Market Brief: Markets Stabilise on Tariff Hopes

Some semblance of calm is returning to financial markets this morning after US Commerce Secretary Howard Lutnick suggested that the administration could agree to relax tariffs on Canada and Mexico by this afternoon. Equity indices plunged, Treasury yields tumbled, and risk-sensitive currencies sold off during yesterday’s session as investors expressed concern over the growth-negative aspects of the Trump administration’s tariff measures, but reversed higher when Lutnick’s interview with Fox News aired after the North American close, and have added to their gains this morning on similar comments provided during an interview with Bloomberg.

Currency traders remain on tenterhooks however, especially after Trump appeared to double down on his plans in last night’s Congressional address. The president said “Tariffs are about making America rich again and making America great again, and it’s happening, and it will happen rather quickly,” suggesting that the levies would raise “trillions and trillions” in revenue after a “brief adjustment” period. Mainstream economists expect the currently-implemented tariffs—which are much larger, more broadly-targeted, and reaching implementation at a faster pace than in the first Trump administration—to lower overall US growth by roughly a percentage point and raise core inflation by about half a percent over the year ahead, with second-round confidence effects seen contributing to a slowdown in business hiring and investment, raising financial market volatility, and forcing consumers to delay big-ticket purchases.

The Canadian dollar and Mexican peso are both edging higher in early trading, suggesting that traders are taking a hopeful view. We’re not sure this will last: Lutnick has not been a good guide to the administration’s policy approach in recent months, and has often contradicted himself in the same day, as can be seen here and here. Although we remain of the opinion that tariffs on the two countries will ultimately be lifted, both currencies are vulnerable to a renewed selloff if the current sense of optimism proves unfounded.

In what may prove to be a bigger development, incoming chancellor Friedrich Merz delivered one of the most positive economic shocks in Germany’s post-reunification history yesterday, announcing plans to create a 500 billion euro infrastructure investment fund, deliver a substantial increase in defence spending, and reform borrowing rules that have kept the country in a fiscal straitjacket since the 2008 financial crisis. German bond yields posted the biggest one-day jump since the common currency area was formed and the euro surged against the dollar as Merz said his party and its likely coalition partners would propose legislation next week that would amend the constitution so defence expenditure exceeding 1 percent of economic output is exempt from the “debt brake”. "In view of the threats to our freedom and peace on our continent,” Merz said, “the rule for our defence now has to be 'whatever it takes'”.

Spillover effects could be substantial. After decades of underconsumption, Germany could become a net contributor to overall demand in the euro area, helping to reduce internal imbalances, lifting nominal growth levels, and reducing the bloc’s trade surplus relative to the rest of the world. Excessive levels of defence spending can act as a drag over long periods of time, but the sector tends to generate high value, high wage jobs, and research and development efforts can boost innovation levels on an economy-wide basis, helping to enhance overall productivity.

China also telegraphed a move away from its long-standing economic orthodoxy, with Premier Li Qiang directing authorities to prioritise making “domestic demand the main engine and anchor of economic growth” in the year ahead when delivering his report to the annual plenary session of the National People’s Congress. According to the government’s work report, Beijing will take steps to provide subsidies for household consumption, work to raise wages for low- and middle-class income groups, and enhance the social safety net in an effort to stabilise spending and put a floor under still-weak property markets. “New Productive Forces”—a slogan previously used to describe the Party’s focus on manufacturing and innovation—played a significantly smaller role in this year’s address, suggesting that planners are beginning to appreciate the risks associated with exporting Chinese imbalances to the world.

With the caveat that there are major unknowns ahead, currency markets could be sliding down the “dollar smile”. Under the smile framework, originally created by Eurizon’s Stephen Jen, and illustrated below, the greenback tends to outperform when global recession fears or financial crisis risks are rising (the left-hand side) or when the US economy is doing significantly better than its global counterparts (the right-hand side), but weakens when the US is doing relatively well, albeit not spectacularly so (the bottom). If markets are now in the “buy on news” stage of pricing in tariff risks, and global stimulus efforts combine with a darker US outlook to depress expected growth differentials, the dollar’s slide could accelerate—at least until a bigger shock happens and the currency’s safe haven appeal returns.

Please note: The morning Market Brief will be on hiatus between March 10 and March 21 as I take a badly-timed vacation. Try not to do anything that might trigger currency volatility. Thank you for your cooperation : )

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