Market Brief: Markets Stabilise as Policy Risks Recede

Financial markets are overcoming post-traumatic stress syndrome three days after Donald Trump started—and then temporarily paused—a potentially-catastrophic trade war with Canada and Mexico. Benchmark ten-year Treasury yields are inching lower and major equity bourses are headed for a stronger open after Treasury Secretary Scott Bessent called tariffs a “means to an end,” and said the new administration is focused on bringing down interest rates. The dollar is holding firm against its rivals.

The number of Americans submitting initial applications for unemployment benefits rose incrementally to 219,000 in the week ended February 1, and continuing claims fell slightly in the prior week, bolstering bets on a relatively solid pace of hiring in tomorrow’s January non-farm payrolls report. Data released earlier in the week showed demand for workers dissipating somewhat in December, but the layoff rate held steady, and the quits rate—an indicator of worker confidence—moved up slightly, giving the Federal Reserve room to stay on hold for now. Just two rate cuts are priced in between now and 2027—far fewer than had been expected at this time last year.

The pound is down almost a full percentage point against the dollar after the Bank of England cut rates by a quarter point to a 19-month low. The vote itself was dovish—seven of nine members of the Monetary Policy Committee supported the move, and two favoured a larger half-point cut, with Catherine Mann making a dramatic pivot away from her previous commitment to keeping rates steady—but the Bank also provided a surprisingly-hawkish set of forecasts, warning that inflation could accelerate “quite sharply” later this year before subsiding, and outlining a policy path that includes just two more cuts over the next three years. The pound’s losses may prove somewhat limited: the services-driven British economy is largely sheltered against trade war risks, and if, as we expect, the dollar's upward momentum fades a bit and interest rate differentials stay canted toward the currency, traders could turn modestly less bearish on the exchange rate’s prospects in the days to come. No such luck for the euro of course: traders expect Trump to turn his sights toward the bloc's massive trade surplus against the US at some point, and near-term risks remain biased to the downside.

The Mexican peso is weakening ahead of this afternoon’s monetary policy decision. Investors expect policymakers to accelerate the pace of easing, delivering a 50 basis-point rate cut after Governor Victoria Rodriguez telegraphed a more aggressive approach in comments last month. The economy shrank more than expected in the last quarter of 2024, core inflation is holding steady at just under 3.75 percent on a year-over-year basis, and the Trump administration’s immigration and trade plans are adding to the headwinds facing growth in the months to come. Moves in the exchange rate have been surprisingly modest in recent months, and we think this reflects the dissipation in domestic political risk—which has accompanied President Claudia Sheinbaum’s gradual assertion of independence from her predecessor—being offset by the rise in uncertainty regarding US policy changes.

Chinese countermeasures against US tariffs are generally being taken in stride by investors who expect the economy to remain insulated against a trade-driven downturn. As previously outlined, policymakers are expected to step up support efforts in the months ahead, China’s reliance on exports to the US is relatively low, and the renminbi has depreciated roughly 3.5 percent against the American dollar since the end of September, limiting the extent to which the country’s competitiveness will suffer if trade war hostilities settle near current levels.

Here in Canada, the economy could bear scarring from trade war threats long after the president has moved on to things like creating the MAGA Strip. Already-weak business investment is unlikely to rebound as long as real energy prices remain tame and the possibility of tariffs remains in place, and consumer sentiment—which had been improving in reaction to the Bank of Canada’s easing efforts—looks vulnerable to a renewed downturn. Where we had previously expected a broad-based stabilisation in the country’s all-important housing market, we are now far less confident: historically, price dynamics have been driven by employment conditions more than interest rates themselves, and there are good reasons to worry that the jobless rate could climb further in the months ahead as a sense of caution settles across the business landscape. Some home price deceleration could, of course, be a good thing—outperformance in real estate values relative to incomes has contributed to widening inequality and an increasingly-distorted economy in recent decades—but won't deliver the positive impetus to short-term growth that might otherwise have been expected.

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