Unpacking a Puzzling Dollar Decline

The US dollar index fell yesterday, struggling to hold above its 50-day moving average and an upward-sloping trendline that has been in place for several months. The dollar weakened against most major currencies, except for the traditional safe havens—the Japanese yen and Swiss franc. This decline was somewhat surprising given the risk aversion in equity markets amid fresh US tariffs and cautious rhetoric from the Federal Reserve, which pushed US yields higher across the curve.

Signs of Tariff Fatigue in FX
US President Donald Trump signed a proclamation to reinstate a 25% tariff on steel and aluminium imports, effective from 12 March. The European Union vowed to retaliate, raising the prospect of an escalating trade dispute between transatlantic allies. The EU may act swiftly by reintroducing duties it first imposed on the US during Trump’s previous term. Tariff risks remain significant, as evidenced by recurring headlines, yet currency markets took the latest developments in their stride, with risk-sensitive FX gaining ground against the dollar.

A review of macroeconomic data does not fully explain the dollar’s decline either. Admittedly, sentiment among small-business owners in the US dipped slightly in January from December’s six-year high, largely due to uncertainty over tariffs and their potential impact on growth and inflation. However, business owners remain largely optimistic about deregulation and tax policies, with 77% believing it is a good time to expand and 47% expecting improved business conditions ahead.

Monetary Policy Rhetoric
Cleveland Fed President Hammack indicated a preference for keeping interest rates steady for the foreseeable future, while Fed Chair Powell reinforced the message of patience on rate cuts during his semi-annual monetary policy testimony to the Senate. Markets remained unfazed, continuing to price in just one additional Fed cut this year.

Perhaps investors are wary that US economic growth could slow due to tariffs, inflation, and tight monetary policy. Alternatively, the dollar’s valuation may simply be stretched. Bullish positioning on the greenback is crowded, and as we have previously argued, with trade risks and the Fed’s pause already priced in, the dollar likely requires evidence of an even stronger US economic backdrop or a sharp deterioration in global risk sentiment to advance significantly.

Euro Searching for Clarity Amid Uncertainty
Market positioning on the euro is approaching levels last seen during the initial wave of the pandemic in 2020. The single currency faces multiple headwinds, ranging from weak Eurozone cyclical dynamics and dovish monetary policy to political and geopolitical risks, particularly in light of Trump’s tariff threats. Rising natural gas prices are another concern.

European gas reserves are being depleted at their fastest rate since the 2022 energy crisis due to a combination of cold weather and declining Russian gas imports. Seasonal price spreads also made it uneconomical to replenish stocks during the summer. As a result, some EU nations have fallen short of their storage targets, and with the bloc’s reserves standing at around 50% capacity in early February—well below the roughly 70% recorded last year—concerns over future supply have triggered a surge in gas prices to fresh two-year highs. This is negative for the euro and supportive of the dollar, adding further downward pressure on EUR/USD.

Since the US election, the correlation between US and euro area interest rates has weakened significantly, reflecting diverging expectations for growth and inflation between the two regions. This widening rate differential is another drag on EUR/USD.

Political uncertainty in Europe could also be a source of volatility, although markets appear relatively relaxed about the upcoming German election. Two-week options on the euro, which encompass the election period, imply a potential 1.5% move in EUR/USD in either direction. From the current spot price, this would still leave EUR/USD above $1.01, but given the array of risks facing the euro, a move towards parity remains a possibility. For now, the weaker dollar is allowing EUR/USD to push above $1.03, with its 50-day moving average in sight around $1.04, though the move may prove short-lived.

That said, several factors could offer support for the euro. A softer tariff outcome, a Ukraine-Russia ceasefire, looser fiscal policy in Germany, a cyclical rebound in China, or a downturn in the US economy could all act as catalysts for a more meaningful euro recovery.

Sterling Records Best Day in Two Weeks
The pound ended a three-day losing streak against the US dollar on Tuesday, recording its best daily performance (+0.6%) in over two weeks, thanks to broad-based dollar weakness. However, sterling also gained against a range of other currencies, notably against safe-haven peers such as the Japanese yen (+1.0%) and Swiss franc (+0.9%), as well as higher-beta currencies like the Norwegian krone and Australian dollar. This suggests that a modest paring of Bank of England (BoE) easing expectations may have also played a role in supporting the pound.

BoE policymaker and noted hawk, Catherine Mann, clarified yesterday why she advocated for a 50-basis-point cut last week. She emphasised that this was not a signal for immediate further cuts but rather an attempt to “cut through the noise” and enhance communication with global markets. She also highlighted the need for continued restrictive monetary policy to tackle persistent inflation. Recent survey data suggests that wage disinflation is expected over the course of the year, though inflation expectations remain elevated and above levels consistent with the BoE’s 2% target.

As a result, traders scaled back expectations for BoE rate cuts this year, now pricing in 60 basis points of easing, down from 66bps at the start of the week. Looking ahead, key economic data releases early tomorrow—including GDP estimates for December, preliminary Q4 growth figures, and industrial and manufacturing output for December—will be closely watched by sterling traders, following today’s US CPI report.

Dollar stronger, but key level remains elusive

Foreign exchange markets appear considerably more sensitive to escalating tariff risks than equity investors, who seem relatively complacent about the threats issued by President Trump. While the S&P 500 has remained range-bound since mid-November, it is still up by 6% since the US election, driven by an initial post-election rally. Meanwhile, European equities have slightly outperformed, rising nearly 8% over the same period.

This resilience in global stock markets is particularly notable, given the intensifying trade rhetoric and the significant reduction in expectations for Federal Reserve easing over recent months. However, key upcoming events—Wednesday’s inflation report, Federal Reserve Chair Jerome Powell’s congressional testimony on Tuesday, and further trade developments—could provide the momentum needed for equities to break out of their recent consolidation. The US dollar has strengthened for a third consecutive session, but gains remain limited, with the 3% trading range since mid-December still intact.

As we have previously argued, further upside for the dollar depends on sustained trade escalation and the actual implementation of tariffs. With the Federal Reserve pause fully priced in, the dollar now requires either a stronger US macroeconomic backdrop or deteriorating risk sentiment to make meaningful gains. At present, the high noise-to-signal ratio makes shorting the Greenback a difficult case to justify.

Struggling to hold above $1.0350

EUR/USD extended its losing streak to a third consecutive session, weighed down by dollar strength and ongoing trade concerns. However, the downside has remained limited as European equities continue their impressive performance, with the STOXX 600 closing at a fresh record high, reflecting investor confidence in the region’s economic resilience. Stronger bond yields have also provided some support, as markets reassess the European Central Bank’s (ECB) policy path amid shifting inflation dynamics.

The latest Sentix investor sentiment index showed a marked improvement in eurozone morale, rising to its highest level since July, suggesting that optimism is gradually returning to the region despite persistent economic headwinds. ECB President Christine Lagarde maintained the central bank’s outlook, reiterating that inflation remains on track to return to the 2% target this year. However, she cautioned that rising trade tensions, particularly those stemming from the United States, could pose risks to the outlook, making the ECB’s policy path more uncertain in the months ahead.

Meanwhile, German Chancellor Olaf Scholz issued a stark warning, stating that the European Union is closely monitoring the situation and will not hesitate to retaliate if the US proceeds with tariffs on EU exports. His comments underscored growing concerns that transatlantic trade relations could deteriorate further, injecting another layer of uncertainty into the euro’s outlook. While the currency has managed to hold above key technical levels for now, escalating trade risks and diverging central bank policies could keep EUR/USD under pressure in the near term.

Will the pound outperform the euro again this year?

GBP/EUR is over 1% lower year-to-date but has recently rebounded from five-month lows, thanks to a slightly more optimistic UK domestic backdrop. More significantly, tariff risks are perceived as more damaging to the Eurozone economy than to the UK. The currency pair is encountering resistance around its 50-day moving average at €1.20 but remains above its 200-day moving average, which is trending higher—a sign of sustained upward momentum.

The currency pair continues to avoid substantial daily fluctuations. In fact, GBP/EUR has not recorded a daily rise or fall of 1% or more for over 500 trading days. Though lacking volatility, GBP/EUR experienced a healthy uptrend in 2024, finishing the year nearly 5% higher and recording its highest year-end close since 2016. Two key contributors to this uptrend have been heightened European political risks and elevated UK-German short-term yield spreads, although both have recently stabilised at lower levels. These macroeconomic drivers suggest that GBP/EUR should be trading closer to €1.18-€1.19. Thus, we believe sterling is benefiting from its lower sensitivity to tariff risks compared to the euro. Should tariff threats against the EU materialise, we would not rule out GBP/EUR extending above €1.21—a level it has only surpassed for 1% of the time since Britain voted to leave the EU in 2016.

From a macroeconomic perspective, the Eurozone economy stagnated at the end of 2024, and recent high-frequency indicators suggest that economic activity is likely to remain subdued in the near term. In the UK, economic activity has also weakened, although recent survey data points to a moderate revival. This week’s UK real GDP data is expected to show no economic growth in the fourth quarter of 2024.

In terms of monetary policy, markets are pricing in 66 basis points of Bank of England easing by year-end, compared to 90 basis points for the ECB. The two primary risks to further GBP/EUR upside are increased expectations of BoE rate cuts and a softening of the tariff narrative. The former is already materialising to some extent, with the BoE’s Catherine Mann—previously considered one of the committee’s more hawkish voices—adopting a more cautious tone and expressing concerns about slowing consumption and the labour market.

Sterling Holds Steady Amid Trade Tensions and BoE Signals

Market focus remains on trade tensions, yet the British pound continues to show resilience due to its limited direct exposure to US tariffs. While uncertainty around global trade impacts sterling against traditional safe-haven currencies, it has largely supported other sterling pairs. Meanwhile, the Bank of England’s (BoE) divided vote on interest rates was balanced by an upward revision to inflation forecasts. This week, UK GDP data will be a key factor in determining sterling’s next move.

At the start of last week, sterling experienced heightened volatility due to shifts in global risk sentiment but outperformed other risk-sensitive G10 currencies. Investors appear to view the UK as less vulnerable to direct tariff threats from the US. GBP/EUR extended its gains, climbing past €1.20—four cents above its five-year average. Midweek, focus shifted to monetary policy when BoE policymaker Catherine Mann unexpectedly joined Swati Dhingra in advocating for faster rate cuts, pushing GBP/USD down toward $1.23. The BoE also downgraded its 2025 growth forecast to 0.75% from 1.5%, but a rise in near-term inflation expectations helped support sterling by driving UK gilt yields higher.

Despite a broader downtrend indicated by long-term moving averages, a recent breakout above a descending trendline suggests potential upside. A sustained move above $1.24 could open the door for gains toward $1.26.

US Jobs Report Sends Mixed Signals as Inflation Concerns Persist

January’s US employment data presented a mixed picture for investors. Job growth slowed, but wages rose, reinforcing ongoing inflation concerns fuelled by trade tensions and rising price expectations. This uncertainty helped lift the dollar ahead of the weekend, though not enough to reverse its weekly decline.

Nonfarm payrolls increased by 143k, missing the 175k consensus estimate. However, revisions to the previous two months added 100k jobs, and the unemployment rate remained at 4.0%, beating expectations of a slight uptick to 4.1%. Wage growth remained strong, with average hourly earnings rising 0.5% month-over-month, though the average workweek dropped to 34.1 hours—its lowest level since the pandemic. These dynamics suggest the Federal Reserve may maintain its current policy stance, with options markets now pricing in just two rate cuts for the easing cycle.

Euro Struggles Against Dollar as Trade Tensions Weigh on Sentiment

The euro came under pressure against the US dollar on Friday, though losses were not enough to erase gains from earlier in the week. However, the swift pullback after reaching the 50-day moving average at $1.0410 signalled investor concerns about the Eurozone’s economic outlook amid escalating trade tensions.

The dollar’s strength was further reinforced by its safe-haven appeal during times of global uncertainty. Last week’s market action highlighted both the vulnerability of global markets to shifting policies and the ability of equities to rise as long as corporate earnings continue to exceed expectations.

This week

Looking ahead, markets face a busy economic calendar this week, with key inflation data, industrial production figures, and retail sales reports set to drive sentiment. The Consumer Price Index (CPI) and Producer Price Index (PPI) will be closely watched, given renewed concerns over inflationary pressures. A stronger-than-expected reading could reinforce fears of persistent inflation, potentially influencing the Fed’s rate-cut trajectory. Key data releases this week include UK growth and industrial production figures on Thursday, while US inflation data on Wednesday will also influence GBP/USD movements.

Investor focus will turn to key survey data to assess whether the European economy has found a floor. The ZEW surveys for Germany and the broader Eurozone, along with the EU’s flash consumer confidence reports, will take centre stage. The week will wrap up with the Flash Purchasing Managers’ Index (PMI) on Friday, a crucial forward-looking indicator. For EUR/USD to hold above $1.03 and establish a bottom, the euro will need support from stronger domestic data, especially as trade tensions continue to escalate.

BoE Rate Cut Sparks Pound Volatility Amid Inflation Concerns

The Bank of England (BoE) cut its benchmark interest rate by 25 basis points to 4.5% in a 7-2 vote, a widely expected move. However, the unexpected vote split triggered a brief selloff in the pound. GBP/USD dropped towards $1.23 from $1.25, while GBP/EUR slipped below €1.20. Selling pressure eased after Governor Andrew Bailey provided reassuring comments, and upward inflation revisions cast doubt on the likelihood of further aggressive rate cuts.

The decision highlighted divisions within the Monetary Policy Committee (MPC) and underscored deep uncertainty about the UK’s economic outlook. Dissenters Swati Dhingra and Catherine Mann pushed for a larger 50bp cut, with Mann’s shift particularly notable given her previously hawkish stance. This marked a clear dovish signal. However, the BoE’s inflation forecast revisions provided a more hawkish counterbalance. Additionally, the Bank sharply downgraded its GDP growth projection for 2025 from 1.5% to 0.7%, citing weaker-than-expected economic performance and a more subdued outlook for the first half of the year.

The UK’s persistent supply-side weaknesses continue to complicate the balance between growth and inflation. Low potential growth, sticky wage increases, and lingering inflationary pressures suggest that a prolonged period of sluggish GDP growth may be necessary to bring inflation sustainably back to target.

Looking ahead, next week’s inflation and GDP data will be pivotal in shaping expectations for the BoE’s next move. While the pound’s yield advantage is eroding, its limited exposure to tariff risks should help prevent significant weakness against major currencies.

French Government Survives No-Confidence Vote, Markets React Positively

The French government successfully withstood a no-confidence vote on Wednesday, clearing the way for the long-delayed annual budget to move forward. While widely expected, this outcome remains a constructive development for markets. The French risk premium—measured by the yield spread between French and German bonds—has eased from its peak of 90 basis points to 70. Meanwhile, French equities have outperformed both U.S. and broader European markets, delivering a 7% gain year-to-date.

Additional support for risk assets could come from the European Central Bank, which is expected to lower rates by 87 basis points this year. However, the extent of policy easing will depend on U.S. tariff decisions and the pace of European inflation. Investors have tempered their expectations for rate cuts following remarks from ECB Chief Economist Philip Lane, who warned that inflation may take longer to subside than previously projected.

In the currency markets, the euro has extended its rally for a third straight session—its longest winning streak since late October. EUR/USD must break above the 50-day moving average at $1.0420 to maintain upward momentum toward $1.05.