The Dollar's Strength Amid Conflicting News and Key Economic Drivers
The dollar's reaction to conflicting news about Donald Trump potentially extending tariffs to all countries underscores how much of its strength relies on the anticipation of broad and early tariff measures. This also suggests that the dollar's recent rally is more influenced by fiscal policies than monetary ones, though the latter remains a strong positive driver.
Last week, the dollar index reached a new two-year high after closing 2024 at its highest annual level in two decades. Key bullish drivers for the dollar in 2025 include a resilient US economy, potential inflationary pressures from robust consumer spending and tariffs, and expectations of a slower pace of Federal Reserve rate cuts. However, we remain cautious, noting that the dollar's extended rally in December may have outpaced its underlying fundamentals when compared to our positive dollar factor index.
Looking ahead, volatility is expected to increase this year, driven in part by uncertainty surrounding Trump’s tariff plans and fiscal policy. In the near term, market participants will closely monitor key macroeconomic data, including today’s JOLTs job openings and ISM services reports, as well as Friday’s non-farm payrolls data.
Euro Gains Amid Tariff News and Inflation Concerns
The euro surged over 1% against the US dollar, climbing from near two-year lows, following tariff news from the US. It has since pared back some gains, trading around $1.04. A rise in German short-term yields, driven by hotter-than-expected German inflation data, also provided broader support for the common currency, though GBP/EUR remains steady near €1.20.
German headline inflation accelerated to 2.6% year-on-year in December, up from 2.2% in November and 1.6% in September. This uptick was largely attributed to less favourable energy base effects. While bund yields have risen and European Central Bank (ECB) easing bets have been pared back slightly, economic sentiment remains fragile, and the growth outlook continues to look weak. Stagflation concerns have resurfaced, but they are unlikely to deter the ECB from cutting rates in January, as markets still fully price in a 25bps cut, with three additional cuts expected through 2025.
For the euro, diverging monetary policy expectations between the Federal Reserve and the ECB remain a significant headwind, reflected in the widening short-dated swap rate differential. While peak European pessimism may signal a potential bottom for the euro, the domestic economic and political landscape remains broadly negative for the currency. Rising gas prices and the threat of US tariffs further contribute to the bearish outlook, cautioning against overly optimistic bets on a euro recovery.
British Pound Rebounds Amid Upbeat Retail Sales and Global Uncertainty
The British pound staged a significant recovery against the US dollar on Monday and has maintained those gains, buoyed by strong UK retail sales data. GBP/USD is back above $1.25, recovering from a dip below $1.24 last week, which had placed it nearly two standard deviations below last year’s average rate of $1.28.
The pound appears to be moving in tandem with the euro, experiencing weakness last week followed by a rebound of over a cent this week. Historically, the two currencies have shown a high correlation due to the interconnectedness of the UK and eurozone economies. Recently, this correlation has intensified, likely driven by shared concerns over looming tariffs and rising gas prices. For the UK, energy dependency amplifies terms-of-trade challenges, adding pressure on the pound. Additionally, the currency’s recent movements underscore its sensitivity to US developments, particularly the uncertainty surrounding tariffs.
Domestically, the pound's bullish 2024 outlook faces headwinds from the October 30 budget and low business confidence, which recently hit a two-year low. While there is a risk of economic surprises skewing negative in 2025, today’s retail sales data offered a brighter note. Retail sales surged 3.1% in December, sharply reversing November’s 3.4% decline and far exceeding expectations of a 0.2% drop.
Supporting the pound further, UK 10-year yields, currently at 4.61%, are near their highest levels since 2008. The yield spread between the UK and Germany remains at multi-decade highs, helping GBP/EUR stay elevated above €1.20.
