FX Analysis: A "Tarrific" Plan

Institutional currency investors have been heavily short CAD in recent months, as President Trump aggressively applied his brand of “economic force” against Canada.

Market sentiment started to shift when President Trump announced a 30-day suspension of the 25% tariffs on non-energy imports from Canada. This developed into a full-blown short squeeze once President Trump announced his reciprocal tariff plan, which, as previously discussed, removed the immediate bullish catalyst for the USD.  

Our factor model for USDCAD, which includes monetary policy, commodity prices and risk sentiment but excludes tariffs, projects a short-term fair value around 1.42, unchanged from our last update (graph 3). Until this week, the pair was overshooting to the topside on tariff fears. We would not be surprised to see some overshoot to the downside in coming weeks as speculative long USD positions are unwound.

However, our medium-term forecast remains anchored at 1.48, which we expect could realize by mid-year. This is based on our view External link. that the US economy will remain on a stronger footing, while Bank of Canada may deliver more easing than the market’s terminal rate pricing of around 2.5%. While the threat of immediate 25% tariffs has receded, tariffs are set to rise, with our economics team expecting application as early as Q2 for Canada. Consensus forecasts for USDCAD have recently increased, with our 1.48 forecast at the higher end of the spectrum.

Where could we be wrong? We see two scenarios where CAD could outperform our forecast.

First, after the federal elections, the next Canadian prime minister might secure a better deal with President Trump. Trump has shown willingness to ease tensions in recent meetings with the Japanese and Indian prime ministers, provided the other party offers good optics and concessions. India lowered tariffs, and Japan offered investments. Canada could offer more defence purchases to enhance its role in patrolling the Arctic. Persuading the US administration to renegotiate CUSMA ahead of schedule could also provide a signal to markets as to how long a regime of high effective tariffs on Canada might last.

Second, the US economy could slow down. Business uncertainty and tighter immigration enforcement could impact employment data. The DOGE cutbacks to federal spending and workforce add uncertainty; while reducing waste might improve long-term efficiency, rapid spending cuts could slow near-term growth and weigh on the USD. Notably, a quarter of new US jobs in the last six months were in government, and media reports suggest about 200,000 federal probationary employees have been let go, which could show up in the March nonfarm payrolls report due in early April. 

EURUSD fell to a low of 1.014 in early February on tariff-related noise, but recovered to 1.05, close to our estimate of its short-term fair value (graph 4). This was driven by broad USD selling, relief over delayed tariffs, and rising optimism for a peace deal in Ukraine.

Betting markets now assign a 70% chance of a Ukraine ceasefire this year. If a deal is made, Russian gas flows to Europe are expected to increase, which has caused TZT gas futures to fall sharply. Investor sentiment has improved, reflected in the strong performance of European equities over the last two weeks.

While the delay in US tariffs and the prospects for a ceasefire in Ukraine are encouraging for market sentiment, we remain cautious on the eurozone outlook. The Trump administration is likely to press European governments to raise defence spending and finance Ukraine reconstruction and will eventually impose tariffs. This will limit the fiscal headroom for stimulus spending. Meanwhile the ECB has offered little pushback on market pricing of three more rate cuts this year.

We remain confident that EURUSD will fall back to parity later this year. Our forecast relies on the US imposing reciprocal tariffs on the eurozone, though the size is uncertain given the very broad criteria External link. the Trump administration has set. Furthermore, we assume ECB will take interest rates down to 2%, and the Fed to around 4%, maintaining a substantial gap.

There are risks to our view.

First, the German federal elections on February 23 could allow for a much-needed course correction on economic policy. While Friedrich Merz, the leader of the CDU, is very likely to become the next chancellor, his ability to implement critical reforms will depend on the strength of the coalition he forms.  

Second, the final tariff burden may be less than expected. Over the next few months, European leaders may negotiate behind the scenes to address US concerns. For instance, the recent news that the EU will offer to cut tariffs External link. on US car imports and ease External link. fiscal rules to boost defence spending is an encouraging sign. 

President Trump has raised tariffs on all Chinese imports by 10%, increasing the effective tariff rate from 20.4% to 30.4% on our calculations. In response, Chinese authorities implemented targeted measures, including tariffs on certain US exports and restrictions on rare earth exports to the US, but chose not to devalue the renminbi.

Most analysts expected the People’s Bank of China (PBoC) to counter the tariff hike with a proportional currency devaluation, as during the 2018–19 tariff war. However, the PBoC maintained a stable daily fixing for the USDCNY and increased market interventions to keep the exchange rate around 7.30. In its Q4 monetary policy report, released on February 13th, the PBoC reiterated its “three firm commitments” to defend the currency: countering herd behaviour, preventing the risk of overshooting, and avoiding market manipulation. This suggests that the central bank aims to keep the USDCNY spot rate stable in the near term.

There are two explanations for this. First, Chinese authorities may expect currency devaluation would provoke even higher tariffs from President Trump. Second, the share of China’s exports to the US has declined to only 15%, making the hit to GDP more manageable than in the past.

Given the signals coming out of the PBoC, we have moderated our expectations of a higher USDCNY, reducing our year-end forecast from 7.65 to 7.40.  

GBP remains inversely correlated with gilt yields, as the market continues to keep the spotlight on public finances.  

The Office of Budget Responsibility (OBR) has cut its growth forecast for the economy, effectively wiping out the £10B headroom that Chancellor Reeves had kept in the Autumn Budget last year. This makes it likely that the government will need to cut spending, borrow more, or raise taxes to meet fiscal rules. The final forecasts will be presented on March 26. Balancing the pro-growth agenda with bond market concerns about fiscal sustainability will be challenging.

The UK’s twin deficits and rising gilt yields have pressured the pound, reflecting market concerns about fiscal stability and investment flows. Investors are wary of government spending and borrowing, as well as the risk of an abrupt slowdown on forced belt tightening, leading to a weaker currency. As the Spring Budget approaches, fiscal headlines will likely continue to impact the pound. The government’s handling of spending and borrowing will be crucial in addressing these issues.

Another risk to the pound is that the Bank of England delivers more rate cuts than market expectations. The market is pricing about two cuts over this year, which is what we expect too. But the MPC meeting on February 6 was more dovish, with two MPC members voting for a 50bps reduction.

There are two upside risks for the pound.  

First, risky assets have been rallying of late as the risk of an imminent hike in tariffs has receded. GBP is a high yielder in G7 and tends to benefit from carry trade inflows during risk-on periods.

Second, President Trump appears to have invited Prime Minister Starmer for a meeting in an impromptu phone call. If the recent visits of the Japanese and Indian leaders are a guide, markets should follow this meeting closely.