Wild Swings: A Glimpse of What Lies Ahead
This week in the foreign exchange (FX) market has already been a turbulent one, influenced by international developments, particularly in the United States. The market sentiment initially improved following the nomination of Scott Bessent as Treasury Secretary, prompting traders to unwind their “Trump trades.” However, the “Trump trade” was reignited when the president-elect renewed his threats of tariffs. While the overbought US dollar has paused for breath, its counterparts have experienced significant volatility.
The imposition of an additional 10% levy on goods from China and a 25% tariff on all products from Mexico and Canada caught markets off guard. The Canadian dollar (CAD), in particular, dropped to a fresh four-year low against the US dollar. Hedging costs for CAD soared to their highest level in over two years, while one-month risk-reversal options—a metric indicating the cost of purchasing versus selling a currency and a gauge of market sentiment—are now at their most bearish for CAD in two years. According to Barclay’s import substitution model, a 25% tariff on all imports from Canada could cause a 19% depreciation of CAD against USD. While this threat may be exaggerated, the sharp movements in FX markets following Trump’s announcements underscore the extent of volatility his comments can provoke, as well as their widespread effects.
On the economic front, the US Conference Board’s consumer confidence index aligned with expectations, rising to 111.7—its highest level since July of last year. The likelihood of a Federal Reserve rate cut next month remains uncertain, and investors are expected to maintain interest rates within a range until clearer indications emerge from October’s core PCE deflator, which will reveal whether disinflationary progress is continuing or has stalled. This data is due later today.
The Allure of the Yen
The Japanese yen is in high demand today, despite improved investor sentiment following a ceasefire agreement between Israel and Hezbollah. This suggests that FX traders are positioning for a potential interest rate hike from the Bank of Japan (BoJ) next month.
The yen has strengthened nearly 2% against the US dollar this week, while also appreciating by around 1% against the euro, Australian dollar, and pound sterling. In fact, the yen has risen against 86% of the global currencies tracked this month. The last time the yen experienced such broad-based strength was during the summer when carry trades were being swiftly unwound.
Rates traders now price a greater than 65% probability of a BoJ rate hike in three weeks. Investors are closely monitoring Tokyo’s inflation data, due later this week, which could provide further insights into the BoJ’s monetary policy trajectory.
A Not-So-Sterling Fourth Quarter for the Pound
Even before the US election, the pound’s upward momentum had begun to wane. GBP/USD has fallen by over 5% quarter-to-date—a stark contrast to its historical average gain of 1% in the fourth quarter since 1971. The pair has breached key moving average support levels, trading near oversold territory on both daily and weekly charts.
In addition to external pressures, the UK economy is faltering, and its debt dynamics are once again drawing scrutiny. Following last week’s disappointing retail sales and PMI data, further deterioration in UK economic indicators could lead to broad-based sterling weakness. This year’s rally in the pound had largely been underpinned by an improving UK economic cycle, which lent sterling an advantage through its relatively high interest rates compared to other currencies.
Although UK rates remain elevated and are expected to stay so until 2025, international developments—especially the geopolitical fallout and the influence of the US election—are amplifying sterling’s downward momentum via the strong US dollar channel.
The incoming Republican administration is likely to prioritise countries with substantial trade surpluses with the US, imposing significant tariffs on imports. The UK, with its smaller trade surplus, is likely to be lower on Trump’s agenda. Nonetheless, the positive dollar environment could persist into next year, with GBP/USD potentially falling below $1.25 if EUR/USD approaches parity.
