Tariffs, AI Disruptions, and the Fed: A Market Caught in the Crossfire
Overshadowing a Federal Reserve (Fed) rate decision is no easy feat, regardless of how uneventful a particular meeting may seem. Yet this week, a relentless wave of tariff rhetoric from President Trump and the disruptive "DeepSeek shock" in the AI sector have managed to divert attention. Tuesday’s trading session underscored just how volatile politically driven markets can be. A single comment from Trump, advocating for steeper tariffs than those proposed by his officials, was enough to send investors flocking to the U.S. dollar, which strengthened against all G10 currencies. With the February 1st deadline approaching, the first round of tariff rollouts is imminent, including new levies on chips, pharmaceuticals, and steel.
Despite these distractions, Wednesday’s Fed decision remains pivotal in shaping global monetary policy in the coming months. Policymakers are expected to hold rates steady, pausing the easing cycle that began in September. This decision unfolds against a complex backdrop of escalating trade tensions and AI-driven market turmoil, which has triggered a sharp equity sell-off. However, the Fed’s room to maneuver remains limited. Markets have fully priced in an unchanged rate stance, and with the labour market showing resilience, any deviation could be risky. Inflation has trended favourably over the past year, but the recent slowdown in disinflation gives the Fed little incentive to make an aggressive shift.
With a strong U.S. economy and looming tariff uncertainties, it would likely take a major global market downturn to push the Fed toward a dovish stance in early 2024. The balancing act between risk sentiment and monetary policy was evident this week, as equity market turbulence marginally increased expectations of future rate cuts. Moving forward, the Fed’s ability to navigate these competing forces will determine whether this pause turns into a prolonged hold or a return to rate easing later in the year.
Euro Struggles as Markets Bet on Aggressive ECB Rate Cuts
Traders are increasingly betting on significant rate cuts from the European Central Bank (ECB) this year, driven by concerns over the Eurozone’s sluggish economic outlook. Growth remains fragile, business sentiment is weak, and consumer spending lacks momentum, fueling expectations of policy easing to support demand. However, persistent inflationary pressures—both domestic and global—complicate the ECB’s decision-making.
Although inflation has cooled from its peak, underlying price pressures, particularly in wages and services, remain sticky. Inflation expectations, after reaching a low, have started to rise again. At the same time, global risks—including supply chain disruptions, volatile commodity prices, and potential trade tensions—pose fresh challenges, limiting the ECB’s ability to ease aggressively.
For now, EUR/USD remains heavily influenced by U.S. market developments. After peaking around $1.0530 earlier this year, the euro has slipped into the low $1.04 range amid selling pressure ahead of the Federal Reserve meeting. The currency now awaits further direction from central bank decisions and looming tariff risks. So far, its performance aligns with expectations of a bottoming phase, with little room for significant upside. This is further supported by declining bond market risk premia, as the French-German yield spread narrows from over 90 basis points last year to 72 basis points, signalling renewed investor interest in French bonds.
Rachel Reeves’ Fiscal Strategy in Focus as Markets Seek Clarity
Amid recent instability in UK assets and a growing disconnect between sterling and gilt yields, Rachel Reeves’ speech today has captured market attention. With limited fiscal headroom, she faces mounting pressure to tighten spending plans while simultaneously identifying new investment avenues to stimulate economic growth. Investor sentiment will be crucial—a well-received strategy could strengthen sterling, while uncertainty may trigger further volatility in UK markets.
A key proposal under consideration is the "surplus release" plan, which would unlock corporate pension scheme surpluses—worth tens of billions of pounds—for reinvestment in British businesses and infrastructure. Additionally, markets anticipate government backing for major infrastructure projects, including a potential third runway at Heathrow Airport. These initiatives aim to revitalize the UK economy by attracting investment and fostering long-term growth.
Sterling and gilt movements will depend on how effectively Reeves conveys her economic vision. If her proposals are viewed as both pro-growth and fiscally responsible, gilt yields could rise in an orderly manner, signalling confidence in the UK’s long-term prospects. Such a scenario could push GBP/USD above $1.25 and GBP/EUR toward €1.20. However, a lack of clarity or doubts over policy execution could weigh on investor confidence, putting renewed pressure on the pound.
