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Markets whipsaw as trade war escalates

Trading blows. Monetary divergence another euro headwind. The UK is not immune.

Written by the Market Insights Team

After a brief reprieve in financial markets thanks to the announcement of delayed tariffs on Canada and Mexico, investors are dissecting the barrage of tariffs announced by China in retaliation to the new 10% tariffs on Chinese imports. European stocks are struggling for direction, oil prices are slumping and safe haven currencies are in firm demand. The euro is the worst performer on the week, down over 1% versus the US dollar, and swinging 3.5% over the past seven days, whilst the Chinese yuan, AUD and NZD are all on the backfoot this morning.

Trading blows

George Vessey – Lead FX & Macro Strategist

Uncertainty is high when it comes to the tariff situation, causing spells of volatility across asset classes. Due to the hardened US approach on tariffs over the weekend, stocks and cryptocurrencies were plunging, US yields were rising and the US dollar was poised for one of its best days in years. But markets took a U-turn when the news broke that Mexico and Canada tariffs would be delayed for one month after conversations between country leaders on Monday.

The market turbulence didn’t stop there though. China’s tariff deadline passed and as a result, the world’s second largest economy retaliated by slapping tariffs on imports of US LNG, coal, crude oil and farm equipment and announced an antitrust probe into Google. Oil is down around 2% and the Chinese yuan is around 1% weaker versus major peers. Without question, the main theme driving markets is tariffs. Trump’s actions suggests he likes tariffs as a weapon, but how much is he willing to negotiate after they are imposed and what deals is he willing to strike? Until there is more clarity on the duration or magnitude of tariffs, we expect volatility to remain elevated, particularly in FX. Growth-sensitive and commodity-backed currencies should continue underperforming whilst the revival of safe haven demand makes the Japanese yen and Swiss franc appealing for diversification strategies beyond the US dollar.

The dust hasn’t settled on these announcements – they could still be watered down – creating considerable uncertainty. But the latest set of tariffs will lead to weaker GDP growth, higher unemployment, higher interest rates, and higher inflation this year in Canada, Mexico, and the US. At some point, the entire US-tariff narrative could come back to haunt the dollar when the extent of the hit to the US economy becomes clearer. For now, the health of the US economy is strong though, as evidenced by data yesterday showing the ISM manufacturing PMI rising above 50, pointing to the first expansion in the factory sector after 26 consecutive months of contraction. New orders jumped to their highest since 2022 and price pressures remain elevated.

Chart of cross asset volatility

Monetary divergence another euro headwind

George Vessey – Lead FX & Macro Strategist

The euro’s fortunes were turned upside down when Trump was elected in November. The common currency has fallen from a peak of $1.12 last year to around $1.01. It faces multiple headwinds, both political and cyclical. For example, a no confidence vote in France is now expected on Wednesday. However, speculation that the US will restrict trade with the EU is the latest negative catalyst and one that increases the risk of EUR/USD falling to parity or lower.

The trade risks have also reinforced the monetary policy divergence narrative, which is yet another headwind for the euro. Investors have boosted bets on monetary easing from the European Central Bank (ECB) due to growth concerns, pricing in more than three rate cuts over the rest of 2025. German bund yields are sliding as a result. But bets on the Fed are moving in the other direction, driving US Treasury yields higher. Thus, the spread between US-German yields are near their highest in five years and adding further fuel to the decline in EUR/USD. The big question from here is whether the market has adequately priced in trade-risk premiums. Given the currency pair is not too far (~2%) from where rate differentials suggest the pair is fairly valued, the risk is that a bigger risk premium needs to be priced in to reflect the hard tariff approach being peddled by Trump.

Unless the news breaks that the tariffs won’t be rolled out, we wouldn’t be surprised to see EUR/USD retest its cycle low and head toward the psychological barrier of parity. Indeed, sentiment in the FX options market has turned the most bearish on the euro in six months according to one-week risk reversals.

Chart of EURUSD and GBPEUR

The UK is not immune

George Vessey – Lead FX & Macro Strategist

Will Britain be spared tariffs? It appears it will be due to its goods trade deficit with the US. It has a trade surplus in services, but these are hard, if not impossible to target with tariffs. The pound is a risk sensitive currency though, and the UK is heavily exposed to higher interest rates, which keeps risks tilted lower for GBP/USD. But as evidenced by the gap open higher in GBP/EUR on Monday, it seems the pound could outperform its European peers in this escalating tariff backdrop.

American figures show the US to have a goods trade deficit of $209bn with the EU, $279bn with China, $152bn with Mexico and $68bn with Canada. In contrast, it has a goods trade surplus of $9.7bn with the UK. This should keep Britain out of the firing line and might make the pound look like something of a safe haven currency, though we’re not convinced. The UK is not totally immune to tariffs even if it is not a direct target. Britain’s economy will be sensitive to a slowdown in growth in big markets like the EU (its largest trading partner). Plus, the spillover from higher interest rates will make life even more challenging for the Treasury, with borrowing costs surging and limited fiscal headroom.

The pound could extend gains against the euro towards €1.21/22, well above its 5-year average of €1.16. However, the near-term bias versus the dollar points lower and we wouldn’t be surprised to see GBP/USD trading closer to $1.20 if EUR/USD falls to parity given the positive correlation held between the two exchange rates.

Chart of US trade deficits

Oil swings 5% in a week

Table: 7-day currency trends and trading ranges

Table of FX rates

Key global risk events

Calendar: February 3-7

Table of risk events

All times are in GMT

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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.

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