Market Brief: Currencies Stabilise As Threats (Seemingly) Subside

Currency markets are steadying this morning after several central bank decisions passed without triggering undue volatility, and President Donald Trump’s nominee for Commerce Secretary suggested that tariffs might not be implemented against Canada and Mexico. In comments during a confirmation hearing yesterday, Howard Lutnick* noted the import taxes were designed to force “action from Mexico and action from Canada,” and said “As far as I know, they are acting swiftly, and if they execute it, there will be no tariff. And if they don’t, then there will be”.

The US economy expanded as expected in the fourth quarter of last year, but details under the hood painted a puzzling picture of underlying developments. According to the Bureau of Economic Analysis, output climbed at a 2.3-percent annualised rate in the final three months of 2024—with a 4.2-percent increase in consumer spending doing much of the heavy lifting—but net exports remained positive and inventories fell, suggesting that the tariff front-loading we’ve been expecting simply isn’t showing up in the data**. A measure of growth often preferred by economists—final sales to domestic purchasers—rose at a 3.2-percent pace, suggesting that fundamental momentum remained strong.

Yesterday’s Federal Reserve decision ultimately left interest rate expectations effectively unchanged, but there were a few hiccups along the way. The replacement of a sentence in the statement acknowledging that “progress” had been made toward achieving the central bank’s inflation goal with one simply noting that “inflation remains somewhat elevated” was initially interpreted in markets as a sign that officials were growing less confident in the easing of price pressures, but Chair Powell poured cold water on that during the post-decision press conference, saying that the change was “not meant to send a signal”. Questions on the Trump administration’s trade, immigration, fiscal policy and regulatory policy changes were effectively rebutted as the Chair repeatedly suggested that no plausible conclusions could be drawn until details are announced and implementation gets underway.

The European Central Bank opted to cut interest rates this morning, surprising precisely no one. In a widely-anticipated decision, policymakers delivered a quarter-point reduction in policy rates, and left statement language largely untouched, pledging to “follow a data-dependent and meeting-by-meeting approach to determining the appropriate policy stance,” and “not pre-committing to a particular rate path”.

Data released earlier showed the European economy stagnating last quarter, disappointing economists who had expected a modest expansion. According to Eurostat, output flatlined in the common currency area over the last three months of 2024 as the German economy shrank -0.2 percent, France entered a post-Olympics contraction, and Italy, Spain, and other countries turned in weak performances. Given that a rise in inflation-adjusted household incomes was expected to begin providing a tailwind to bloc-wide growth by now, market expectations*** for a strengthening in the euro over the course of this year might hinge on a slowdown in the US, not an acceleration in Europe.

Yesterday’s Bank of Canada decision left the exchange rate effectively unmoved. Officials delivered a widely-anticipated rate cut, ended quantitative tightening efforts, and removed any form of forward guidance from the statement, prompting Governor Tiff Macklem to say “We have a lot of uncertainties out there. It just didn't seem very useful to provide guidance". "We don't know what the US is going to do,” he admitted, “And even when we do know more, we're going to have to do some work to figure out exactly how that is going to play out through the economy."

The accompanying Monetary Policy Report took a slightly more optimistic view of the future than many expected. In a special insert, the Bank presented new modelling that estimated the hit to Canada’s gross domestic product at around 2.5 percent in the first year after universal 25-percent tariffs are implemented—a devastating blow to be sure, but substantially smaller than the 6-percent shock that was shown in July 2019, and less significant than many private-sector appraisals.

Moves in the Canadian dollar loomed large over the proceedings. In response to a question from the Wall Street Journal's Paul Vieira during the post-decision press conference, the Governor noted that the Bank’s six consecutive rate cuts had thus far had a “relatively modest” impact on the exchange rate, saying “the recent depreciation in we’ve seen in the Canadian dollar has been more driven, in our view by trade uncertainty, and particularly President Trump’s threats to impose 25 percent tariffs on Canadian exports. You can see that from a number of things, but in particular if you look at the timing of the depreciation, it follows very closely on President Trump’s threats”. "The bigger the movements in the Canadian dollar,” he said, “the more we're going to have to take those into account as we set policy going forward,” seemingly suggesting that the Bank’s rate settings and communications could be used to tilt against further weakness.

From our perspective, a clear warning signal was embedded in the Bank’s assessment of recent exchange rate moves. According to an estimate of the “foreign exchange rate risk discount” summarised in the Monetary Policy Report****, the loonie is trading roughly 4 percent (around 500 basis points) weaker than it would be in the absence of Trump’s tariff threats. If this is correct*****, the currency could travel a little less in the event that tariffs are implemented—perhaps through the 1.50 threshold, but maybe not as far as 1.55—and might be prone to an extraordinarily-violent snapback if the threat is lifted.

*We have no idea whether Lutnick has a clear understanding of Trump's plans. To paraphrase Churchill, Trumpian "political intrigues are comparable to a bulldog fight under a rug. An outsider only hears the growling, and when he sees the bones fly out from beneath, it is obvious who won.”

**We would expect to see inventories rising and net exports falling if US businesses were front-running tariffs to a significant degree.

***This chart is derived from the cost that market participants are asked to pay for insurance against a move in the exchange rate above or below given thresholds. At the moment, the cost is higher for option strikes above the current spot rate across all four quarters in 2025, suggesting that overall market sentiment is skewed toward a gradual climb in the euro.

****This chart is fully recreated from the Bank's Monetary Policy Report. No points for originality here.

*****Decomposing exchange rate movements into their constituent components is notoriously difficult. Our own amateur estimates, which incorporate asset price co-movements to a greater degree and pin more of the decline on overall macroeconomic interest rate sensitivities, suggest that the loonie is discounted by less than 1.5 percent.

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