Trump turns up the tariff temperature

Judging by market reaction, there is still a firm expectation that the worst-case scenario will be avoided. European bourses opened the week down ~0.5% which while not insignificant, is a far cry from the volatility seen back in March / early April (see VIX index chart below). The response in the FX market is interesting with the dollar stronger across the board. Whilst a weaker euro might not be that surprising given the impact tariffs would have on the European economy, the single currency is trading higher against both the pound and the yen, implying the move in EURUSD is more about dollar strength than euro weakness.

A couple of points worth considering:

1. Don’t rely on correlations – we’ve written numerous articles in recent months about the breakdown of traditional correlations between equity markets, interest rates and exchange rates. For the past couple of months, talk of tariffs has been met by weaker equity markets and a softer dollar. Maybe we shouldn’t read too much into a one day move, but it’s notable that we’re seeing more of a ‘traditional’ risk off reaction in the markets today.
2. The dangers of complacency – Whilst there is clear desire to reach an agreement, particularly from the European side, it feels like markets are somewhat complacent about the risks of this not happening. Global equity indices remain close to record highs while volatility in both FX and interest rates remain surprisingly subdued. As the next two weeks unfold, if there aren’t signs of progress being made, there is a clear risk of markets becoming increasingly volatile.
3. Negotiation tactics – Trump has shown that he’s not adverse to extreme demands followed by small, slow concessions. The problem with this strategy is that it can result in negotiations being drawn out, even to the extent that a deadline is allowed to pass before a resolution is found later. That may be all well and good, but the market volatility caused in the interim is particularly difficult to manage.

What does it mean for our IR and FX views?

In short, we see no reason to change our long-term bearish view on the dollar. Given the uncertainty created by Trump and his policies, we continue to expect foreign investors to diversify their holdings away from the US (which in turn should weigh on the dollar). That said, we’ve already seen the dollar depreciate >15% since the beginning of the year and knowing markets rarely move in straight lines, a correction, or even just a period of consolidation, would not be untoward in the near term and wouldn’t change our long-term bias.