22/02/2025 Week Ahead

Dollar Rally Unwinds as Market Focus Shifts to US Tariffs

The anticipated “Trump trade” rally in the dollar has not fully materialized, leaving many observers puzzled. However, the surge in the greenback from late last September suggests that the move had already taken place. Around the time of the Federal Reserve’s 50 basis point rate cut and growing investor focus on US election polls, the dollar gained significant traction. In Q4 2024, the Fed’s real broad trade-weighted dollar index rose 4.9%, marking its best quarterly performance since 2016. The Dollar Index also climbed about 10% from late September through early January. However, since mid-January, the currency's rally has been unwinding, with momentum indicators stretched and new US tariff risks looming. While some correction has already occurred, the extent of further declines remains a key question. Current trends suggest that the unwinding process is nearly complete.

Looking ahead, upcoming economic data is unlikely to significantly alter central bank expectations. The recent upside surprise in US CPI and PPI is not expected to be reflected in the Fed’s preferred inflation measure, the PCE deflator. Meanwhile, Japan’s February CPI, particularly Tokyo’s core inflation reading, is expected to show only a slight increase, as energy subsidies continue to temper price pressures. In Canada, Q4 GDP data will be released following a 0.2% contraction in November. However, US tariff policies, set to take effect as early as March 4, may hold greater weight in shaping market sentiment and interest rate expectations. Additionally, China’s February PMI, due on March 1, is projected to show a modest improvement.

With geopolitical risks and trade policy uncertainties dominating headlines, markets remain cautious. The dollar's recent correction appears largely complete, but its trajectory will be closely tied to evolving US tariff developments and broader economic trends.

United States of America

Overview

The US has emerged as a key disruptive force in global markets, with escalating tariff threats and geopolitical moves that add uncertainty. March marks a new phase in US trade policy, with 25% tariffs on Canada and Mexico set for review, potential steel and aluminum tariffs scheduled for March 12, and further reciprocal and auto tariffs expected soon after. While concerns of "tariff fatigue" exist, these policies could create supply shocks with inflationary pressures while simultaneously dampening demand. Additionally, broader policy shifts, including immigration crackdowns and federal workforce reductions, are likely to impact labor markets, consumption, and overall economic growth.

Economic Drivers

Despite concerns over inflation, the latest CPI and PPI readings appear to be overstated, with core and headline PCE deflators expected to show a slight decline. January’s PCE deflators are projected at 2.5% (down from 2.6%), while core PCE is likely at 2.6% (down from 2.8%). Personal income and consumption also slowed to a moderate but steady 0.3% month-over-month pace. These factors contribute to an economic outlook that remains stable, with the Atlanta Fed’s model tracking Q1 2025 GDP growth at 2.3%, in line with Q4 2024.

Data and Events

Key data releases in the coming week include January’s durable goods orders, which will offer insight into growth momentum, and housing starts, which will feed into residential investment trends. Various regional Fed surveys and the Conference Board’s consumer confidence report are also expected, though they typically have minimal market impact. With trade policy overshadowing economic data, investors remain focused on tariff risks and their potential economic consequences.

Price Action

The Dollar Index has been in a corrective phase since peaking at 107.40 on January 13. Last week, it met the 38.2% retracement target from last September’s low (100.15), reaching 106.35. The next key retracement level (50%) sits at 105.15. Moving averages continue to decline, and momentum indicators remain weak. However, with new tariff risks emerging, traders are watching for reversal signals. A move above 107.40 would suggest a shift in trend.

Key Points:

• US tariffs on Canada, Mexico, and key industries are set to take effect or be reviewed in March.
• Inflation data suggests underlying price pressures are easing, with core and headline PCE deflators expected to slow.
• Q1 2025 economic growth is tracking at 2.3%, similar to Q4 2024.
• Durable goods orders and housing data will provide further economic insights, but market focus remains on tariffs.
• The Dollar Index remains in a downtrend, with key levels at 105.15 (support) and 107.40 (resistance).

Australia

Overview

The Australian dollar has shown renewed strength, supported by shifting yield spreads and improving inflation trends. The 60-day inverse correlation between the Australian dollar and the US Dollar Index has eased from 0.70 in early November to just under 0.55. Meanwhile, the correlation between the Australian and Canadian dollars remains above 0.70. Australia’s two-year yield discount to the US, which exceeded 50 basis points earlier this month, has now narrowed to less than 35 basis points. This shift comes as the Reserve Bank of Australia (RBA) takes a measured approach to easing, with markets not fully pricing in the next rate cut until July.

Economic Drivers

Hopes that Australia would be exempt from upcoming US steel and aluminum tariffs have been dampened by opposition from US trade officials. Prime Minister Albanese has pushed for an exemption, but Trump’s trade advisor, Peter Navarro, has firmly resisted the idea. These trade tensions add another layer of uncertainty to the Australian dollar’s outlook.

Data and Events

Australia’s January monthly CPI release will be closely watched, though the RBA still places more weight on quarterly readings. Inflation appears to have bottomed in September and October at 2.1%, before rising in November and December to end the year at 2.5%. In January 2024, CPI stood at 3.4%. While the RBA has already begun easing, it remains cautious about further rate cuts.

Price Action

The Australian dollar reached a high of $0.6410 before the weekend, marking its strongest level since mid-December. This nearly aligned with the 38.2% retracement of the decline from $0.6940 in September to $0.6090 in early February. The next key resistance level, the 50% retracement, is another cent higher. Although momentum indicators are stretched, they have not turned down yet. The Aussie settled near session lows at $0.6350 in late North American trading, with immediate support around $0.6330.

Key Points:

• The Australian dollar’s correlation with the US Dollar Index has weakened, while its link to the Canadian dollar remains strong.
• Australia’s two-year yield spread with the US has narrowed from 50 bp to 35 bp.
• Prime Minister Albanese is pushing for tariff exemptions, but US officials oppose them.
• Australia’s CPI rose from 2.1% in September-October to 2.5% in December and stood at 3.4% in January.
• The Australian dollar tested $0.6410, with the next key resistance near $0.6510, while support is seen around $0.6330.

Canada

Overview

The Canadian dollar faced volatility as US tariff threats loomed over trade relations. The prospect of a 25% tariff on Canadian exports, excluding energy, which would face a 10% duty, initially pushed USD/CAD close to 1.48. Markets anticipated that such a shock would force the Bank of Canada (BoC) into a more aggressive rate-cutting cycle. However, when the tariff implementation was postponed, Canada’s two-year yield discount to the US narrowed, and the Canadian dollar strengthened. While concerns remain over the March 12 deadline for US aluminum and steel tariffs, markets are awaiting further negotiations before reacting strongly.

Economic Drivers

US inflation concerns eased after softer-than-expected retail sales and manufacturing output, along with the belief that CPI and PPI overstated inflation relative to the Fed’s preferred PCE deflator. These factors contributed to a broader pullback in the US dollar, allowing the Canadian dollar to hit new highs since mid-December. Additionally, Canada has maintained a small current account deficit of less than 1% of GDP since Q4 2022, though the shortfall may have more than doubled in Q4 2024.

Data and Events

Canada is set to release December and Q4 2024 GDP figures, though the data is considered outdated given recent developments. GDP growth likely accelerated to 1.5%-1.6% (annualized) from 1.0% in Q3, with consumption and government spending slowing while fixed investment and net exports improved. The swaps market currently prices in nearly a 50% chance of a BoC rate cut at its March 12 meeting.

Price Action

USD/CAD found near-term support above 1.4150, with resistance seen around 1.4250-1.4260. A break above this level could push the pair toward 1.4300, with further upside potential toward 1.44-1.45. Despite recent gains for the Canadian dollar, momentum indicators suggest a possible USD recovery in the near term.

Key Points:

• Initial tariff fears pushed USD/CAD near 1.48 before a postponement eased pressure.
• The US CPI and PPI reports were seen as overstating inflation, contributing to a broader USD pullback.
• Canada’s GDP likely grew 1.5%-1.6% in Q4, with improved investment and net exports.
• The Bank of Canada meeting on March 12 has a nearly 50% chance of a rate cut.
• USD/CAD support is around 1.4150, with resistance at 1.4250-1.4260 and upside potential toward 1.44-1.45.

China

Overview

Despite speculation, China has not responded to the recent 10% US tariff on Chinese imports with currency depreciation. The yuan remains relatively stable, as Beijing seeks neither a strong nor weak currency but one that is broadly stable against the US dollar. Many analysts view China as a key beneficiary of recent US policy shifts, including foreign aid cuts and broader tariff threats. Meanwhile, China has announced tariff eliminations for imports from the world’s poorest countries.

Economic Drivers

China’s domestic economy still requires support, but the People’s Bank of China (PBOC) has not signaled immediate rate cuts or reserve requirement reductions. Instead, it may increase lending volume while downgrading the importance of the one-year Medium-Term Lending Facility rate as a benchmark. The US 10-year yield premium over China has narrowed to less than 275 basis points, the lowest in two months. Additionally, mainland Chinese companies listed in Hong Kong have surged nearly 19% this year, reflecting investor optimism.

Data and Events

China will release February PMI data on March 1. In January, the manufacturing PMI dropped to 49.1 from 50.1, marking a five-month low and matching the 2024 lows seen in February and August. The non-manufacturing PMI fell to 50.2 from 52.2, staying above contraction levels but at its lowest since December 2022. The composite PMI stood at 50.1, also matching the 2024 low from August.

Price Action

The dollar briefly hit a two-month low near CNH7.23 before rebounding to settle at CNH7.2550. However, it posted a third consecutive weekly decline, the longest losing streak in four years. Contrary to expectations, the yuan has strengthened by about 1% since the US announced its latest tariffs. Meanwhile, the PBOC continues to maintain a tight trading range for the yuan, reinforcing stability.

Key Points:

• China has not used currency depreciation to counter the new 10% US tariff.
• The PBOC is not expected to cut rates soon but may expand lending.
• The US 10-year yield premium over China has narrowed to a two-month low.
• February PMI data is due on March 1, with January figures showing a slowdown in manufacturing and services.
• The yuan has gained 1% since the US tariff announcement, while the PBOC keeps the currency within a narrow range.

Europe

Overview

The transatlantic alliance is facing its most severe crisis since the 1956 Suez Crisis, driven by US tariff threats, peace talks with Russia, and alleged political interference in Germany’s elections. This instability raises concerns about Europe’s financial commitments, particularly the costs of rebuilding Ukraine and increasing defense spending, which could lead to a rise in long-term European bond issuance. The initial market reaction to potential peace in Ukraine briefly lifted the euro, but the broader outlook remains uncertain.

Economic Drivers

The European Central Bank (ECB) is expected to cut rates further, with markets pricing in two rate cuts in the first half of 2025 and another in the second half. The outcome of the German elections will have political implications, though a CDU victory without an outright majority seems likely, leading to a coalition with the SPD and Greens. The AfD may place second but is not expected to be part of the government. Meanwhile, uncertainty surrounding US trade policy continues to weigh on sentiment, with further developments expected in March.

Data and Events

The economic calendar is light on high-impact releases. Credit data accompanying January’s money supply figures may show marginal improvement, while European Commission confidence surveys typically generate little market reaction. The ECB’s one- and three-year inflation expectations stood at 2.8% and 2.4%, respectively, at the end of last year, offering insight into inflation trends ahead of the March policy decision.

Price Action

The euro tested two-month highs last week but failed to break higher, peaking near $1.0505 after previous attempts at $1.0525 and $1.0515. Support was tested around $1.04, with a break below this range being a key technical signal. With the ECB widely expected to cut rates on March 6 and US tariff threats set to enter a new phase next month, the euro remains under pressure.

Key Points:

• US policy shifts have strained transatlantic relations, affecting European economic stability.
• The ECB is expected to cut rates twice in H1 2025 and once more in H2.
• German elections will likely result in a CDU-led coalition with the SPD and Greens, excluding the AfD.
• Limited high-impact data, but ECB inflation expectations remain a focus.
• The euro failed to break recent highs and remains vulnerable ahead of the ECB’s March decision.

Japan

Overview

The yen’s movement is primarily influenced by US interest rates and the Bank of Japan’s (BOJ) monetary policy. While often perceived as a safe-haven currency, its role in carry trades and its correlation with US rate shifts play a larger role in its fluctuations. Last week, Japanese policy developments were more impactful, as BOJ Governor Ueda remains committed to policy normalization. Meanwhile, the dollar’s correlation with the yen and yuan has weakened since last year’s carry trade unwind. Uncertainty remains over whether the Trump administration will grant Japan exemptions from its metal and tariff measures, given Japan’s trade deficit overall but surplus with the US.

Economic Drivers

The BOJ’s policy path hinges on inflation and economic performance, with signs pointing toward gradual tightening. Tokyo’s February CPI will be a key indicator, especially after January’s 3.4% headline inflation, which was temporarily inflated by the transition between energy subsidy programs. Fresh food prices, including rice, continue to rise, adding upward pressure on inflation. Excluding fresh food and energy, core inflation has stabilized between 1.8%-1.9% in recent months, supporting the case for BOJ tightening.

Data and Events

Japan will release January industrial production and retail sales data, both expected to improve from prior readings (0.3% and -0.7%, respectively). However, Tokyo’s inflation data remains the most critical release, as it often signals the broader national CPI trend, which will be reported in the coming weeks.

Price Action

The dollar recently tested key retracement levels, slipping below JPY149 ahead of the weekend—its lowest level since early December. Although typically influenced by US Treasury yields, recent movements were more driven by Japanese government bond (JGB) yields and narrowing spreads, which fell to around 300 basis points—the lowest in three months. The US 10-year yield dropped 17 basis points in three sessions to 4.40%. Since peaking on January 10, the dollar has weakened by about 6.25% against the yen. While momentum indicators suggest a stretched market, the technical outlook remains weak unless the dollar can reclaim the JPY151 level, with stronger resistance at JPY152.40-60.

Key Points:

• The yen’s movement is driven by BOJ policy shifts and US interest rates, with its safe-haven status tied to carry trades.
• The BOJ remains on a gradual tightening path, with inflation developments playing a crucial role.
• Japan’s industrial production and retail sales are expected to improve, while Tokyo CPI offers key inflation insights.
• The dollar fell below JPY149, its lowest since December, with JGB yields impacting the exchange rate more than usual.
• A move above JPY151 could stabilize sentiment, but a return above JPY152.40-60 is needed for a bullish shift.

United Kingdom

Overview

Sterling experienced a significant decline of nearly 10% from late September to mid-January, primarily following movements in the US dollar. The currency's rolling 60-day inverse correlation with the Dollar Index has reached a three-year high, indicating a strong connection between their movements. Meanwhile, the correlation between sterling and the euro has also risen, suggesting closer ties in their price movements. The UK’s two-year yield has aligned with the US two-year yield, while the UK’s 10-year yield premium has increased, marking a notable shift in the bond market.

Economic Drivers

UK economic data remains of secondary interest to market participants. Key reports such as the February CBI reported sales and the Nationwide house price index are not expected to generate significant market reactions. The swaps market reflects low expectations for another Bank of England (BOE) rate cut next month, but there is strong support (approximately 82%) for a rate cut in May. Additionally, Prime Minister Starmer's upcoming visit to Washington may overshadow domestic data. The UK’s proposal for a European “reassurance force” could complicate its relations with Moscow, aligning too closely with NATO operations, while the strategic trade dynamics between the US and UK remain complex yet present both sides with slight bilateral surpluses.

Data and Events

The UK economic landscape features limited high-impact data releases. The upcoming February CBI reported sales and the Nationwide house price index are unlikely to attract significant market attention. Market sentiment is also influenced by political events, particularly Prime Minister Starmer’s visit to the US.

Price Action

Sterling rose to a new two-month high near $1.2680 ahead of the weekend, marking its third consecutive weekly advance, the longest stretch since last April. This movement has seen sterling meet the 38.2% retracement level of the 10% decline from Q4 2024, found around $1.2610. The next key retracement level at 50% is near $1.2765, with the 200-day moving average slightly below $1.2790. A close near session lows indicates potential weakness, with a break below $1.2550 suggesting further declines.

Key Points:

• Sterling fell nearly 10% from September to January, closely tracking US dollar movements.
• Strong inverse correlation between sterling and the Dollar Index indicates a significant connection.
• UK economic data lacks high impact, with market focus shifting to political developments.
• Sterling rose to a two-month high near $1.2680, matching its longest advance since last April.
• Key technical levels include 38.2% retracement at $1.2610 and 50% retracement near $1.2765; a break below $1.2550 could weaken momentum.