Forex: Dollar softens slightly amid gradual tariff pledge

The FX markets are currently dominated by a seismic shift in Federal Reserve rate cut expectations, all triggered by a surprisingly robust non-farm payroll report. Expectations have cooled, with the next Fed cut not expected until October, plunging EUR/USD to a stark low of 1.0177 and magnetizing the G-10 currencies in its descent. Despite this dive in the plunge tank, USD/CNY has held its ground, buffered by vigorous Fix interventions from the Chinese central bank.

Yet, in a twist, the US dollar softened at the New York close yesterday amid emerging reports that President Trump's top economic advisers are meticulously planning a gradual rollout of trade tariffs. This strategy, spearheaded by notable figures like Treasury Secretary nominee Scott Bessent, Kevin Hassett of the National Economic Council, and Stephen Miran from the Council of Economic Advisors, aims to dampen sudden inflation shocks and optimize negotiation leverage. The proposed incremental monthly tariff increases of 2% to 5% could deftly spotlight Trump's prowess as the "Deal Maker in Chief," potentially reshaping global trade dynamics a little less ominously.

Despite these developments, the dollar's depreciation was relatively modest, as a hawkish Fed narrative still influences the broader market. This backdrop and ongoing adjustments in Fed rate cut expectations continue to be a significant driver of the latest fluctuations in the dollar and its impact on global currencies.

The Bank of Japan (BoJ) is caught between a rock and a hard place, navigating uncertainties around Trump's tariff strategies and the People's Bank of China's (PBoC) foreign exchange policies. While the market has somewhat resigned to the PBoC's efforts to stabilize the yuan, the act presents a conundrum for foreign investors. It makes Chinese investments appear overly expensive, given that the yuan should arguably be much weaker based on interest rate differentials with the U.S.

During his recent speech, Deputy Governor Himino attempted to offer guidance but stopped short of a strong signal for a rate hike next week. Nevertheless, he left enough ambiguity to keep the door open for such a move, with the markets now pricing in a 15 basis point adjustment, implying that a 25 basis point hike is about 65% expected. The BoJ's strategy seems to be to maintain flexibility in their decision-making, with the USD/JPY exchange rate potentially influencing their actions. A significant factor could be a surge in US yields following tariff announcements post-inauguration, which might provide the BoJ the impetus to raise rates at the upcoming meeting.

The US is set to release PPI figures for January later today, with the core measure expected to accelerate by an unwelcome 0.3% MoM. This is likely to fuel further skepticism about the possibility of Fed easing and could bolster the dollar ahead of tomorrow’s CPI release. The dollar index (DXY) seems poised to climb above the 110.0 mark after a modest, likely positioning-driven correction following the news of a gradual tariff implementation.

In Europe, economic support remains scant, leaving the EUR/USD vulnerable to further declines. ECB officials like Lane have expressed concerns that the inflation target will likely be missed if the economy doesn't pick up pace. This highlights both structural and cyclical growth issues within the eurozone. Olli Rehn has argued for interest rates to be adjusted to a neutral level by mid-2025.

With the ECB signalling a commitment to continued monetary easing, expectations have coalesced around a significant easing of up to 100 basis points by the year's end. This dovish stance from the ECB starkly contrasts with the potential for yet another hawkish shift in the USD curve, especially in the wake of forthcoming PPI/CPI data. This dynamic sets the stage for a critical test of the strength of the EUR/USD exchange rate, as diverging central bank policies could exert substantial pressure on the currency pair.

Even amid the backdrop of robust U.S. labour market data and ongoing tariff discussions, the outgoing Biden administration has dropped two potentially game-changing policies onto the global stage. Firstly, Biden has rolled out new restrictions on the sale of advanced AI chips and the volume of computing power available to foreign markets, cleaving the world into three distinct levels: Level 1, which includes allies like Europe and Japan; Level 2, encompassing a broad swath of nations including those in Southeast Asia; and Level 3, which notably includes China and Russia. This pivotal move introduces a lengthy consultation period, leaving the world on tenterhooks to see if the Trump administration will uphold these divisive classifications.

Simultaneously, Biden's team has unleashed sweeping sanctions targeting Russia's oil trade, which affect everything from tankers to insurers and traders, sending Brent crude prices surging to $81 per barrel. These sanctions threaten global oil dynamics, particularly impacting countries like India and China, where 25% of Russian seaborne oil could face disruptions. As the political and economic landscapes continue to evolve, the real impact of these policies—both immediate and long-term—remains a hotly anticipated and potentially volatile unfolding story.

Remember that higher oil prices are dollar-supportive, given the US is the world’s largest oil producer.