Tariff Turmoil Fuels Market Volatility

Uncertainty surrounding tariffs is driving sharp fluctuations across asset classes. Over the weekend, the US adopted a tougher stance, triggering a plunge in stocks and cryptocurrencies, a surge in US yields, and a significant rally in the US dollar. However, markets reversed course after news broke that tariffs on Mexico and Canada would be delayed for a month following discussions between leaders on Monday.

The turbulence didn’t stop there—China’s tariff deadline passed, prompting retaliation with levies on US LNG, coal, crude oil, and farm equipment, alongside an antitrust probe into Google. As a result, oil fell by 2%, and the Chinese yuan weakened by 1% against major currencies.

Tariffs remain the dominant market driver, with Trump viewing them as a strategic tool. The key questions now are how much he is willing to negotiate post-implementation and what deals he is prepared to strike. Until more clarity emerges on the duration and scale of these tariffs, volatility is expected to persist—particularly in FX markets. Growth-sensitive and commodity-linked currencies are likely to remain under pressure, while safe-haven demand strengthens the appeal of the Japanese yen and Swiss franc as diversification options beyond the US dollar.

Euro Under Pressure as Trade Risks Mount

The euro’s fortunes took a sharp turn after Trump’s election in November, tumbling from a peak of $1.12 last year to around $1.01. The currency faces mounting headwinds, both political and cyclical. A no-confidence vote in France, expected on Wednesday, adds to the uncertainty, but speculation that the US will restrict trade with the EU is the latest and most pressing threat—one that raises the risk of EUR/USD falling to parity or lower.

Trade tensions have also reinforced the monetary policy divergence narrative, further weighing on the euro. Investors are increasingly betting on aggressive European Central Bank (ECB) rate cuts due to slowing growth, with more than three cuts priced in for 2025. This has sent German bund yields sliding, while expectations for the Federal Reserve have moved in the opposite direction, pushing US Treasury yields higher. As a result, the US-German yield spread is near its widest level in five years, exacerbating EUR/USD weakness.

The key question now is whether markets have fully priced in the trade-risk premium. With EUR/USD only about 2% from where rate differentials suggest fair value lies, the risk remains that a larger premium needs to be factored in, reflecting Trump’s hardline tariff stance.

Unless a reversal in trade policy emerges, EUR/USD could retest its cycle low and move toward the psychologically significant parity level. Market sentiment has turned increasingly bearish, with FX options positioning showing the most pessimistic outlook for the euro in six months, as reflected in one-week risk reversals.

Pound Finds Respite from Tariffs but Risks Remain

Britain appears poised to avoid US tariffs, largely due to its goods trade deficit with the US. While the UK runs a trade surplus in services, these are difficult—if not impossible—to target with tariffs. However, despite this exemption, the pound remains a risk-sensitive currency, and the UK’s heavy exposure to higher interest rates keeps downside risks in focus for GBP/USD. That said, as seen with GBP/EUR’s gap higher on Monday, sterling could outperform its European peers in this escalating tariff environment.

US trade data underscores the rationale behind Britain’s likely exemption. The US runs a goods trade deficit of $209 billion with the EU, $279 billion with China, $152 billion with Mexico, and $68 billion with Canada, but holds a $9.7 billion goods trade surplus with the UK. While this suggests Britain may stay out of the firing line, calling the pound a safe-haven currency remains questionable. The UK is still vulnerable to global trade tensions—especially if a slowdown in the EU, its largest trading partner, weighs on growth. Additionally, the impact of higher interest rates will further strain the Treasury, with rising borrowing costs and limited fiscal flexibility adding to economic pressures.

Sterling could extend gains against the euro toward €1.21–1.22, well above its five-year average of €1.16. However, against the dollar, near-term risks remain tilted lower. If EUR/USD falls to parity, GBP/USD could trend closer to $1.20, given the strong correlation between the two exchange rates.