FX Market Update: USD Poised for a Comeback.

• USD Recovery Potential: The dollar remains pressured but could rebound if economic data challenges bearish sentiment.
• Inflation & Fed Policy: February CPI data is a crucial driver for USD movements, with a higher-than-expected reading likely supporting the dollar.
• EUR/USD Overvaluation: The pair remains about 1.5% overvalued, and technical resistance, along with a potential ECB dovish shift, could cap gains.
• GBP/USD Stability: Sterling remains firm near a four-month high, awaiting US CPI data for further direction.
• Political & Trade Risks: The US-Canada tariff dispute, Ukraine ceasefire, and potential US government shutdown remain key factors influencing markets.

USD: Signs of a Rebound
Global risk sentiment took another hit as President Trump initially threatened to double tariffs on Canadian steel and aluminum before retracting the move following Ontario’s suspension of a 25% surcharge on electricity exports. Markets have been searching for relief from trade tensions, but there’s little indication that stock market volatility will deter Trump from his protectionist stance. US global tariffs on steel and aluminum are now in effect without exemptions.

The dollar extended its losses yesterday but showed signs of recovery overnight. With US tariffs rolling out, we see room for the greenback to strengthen. If upcoming data doesn’t support market pessimism regarding the US economy, sentiment could shift quickly. The prevailing bearish outlook hinges on the idea that tariffs are exacerbating an economic slowdown, yet past recessionary warnings in the US have often been misguided.

Meanwhile, inflation hasn’t weakened enough to justify another Fed rate cut. Today’s February CPI release could push the dollar higher if our forecast of a 0.3% core CPI month-on-month increase is accurate. That aligns with consensus, but the dollar is already pricing in substantial negatives, making it more sensitive to any hawkish signals. We hold a bullish bias on USD today.

In political developments, Ukraine has agreed to a 30-day ceasefire, brokered by the US, pending Russian approval. Domestically, the US House passed legislation to avert a government shutdown on Saturday, but Senate approval still hinges on a few moderate Democrat votes. Markets remain cautious about fully discounting shutdown risks.

EUR: Overvalued and Facing Resistance
EUR/USD gained support following Ukraine’s ceasefire agreement but slipped from 1.095 to just below 1.090 as the dollar rebounded and the EU announced €26bn in retaliatory tariffs against the US. Since markets had largely anticipated a Ukraine-Russia truce, further EUR/USD gains could be limited, particularly given stretched technical indicators.

Despite last night’s pullback, EUR/USD remains about 1.5% overvalued based on our short-term fair value model. CFTC data shows speculative positioning has returned to neutral, with net-short positions shrinking from 11% of open interest at February’s end to just 1.5% as of March 4.

With US core CPI potentially curbing Fed dovishness, the two-year EUR/USD swap rate differential (-144bps) may struggle to tighten beyond -140bps and could even widen, making EUR/USD appear even more expensive. Additionally, ECB President Christine Lagarde and other ECB speakers may adopt a more dovish tone in response to the EU’s retaliatory tariffs.

At this stage, we see a greater likelihood of EUR/USD falling to 1.080 than rallying to 1.10.

GBP: Holding Strong Near Four-Month Highs
GBP/USD remains firm near its four-month peak of 1.2965 in Wednesday’s European session. The pair maintains gains while the US dollar finds temporary support ahead of the February US CPI data, due at 12:30 GMT.

US inflation data will be pivotal in shaping market expectations for the Federal Reserve’s monetary policy. Fed Chair Jerome Powell recently stated that the central bank could maintain “policy restraint for longer if inflation progress stalls.”

Economists expect year-over-year headline inflation to slow to 2.9% from 3% in January, while core CPI is projected to ease to 3.2% from 3.3%. Monthly growth for both measures is expected at 0.3%.

Signs of easing inflation could boost expectations for a Fed rate cut in May. The CME FedWatch tool now indicates a 42% probability of a May rate cut, up from just 10.4% a month ago. However, persistently high inflation figures could dampen those expectations.