Lessons from a very short trade war

Lessons from a very short trade war

Markets are responding to Trump’s last-minute deals with Mexico and Canada, which delayed tariffs for a month. The markets will likely deal with tariff threats more carefully. However, an additional layer of uncertainty has weighed against massive dollar appreciation. In the meantime, sterling enjoys an unusual status as a haven.

To summarize the events of yesterday in a nutshell, the US reached an agreement with Mexico in the first place, and Canada and everyone else agreed to postpone tariffs for a minimum of a month. Trump achieved a more substantial commitment to security at the border from both countries, but there was a lack of discussions on trade.

Within a few minutes, markets changed from a scramble to evaluate the impact of Trump’s massive protectionist decision to buying dips in previously affected currencies. USD/CAD and USD/MXN are trading below Friday’s closing. This week, as the US increased its threat of tariffs, we suggested that Trump’s handling of this particular round of protectionism could set an example markets could follow as a reference point going forward. If markets couldn’t fully assess the effect of tariffs until the final minute, the change by Trump might warrant more caution regarding future threats to protectionism.

One of the fundamental theories behind the hesitation to ultimately price in the tariffs is that there had to be an obvious economic benefit to justify the need for such measures. In Canada and Mexico, where the majority of border security was mentioned as the reason for protectionism, this motive was not evident, so there was astonishment at Trump’s announcement of tariffs over the weekend. The issue of whether Trump was planning an 11th-hour agreement with both countries or was motivated by a backlash from the domestic market remains unanswered. Whatever the case, markets have to adhere to a rationale, and we believe the conclusion could be that Trump is willing to lie his way to win a deal regardless of trade or border security.

This means that the dollar will not be able to experience considerable gains in the face of directly and indirectly affected currencies because of the announcement of tariffs. However, this will happen only when duties are implemented, and there are signs that they will remain. Let’s take AUD, NZD, and China tariffs as examples. US tax rates on China are set to go into effect on February 10, and Beijing has already declared a retaliatory 10% duty on US energy and farm equipment exports that will come into effect on February 10. A currency pair like AUD/CAD could fall sharply in this scenario, given that Canada has avoided the tariffs and China did not; however, it is just 0.5 percent lower on the day. This suggests that markets have priced in a strong possibility, and there is a good chance that both the US and China will likely agree and put off tariffs.

Another point is that markets aren’t entirely weighing up the possibility of tariffs just now. This is because tariffs were delayed only by one month. In addition, the volatility of news about trade in the past few days leaves markets with more uncertainty and unpredictability that can harm high-beta currencies due to direct protectionist exposures and risk-sensation consequences.

We will likely see another decline in the US dollar all over if you believe that the US and China can move toward a de-escalation within the next few days. Now that Trump has made explicit the threat of tariffs in everyday news reports, the case of a structural movement in the dollar seems weak, and we can still expect support to DXY at approximately 108.0. Today, the main event on the US calendar is the December JOLTS job figures, but revisions following the tariff threat will remain the main focus.

EUR: Don’t get too excited

Yesterday’s US-Canada-Mexico tariff war was the primary factor in the USD/EUR exchange – the eurozone’s Flash CPI estimations for January were a bit higher than expected. The primary measure remained unchanged at 2.7 percent (expected 2.6 0.7%) for the fifth month. The headline climbed for the fourth straight month and again shook up the ECB’s somewhat optimistic stance regarding disinflation.

Our economics team explains that the upside risks are still crucial for inflation. However, we are confident the path will remain deflationary for the rest of this year. We still expect the rate to be reduced to 2.0 percent in the eurozone.

Examining the implications of Trump’s handling of Mexico and Canada’s threat of tariffs and the impact on eurozone sentiment has improved because of hopes that a deal can be reached and the threat of protectionism will be averted. But extra caution is required in this respect. Suppose part of Trump’s motivation to delay tariffs against US neighbors was the fear of domestic backlash to avoid immediate economic harm to US consumers. That isn’t necessarily the case for EU tariffs. For those tariffs, Trump can afford to take a more extended approach and perhaps keep them in place for a more extended period, which could make those in the EU suffer some “pain” before striking an agreement. The most important thing is that the motivations behind tariffs against the EU are not border-related, and where the agreement may be more straightforward to come through, as we witnessed yesterday, but rather on trade imbalances that often require more lengthy negotiations.

With this all being said, we are skeptical that the euro will see an enthralling rally. Trump has previously suggested that the EU will be next on his list of tariffs, and markets may probably prefer buying down the declines in currencies that have surpassed the point of protection in the face of the euro but are yet to experience the most severe consequences. We expect a China-US trade deal to push EUR/USD closer to 1.040. However, the price could stall around the 1.040 mark.

GBP: The biggest winner in the tariff drama

On Tuesday, the pound emerged as a haven in procyclical currencies holding its ground after the American trading war stopped. The reason is straightforward: the UK is not a country with much loss due to US tariffs. UK exports to the US are lower than 2 percent of GDP, and exports to China are less than one percent. In addition, Trump seems in no hurry to punish Britain with tariffs. The UK has trade tariffs, particularly given that its trade balance with the US is likely negligible. Following an earlier phone call, Trump was also quite amicably with UK Premier Minister Keir Starmer.

Another element that contributed to sterling’s strength was the visit of Starmer to Brussels. It was designed to improve the EU-UK defense pathway; however, markets could double-read Starmer’s intention to eventually reengage politically with his EU. The sterling currency is undoubtedly good, as it is susceptible to any change that could boost a declining growth outlook.

There are, however, a few adverse risks to currency this week given that we can expect headlines this morning that confirm the fiscal headroom of that UK Chancellor has dwindled because of the higher cost of borrowing. The Bank of England may deliver a more dovish rate reduction on Thursday. However, the EUR/GBP could not revert to the 0.8450 Jan. peak anytime shortly.

CEE: A safe refuge in the EM market

Today’s calendar is devoid in the region. However, the global situation provides plenty of energy. Following yesterday’s increase in the inflation rate in Turkey, which surprised the positive and mixed PMI numbers, the following two events are NBP and CNB gatherings scheduled for Wednesday and Thursday. In the markets, the news of yesterday’s US tariffs led to a sharp selling-off in CEE currencies and the other EM space, but CEE shows some resistance to the kind of headlines being reported. However, we also saw a significant decline after the news from Mexico, particularly the rates that erased losses and were higher in the final hours of the same day.

However, we can see both the CZK and HUF as being vulnerable to this risk, and the stronger US dollar will keep this region under stress. According to us, the CNB rate was reduced on Thursday, and an increase in inflation in Hungary in the coming week will be FX negative for the local front and will leave these currencies more vulnerable. However, the more hawkish NBP will likely keep the PLN in good standing. The rate differential witnessed the highest increase yesterday in Poland compared to CEE counterparts and the press conference on Thursday. This is another reason yesterday’s PLN decline benefits us despite current robust PLN levels.