USD on the Brink: Tariffs, Stimulus, and Market Volatility.

• Dollar Weakness Intensifies: The DXY index dropped below 106 as European fiscal stimulus plans lifted EUR, while US tariffs weighed on markets.
• European Fiscal Stimulus Unleashed: EU leaders activated escape clauses to unlock EUR800bn in spending, while Germany suspended its debt brake for a EUR500bn infrastructure push.
• US Tariff Uncertainty: Conflicting signals on US tariff policies have created volatility, with expectations of broader tariff measures in April.
• EUR/USD Outlook Revised: EUR/USD has broken higher, with revised projections suggesting a 1.03/1.04 range rather than parity in Q2/Q3.
• BoE Policy Under Scrutiny: BoE policymakers testify today, with GBP/USD near resistance at 1.2810; a break higher could extend gains further.

USD: Caught in a Crossfire

The DXY trade-weighted dollar index tumbled below 106 yesterday as European currencies surged on the back of major fiscal stimulus plans. Critics argue that European leaders only act in times of crisis – and the potential US withdrawal of its security support from Europe certainly qualifies as one. Two key developments driving the euro’s strength included: a) the European Commission activating national escape clauses from the Stability and Growth Pact, paving the way for EUR650bn in national spending and additional measures totaling EUR800bn, and b) Germany’s decision to suspend its debt brake, releasing a EUR500bn infrastructure fund.

Further discussions on these measures are expected at today’s European Council meeting. Meanwhile, new US tariffs weighed on global equity markets, pulling them down 2-3%, pushing two-year Treasury yields below 4.00%, and weakening the dollar. During his State of the Union address, President Trump acknowledged that tariffs would cause a “little disturbance.” This disturbance has already dampened US economic activity, contributing to the dollar’s weakness. Over the past four weeks, market expectations for the Fed’s terminal rate have been revised down from 3.75% to 3.50%.

Investor confidence has also been shaken by erratic US tariff policies. USD/CAD briefly crossed 1.45 amid trade tensions between the US and Canada. However, later in the day, US Commerce Secretary Howard Lutnick hinted at a potential tariff relief framework for Canada and Mexico under the USMCA accord. With the new administration counting on tariff revenues to fund its policy programs, any rollbacks are likely to be slow, with broader tariff measures expected in April.

What’s next for the dollar? It remains susceptible to weak US economic data throughout March before tariffs take center stage again in April. This week’s focus will be on Friday’s US jobs report, preceded by today’s ADP employment figures and the ISM Services Index. The latter could influence markets, but unless it surprises to the downside, today’s data shouldn’t pose a major threat to the dollar.

DXY remains vulnerable to the 105.10/40 range, with a deeper move towards 104.00 likely only if Friday’s non-farm payrolls (NFP) report significantly underperforms.

EUR: Fiscal Firepower in Action

EUR/USD surged higher on expectations of a major fiscal push from Europe. The speed of policy shifts, particularly in Germany, has been striking. Attention will now turn to how swiftly the proposed fiscal measures move through German parliament. The anticipated stimulus is already impacting European bond markets, with the German sovereign 2-10 year yield curve steepening by 4 basis points yesterday.

Typically, the combination of looser fiscal policy and tighter monetary conditions is supportive of a currency. However, in this case, the fiscal boost hasn’t shifted European Central Bank (ECB) expectations. The forward ESTR curve still projects a low point for the ECB’s easing cycle near 1.75%, reflecting concerns over potential US tariffs hitting Europe next month.

While we weren’t expecting such a sharp breakout in EUR/USD, we remain unconvinced that the dollar is losing its reserve currency status. This looks more like a cyclical decline driven by soft US economic data. In the near term, US activity data will likely determine whether EUR/USD reaches 1.0670/80 today, or even pushes towards 1.0800 if Friday’s payroll data disappoints significantly.

Looking further ahead, our previous projections of EUR/USD hitting 1.00/1.02 in Q2 and Q3 now seem ambitious. Instead, a 1.03/1.04 range appears more plausible as new US tariffs come into effect next month.

GBP: BoE’s Policy Balancing Act

At 3:30pm CET today, Bank of England (BoE) MPC members Andrew Bailey, Huw Pill, Megan Greene, and Alan Taylor will testify before the Treasury Select Committee on February’s 25bp rate cut. Markets currently price in 57bp of BoE cuts this year, compared to 72/73bp for the Federal Reserve. While we expect three BoE cuts in 2024, the central bank’s recent commentary—especially from dovish members like Dave Ramsden—has emphasized caution and the need for a gradual approach, with stubborn private-sector wage growth remaining a concern.

Aside from the notably dovish Alan Taylor, it’s hard to see where a significant dovish shock could emerge from today’s testimony. GBP/USD is hovering near resistance at 1.2810, and a break above this level could propel the pair higher in this ongoing rally.