Tariffs, Equities, and the Dollar: A Complex Balancing Act.

• Tariff Impact on USD: While tariffs historically boost the dollar, weak U.S. economic data and expectations of Fed easing are limiting its upside.
• Equities & Safe Havens: A decline in U.S. equities could push investors toward the yen and Swiss franc, potentially weakening USD/JPY and USD/CHF.
• European Defense Spending & EUR: Despite a rally in European defense stocks, spending alone is unlikely to significantly impact the eurozone economy or ECB policy.
• GBP/USD Strength: Positive market sentiment, driven by Ukraine ceasefire hopes, has lifted the pound despite weak UK data and a softer USD.
• Market Sentiment as a Driver: With limited data releases ahead, broader market sentiment will be the primary factor influencing currency movements in the short term.

USD: Tariffs Support the Dollar, But Market Uncertainty Holds It Back
During President Trump’s first term, the sequencing of tax cuts (late 2017) and tariffs (March 2018–August 2019) played a key role in strengthening the dollar. The U.S. economy had fiscal support before tariffs were implemented. Today, however, Washington is ramping up protectionist policies early in the new administration without similar economic backing. As the U.S. expands its tariff regime to include Canada and Mexico, weaker domestic economic activity has led markets to adjust expectations, now anticipating 75 basis points of Fed easing this year instead of 50. This shift has dampened the dollar’s potential gains from tariff announcements.

Short-term movements in the dollar may hinge on the response of U.S. equity markets. The imposition of 25% tariffs on major trade partners could be a shock, and historically, trade wars have been detrimental to equities. Investors may seek safer assets, leading to continued outperformance of the Japanese yen and Swiss franc. If U.S. equities decline sharply, USD/JPY and USD/CHF could weaken further.

Tariffs also highlight Washington’s reliance on tariff revenue to fund its fiscal agenda. This suggests tariffs may be slow to roll back and could even be expanded to broader, universal tariffs by April. President Trump is expected to outline this strategy during his speech to Congress at 9 PM ET. Given the centrality of tariffs to his economic vision—particularly in reshoring manufacturing jobs—the environment remains challenging for currencies tied to commodity exports or highly open economies.

Despite near-term volatility, we still expect the dollar to strengthen broadly in the first half of the year, though the path forward will be turbulent. The DXY index, which is heavily influenced by European currencies, remains sensitive to both tariff-related developments and Europe’s growing defense spending. While a strong case can be made for tariff-driven support around 106.15/35, a sharp downturn in U.S. equities could disrupt this outlook.

EUR: European Defense Spending Buzz May Be Overdone
EUR/USD gained ground yesterday, driven by a rally in European defense stocks. While increased defense spending in Europe is a certainty, its broader economic implications remain unclear. Can it meaningfully boost European growth and alter the ECB’s easing trajectory?

Our eurozone economic team remains skeptical. For instance, Germany has only utilized about a quarter of its €100 billion Special Defense Fund, introduced after Russia’s invasion of Ukraine. While we acknowledge the momentum in defense stocks and steeper European bond yield curves, we question whether this is a valid reason to be bullish on the euro.

Instead, EUR/USD’s recent climb has largely been driven by softer U.S. economic data and a repricing of Fed expectations. The two-year yield spread between the U.S. and Europe has narrowed by an astonishing 35 basis points in under a month, solely due to shifts in Fed rate expectations. Further narrowing will likely depend on how U.S. equities react to the latest tariff news.

EUR/USD remains in a precarious position, with looming tariffs posing a risk to the eurozone’s open economy. Should the pair breach resistance at 1.0535/50, we are doubtful such a rally would be sustainable.

GBP: Sterling Gains as Market Sentiment Lifts Risk Appetite
The Pound-to-Dollar exchange rate surged on Monday, buoyed by an upbeat market mood. At the time of writing, GBP/USD was trading at approximately $1.2704, marking a nearly 1% gain from Monday’s open.

The U.S. dollar weakened against major counterparts as positive sentiment, fueled by European discussions on a possible Ukraine ceasefire, drove risk-on behavior. Optimistic remarks from French President Emmanuel Macron and other European leaders about a potential month-long ceasefire lifted investor confidence.

Further pressuring the dollar was the latest ISM manufacturing PMI data, which fell short of expectations, reinforcing concerns about slowing U.S. growth.

Meanwhile, the British pound strengthened despite weaker domestic data. The UK’s final manufacturing PMI for February declined from 48.3 to 46.9, remaining in contraction territory but exceeding the forecast of 46.4. Positive market sentiment overshadowed these figures, supporting the pound’s rally.

Looking ahead, the key driver for GBP/USD on Tuesday will likely be broader market sentiment, given the absence of significant economic data releases from the UK or U.S. Should sentiment turn negative, GBP/USD could face headwinds. However, if Monday’s optimism persists, further gains may be on the horizon as European trading unfolds.