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.

CAD Plunges Following Trump’s Tariff Threat

President-elect Donald Trump has announced plans to impose a 25% tariff on all US imports from Canada and Mexico, along with an additional 10% levy targeted at China. These announcements, signalling the start of Trump’s combative trade agenda, have unsettled FX markets. The Canadian dollar (CAD) weakened by as much as 1.5% within two hours of the remarks, offering a glimpse of the volatility that could define a second Trump presidency.

The initial reaction in the dollar-yuan pairing has been muted; however, the Mexican peso mirrored CAD’s performance, shedding 1.5% so far today. USD/CAD has surged to its highest level in over four years, and the escalation of tariff tensions suggests further gains towards C$1.45 are plausible. Both the pound and euro are benefiting from the weaker Canadian dollar, rising about 0.7% this morning, with GBP finding solid support at its 200-day moving average.

While the full scope of potential retaliatory measures from affected countries remains uncertain, the likelihood of fresh headlines keeps volatility risks elevated. Today’s market reaction to Trump’s comments, combined with the experience of his first term, indicates FX traders are bracing for a turbulent four years. Although options markets trimmed bets on a stronger US dollar following the announcement of Scott Bessent as Treasury Secretary, the tariff headlines have reignited dollar strength across the board.

A Temporary Boost for the Euro

Europe’s economic struggles were underscored this week by Germany’s Ifo index, a key leading indicator, which saw another decline. Despite this, EUR/USD managed a modest recovery from Friday’s dip to $1.0335, hovering just below $1.05. However, concerns over stagflation in Europe suggest that further declines in EUR/USD are likely as the year progresses, even as seasonal trends typically offer support.

After showing a brief recovery in October, the Ifo index fell again in November, declining to 85.7 from 86.5. The drop was driven more by current conditions than future expectations, with weak industrial orders and negative headlines surrounding the war in Ukraine weighing on sentiment. With no substantial tailwinds in sight, parity between the euro and the dollar appears increasingly probable within the next year. Bloomberg data now places the options-implied probability of parity trading within the next six months at 30%, up from 20% at the start of November.

Net short positions in the euro against the dollar have increased, according to COT data, but remain below levels seen during past crises, suggesting room for further downside risks. If Europe’s economic challenges persist, the euro could face its worst two-month stretch since January 2015.

The Pound Struggles for Momentum

GBP/USD is finding it difficult to reclaim the $1.26 level and its 100-week moving average, despite the US dollar beginning the week on a softer note. The yield spread between the UK and US remains relatively stable, with falling yields in both markets. However, the pound has failed to capitalise on improving global sentiment, as evidenced by Monday’s rally in global equities.

The pound also slipped below €1.20 against the euro, losing approximately 0.5% on Monday—its worst single-day performance this month. Money markets are pricing less than a 20% chance of a Bank of England (BoE) rate cut in December, with three cuts fully expected by the end of 2025. While recent inflation increases and fiscal expansion suggest a slower pace of BoE rate cuts initially, rising stagflation concerns are limiting sterling’s potential gains from this outlook.

Looking ahead, the UK’s trade deficit in goods with the US likely reduces its direct exposure to Trump’s proposed tariffs. This supports the case for UK economic outperformance relative to the Eurozone, potentially keeping GBP/EUR on an upward trajectory.

Against the US dollar, however, the picture remains less optimistic. Even with weak seasonal trends for the dollar and month-end flows favouring USD selling this week, GBP/USD remains in a downtrend as long as it trades below $1.28 and its key 200-day and 200-week moving averages, which are clustered around this level.

The United Kingdom's economy is edging closer to recession following the government's controversial budget, which has been criticised for being unfriendly to businesses. Sterling initially gained against the Euro as data revealed a sharp slowdown in the Eurozone economy during November. However, this optimism was short-lived as the UK’s own economic challenges were brought into focus. A Purchasing Managers’ Index (PMI) survey highlighted worsening business sentiment, largely attributed to the government's October fiscal policies. According to S&P Global, the UK composite PMI dropped to 49.9 in November from 51.8, reflecting contractionary pressures that underscore mounting economic challenges.

The UK's manufacturing sector has officially entered contraction, with the PMI falling to 48.6, down from 49.9 in the previous month, in line with global manufacturing headwinds. Alarmingly, the services sector, which forms the backbone of the UK economy, is now teetering on the brink, with a PMI reading of 50, a critical threshold, down from 52. The deterioration in sentiment and output across key sectors highlights a significant slowdown in economic activity. Chris Williamson, Chief Business Economist at S&P Global Market Intelligence, noted the concerning outlook, stating that falling output and consecutive monthly job cuts point to a deepening malaise in the post-Budget economy.

The report also underlined the growing inflationary pressures facing businesses, with November witnessing a sharp rise in input costs, particularly in the service sector. This presents a difficult scenario for the Bank of England. While a weakening labour market might typically prompt rate cuts, rising inflation ties its hands. Currency markets reflected these challenges, with GBP/EUR briefly surging to 1.2094 before falling back to 1.2034, while GBP/USD continued its decline, hitting 1.2523 amidst robust U.S. economic performance. Investors have adjusted their expectations for UK interest rate cuts, now anticipating three reductions next year, with a February cut fully priced in. In contrast to the UK’s struggles, the U.S. economy continues to expand, leaving the Pound under sustained pressure against the Dollar. Meanwhile, lingering uncertainties in the Eurozone could provide limited support for the Pound against the Euro.

UK Retail Sales Decline in October Amid Budget Uncertainty

British retailers experienced a drop in sales last month, as uncertainty ahead of the autumn Budget weighed on consumer spending, according to official figures.  Clothing stores were hit particularly hard, with industry data suggesting that mild October weather deterred shoppers from purchasing warm winter clothing.

The Office for National Statistics (ONS) reported a 0.7% decrease in retail sales volumes — a measure of the quantity of goods sold — following a revised 0.1% growth in September (previously estimated at 0.3%). The October decline exceeded economists' forecasts of a 0.3% drop.

ONS senior statistician Hannah Finselbach commented:  “Retail sales fell back in October following three months of growth. The fall was driven by a notably poor month for clothing stores, but retailers across the board reported consumers held back on spending ahead of the Budget.  “However, when we look at the wider trend, retail sales are increasing across the three-month and annual periods, although they remain below pre-pandemic levels.”  Non-food stores reported a 1.4% drop in sales volumes in October, reversing the 2.3% growth recorded in September.

Euro Downtrend Deepens Amid Macro and Political Headwinds

The euro remains firmly in a downtrend, with EUR/USD falling in seven of the past eight weeks and breaking below the critical $1.05 support level on Thursday. While the pair nears oversold territory based on its 14-day relative strength index (RSI), other technical indicators suggest further losses are likely.

The 21-day moving average has consistently capped any rebounds since early October, while the formation of a "death cross" — where short-dated moving averages dip below longer-dated ones — signals potential further declines. A break below the October 2023 low of $1.0448 could push the euro to its weakest level in two years.

Multiple macro and political challenges continue to weigh on the euro. Trade and tariff risks tied to Trump’s policy agenda, political instability in France and Germany, and the escalating conflict in Ukraine have all dampened sentiment. Investors seeking safe-haven assets have driven demand for German bunds, causing yields to slide across the curve. Additionally, weak Eurozone economic indicators, including today’s flash PMIs, are expected to disappoint, reinforcing the European Central Bank’s (ECB) dovish policy stance.

The bearish sentiment extends to the options market, where traders are paying a premium for puts betting on further EUR/USD declines compared to calls anticipating gains. Implied volatility on the euro has surged to its highest level since the U.S. election, underscoring the heightened uncertainty amid the ongoing selloff.

Dollar Gains Amid Fed Speculation and Geopolitical Tensions

Traders are closely watching for details on Trump’s policy agenda while scaling back expectations for aggressive Federal Reserve rate cuts. Comments from Fed policymakers this week offered little clarity, but the odds of a 25-basis-point rate cut next month have dropped significantly, now at 40%, down from 83% last week.

Geopolitical developments, particularly the escalating Russia-Ukraine conflict, have further boosted the dollar’s safe-haven appeal. The greenback continues to strengthen against the euro and sterling, though it faces resistance from the similarly safe-haven Japanese yen.

On the macroeconomic front, U.S. unemployment benefit applications unexpectedly fell last week to their lowest level since April, signalling a robust labour market. However, continuing claims — a measure of ongoing unemployment — rose to 1.91 million, the highest in three years. Meanwhile, a recession indicator derived from Federal Reserve regional indexes is declining, suggesting an increased likelihood of a "soft landing" or no recession scenario, reinforcing the narrative of U.S. economic resilience.