Market Brief: Markets Stay on Edge Ahead of Inauguration

An uneasy calm is settling on currency markets as traders brace for a “shock and awe” campaign on the policy front when Donald Trump takes office for a second time this afternoon. Ten-year Treasury yields are under pressure after last week’s softer-than-feared inflation and retail sales numbers, the dollar is retreating against most of its rivals on reports of a “very good” call between Trump and Chinese president Xi Jinping over the weekend, and the euro and pound are advancing on a narrowing in cross-Atlantic rate differentials.

Price action in currency markets could intensify shortly after the inauguration ceremony concludes this afternoon. Trump is expected to sign more than a hundred executive orders—directives that allow the president to take action outside of normal Congressional approval processes—within hours of taking the oath of office, and traders will parse these carefully for clues as to how aggressively the new administration intends to prosecute its agenda in the coming months. With equity markets closed and many trading floors short-staffed for observance of Martin Luther King Day, poor liquidity conditions could exacerbate moves.

If we take the president-elect at his word, he will impose 25-percent tariffs on imports from Canada and Mexico as soon as the keys to the White House are handed over. It’s difficult to disentangle the extent to which markets have already discounted the impact of tariffs, but an executive order authorising such an action—particularly if executed under the auspices of the International Emergency Economic Powers Act—could trigger extreme moves in exchange rates, potentially driving the loonie through the 1.50 barrier and the peso beyond the 22 threshold within days. A model published by the Bank of Canada in 2019, and flagged by National Bank chief economist Stéfane Marion in a recent LinkedIn post, suggests that the Canadian economy could take a 6-percent hit in the early stages of a new trade conflict, and suffer more extreme consequences over the long run than its North American counterparts.

We don’t think this is how things will play out. As noted in previous missives, the pain that an all-out trade war could inflict on US households, exporters, and multinationals seems too great to bear for a president who prides himself on his economic stewardship. Instead, a graduated tariff schedule—or an order directing US agencies to “investigate” the national security implications of North American trade imbalances—might provide an opening gambit for negotiations without appearing to betray supporters of his protectionist campaign promises. If this timeline from the nonpartisan Peterson Institute covering negotiations under the first administration provides any indication, noise levels in the media will ultimately dwarf fundamental changes in underlying US trade relationships.

But there are no guarantees, and it is clear that the major questions facing markets won’t be answered in the next few days. Trump’s history suggests that no ‘moment of clarity’ is coming, meaning that uncertainty levels—particularly on the trade front—could remain near historic highs for many months yet, weakening global consumer sentiment, delaying business investment, and raising implied volatility expectations in currency markets.

To us, this suggests that participants will remain unwilling to step in front of the dollar steamroller. Although more nuanced messaging from the White House could trigger a global relief rally in the short run, risk-reward ratios in other currencies will remain skewed to the downside, limiting any appetite for directional bets against the greenback. In inflation-adjusted terms, the dollar has gained more than 45 percent from its 2011 low—rivalling gains achieved in the early eighties when the US under Carter and Reagan coupled an expansionary fiscal stance with tight monetary policy—and could keep grinding higher in the near term, even as the longer-term outlook grows more uncertain.

A relatively quiet data calendar beckons through the latter part of the week. The Bank of Canada will publish its fourth-quarter business and consumer surveys this morning, followed by Statcan’s update on December inflation tomorrow morning, but traders will likely be too distracted by other events to pay much attention. Employment and wage growth numbers out of the UK tomorrow could help calibrate bets on another rate cut from the Bank of England in February, nudging the pound out of its recent range. And the Bank of Japan is widely expected to raise rates on Friday morning as signs of firming price pressures give officials the green light to continue their normalisation campaign.

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