Inflation Data Overshadowed by Tariff Threat

There was a brief respite in risk sentiment yesterday following some positive news on US inflation. However, the rally in stocks and bonds soon faded as the details of the consumer price inflation data were less encouraging, while fears of a global trade war intensified. The US dollar index ended its seven-day decline but remains close to pre-election levels. Meanwhile, today’s US producer price inflation data could complicate the disinflation narrative, potentially making the Federal Reserve’s (Fed) task more challenging.

Canada and the EU are responding to the sweeping US tariffs on steel and aluminium, signalling an escalation in the global trade war. The US dollar’s 3.7% decline so far this month, along with falls in US equities and their underperformance relative to other markets, marks a significant shift in investor sentiment regarding the economic outlook for both the US and Europe. However, a surprisingly subdued set of February US consumer price inflation figures month-on-month pulled the annual headline inflation rate down to 2.8% from 3%, while core inflation dipped to 3.1% from 3.3%. This temporarily halted the stock sell-off that had pushed the S&P 500 towards a correction. Nonetheless, the underlying details were less reassuring, with a sharp 4% month-on-month decline in airfares (a highly volatile component) largely responsible for the softer inflation reading. Moreover, there is growing anecdotal evidence of firms pre-emptively raising prices in anticipation of potential tariffs, as indicated by this week’s NFIB survey, which reported a 10-point increase in the proportion of companies raising prices. The risk here is that core inflation could reverse course and begin climbing again in the coming months.

Concerns over tariffs are already prompting businesses to push prices higher, increasing the likelihood of stronger inflation readings over the summer. This would further complicate the Fed’s policy decisions amid rising recession fears. In addition, key components from the producer price index, due today, which feed into the Fed’s preferred inflation measure, are expected to have accelerated since January. This could make it more difficult for the Fed to implement rate cuts despite slowing US economic activity. As a result, the outlook for equities and broader risk appetite remains bleak.

Will Trump Halt the Euro’s Rally?

The euro’s recent rally lost some momentum yesterday, slipping below the $1.09 mark. While broader risk sentiment improved after softer US inflation data, European markets faced renewed trade tensions and political uncertainty. President Trump has made it clear that he intends to retaliate against the EU’s countermeasures in response to his 25% tariffs on steel and aluminium. This tit-for-tat exchange will further heighten tensions between the two regions and could cap gains for the euro in the near term.

Meanwhile, German bond markets continue to send strong signals. The 10-year Bund yield surged past 2.9%, its highest level in nearly 13 years, as negotiations over expanded government borrowing intensified. The Greens remain hesitant to fully support the fiscal expansion proposed by the CDU/CSU-led coalition, though alternative proposals suggest a compromise may be within reach. If secured, this could pave the way for a significant increase in Germany’s defence and infrastructure spending—an economic shift that is already beginning to reshape investor sentiment towards the Eurozone.

For now, EUR/USD remains supported by the broader move away from the dollar, but trade risks are becoming harder to ignore. If Trump escalates his response, it could weigh on European equities and the euro in the short term. However, should Germany’s fiscal deal come to fruition, it may provide further support for European assets, especially as concerns over US economic growth mount. Investors will be watching closely for new developments on both fronts in the coming days.

Sterling Nears $1.30

Sterling climbed to a fresh three-month peak of $1.2988 on Wednesday, coming within a whisker of the key $1.30 level, a threshold it has been below for 60% of the past five years. GBP/USD is up 3% so far this month, and nearly two cents above its five-year average of $1.28, though it remains in overbought territory according to the 14-day relative strength index. GBP/EUR also snapped a run of six consecutive daily losses as focus turned to EU-US trade war risks following the EU’s retaliation against US tariffs.

While downside risks for the euro and the Eurozone economy have eased amid hopes of significant fiscal reforms, the tariff issue remains a major short-term headwind for the common currency, potentially limiting the euro’s gains against sterling. We are keeping a close eye on the 50-week moving average, currently at €1.1888. Should GBP/EUR close the week below this level, a slide towards €1.1740 seems plausible in the coming month. Otherwise, the pair may remain in a tight range, given real rate differentials suggest €1.19 is a fair valuation. However, there appears to be greater potential for sterling to hold firm against the dollar, as currency traders assess the likely trajectory of interest rates over the next six months. Both the Fed and the Bank of England (BoE) are set to meet next week, and while neither central bank is expected to cut rates, markets are currently pricing in around three cuts by the Fed later this year, compared with just two expected from the BoE.

Indeed, with UK inflation rebounding and inflation breakeven rates suggesting that retail price increases over the next two years are likely to hover around 4%, the BoE may choose to delay its next rate reduction. This expectation has already pushed UK nominal yields higher relative to those in the US, providing further support for GBP/USD. However, as mentioned earlier, sterling remains in overbought territory, making it vulnerable to a short-term pullback as traders take profits.