe is ready to massively boost its defense spending.” Of note, EU legal experts believe the plans will not require unanimous approval by the member countries, which means it cannot be vetoed by Hungary or other problematic nations in the bloc.

OPEC+ announced it would go ahead with its planned output increase next month. Output will rise 138k bbl/day starting in April, with another 2.2 mln bbl/day of production to be restored by 2026. The group stated that “This gradual increase may be paused or reversed subject to market conditions. This flexibility will allow the group to continue to support oil market stability.” Of note, President Trump last month called on the group to “cut the price of oil.” China plans to impose from March 10 an additional 15% tariff on US chicken, wheat, corn and cotton products, and an additional 10% tariff on sorghum, soybeans, pork, beef, seafood, fruits, vegetables and dairy products.

ASIA

Japan finds itself in the spotlight now. Yesterday, President Trump said “Whether it’s the yuan or the yen in Japan or the yuan in China - when they drop them down, that gives us - that puts us at a very unfair disadvantage. It’s very hard for us to make tractors - Caterpillar - here, when Japan, China, and other places are killing their currency.” Finance Minister Kato denied this as “Japan hasn’t adopted a foreign exchange policy to weaken the yen. That can be understood by looking at our recent currency interventions.” Kato is correct, as the BOJ has been intervening to support the yen, not weaken it. On the other hand, JPY is very cheap. Our PPP model pegs USD/JPY fundamental equilibrium at around 98.00. However, USD/JPY overvaluation is justified by relative monetary policies and wide US-Japan real 10-year bond yield spreads. By running large trade surpluses with the U.S., Japan will find itself under greater scrutiny and we believe eventual tariffs. Stay tuned.

Japan reported mixed January labor market data. The unemployment rate came in at 2.5% vs. 2.4% expected and a revised 2.5% (was 2.4%) in December, while the job-to-applicant ratio came in at 1.26 vs. 1.25 expected and actual in December. Wage data have also been mixed lately, with nominal earning rising but real earnings leveling off. The annual spring wage negotiations will be closely watched.

Japan reported soft Q4 capital spending data. Capital spending came in at -0.2% y/y vs. 5.0% expected and 8.1%, while spending ex-software came in at 3.1% y/y vs. 4.7% expected and 9.5% in Q3. Elsewhere, company sales came in at 2.5% y/y vs. 3.0% expected and 2.6% in Q3, while company profits came in at 13.5% y/y vs. 0.3% expected and -3.3% in Q3. These readings will be used for the revised Q4 GDP data out next Tuesday and points to downside risks to the preliminary growth of 2.8% SAAR.

RBA published the minutes to its February meeting. At that meeting, the RBA cut rates 25 bp to 4.10% and signaled a cautious easing path ahead. The minutes offered more insights on bank’s guidance for a cautious easing path ahead. At that meeting, the RBA also debated keeping rates steady but chose to deliver on rate cut expectations as “members agreed that their decision at this meeting did not commit them to further reductions in the cash rate target at subsequent meetings.” Members noted that “interest rates in Australia had not risen as high as elsewhere and that the labor market domestically was in a much stronger position than had been the case in other economies when their central banks first lowered interest rates.”

Australia reports Q4 GDP tomorrow. Real GDP is expected at 0.5% q/q vs. 0.3% in Q3, while the y/y rate is expected at 1.2% vs. 0.8% in Q3. GDP input data already released this week point to decent underlying economic growth. Net exports are estimated to add 0.2 ppt to GDP growth while business investment is projected to be the main drag. Markets brought forward the timing of the next 25 bp rate cut to May from July as heightened trade tensions weighs on the global economic outlook.

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