Forex: The Dollar's whipsaw movement

Markets experienced dramatic fluctuations following a Washington Post report indicating that President Donald Trump's administration might limit impending tariffs to sectors considered vital for national or economic security. This news weakened the dollar as investors and CEOs clung to hopes for a more measured approach to trade policies. Despite this glimmer of optimism, the prevailing sentiment among traders remains skeptical. Many anticipate that Trump's administration will likely pursue a swift and extensive implementation of tariffs, maintaining a cautious stance in the trading community.

Yet, the recent intensification of discussions around U.S. trade policies and the approaching inauguration have somewhat dampened the fervent pre-inauguration demand for the dollar, as market participants speculate on potential policy shifts based on the adage, "where there is smoke, there is fire." In other words, folks are starting to think broad-based tariffs are not a sure thing.

Adding to this week's forex drama, Canadian Prime Minister Justin Trudeau's resignation has expectedly bolstered the Canadian dollar (loonie). However, a Canadian election must be held on or before October 20, 2025. With the Conservative party's substantial lead in the polls and its anticipated more harmonious relationship with President Trump, the ensuing political shift has injected optimism into the loonie's prospects. This political pivot is likely to align Canadian economic policies more closely with the U.S., potentially narrowing the recent wide gap between the Canadian and U.S. dollars.

The WaPo news of potentially selective tariffs caught the FX market overly positioned in dollars, prompting some traders to pare back risk. Despite this, due to other external factors influencing the bond market, most traders remain bullish on the dollar. However, it continued its slide in Asia after an overnight roller-coaster ride.

Traders are now recalibrating their strategies, wrestling with the inherent uncertainty of market probabilities. Unlike the clear-cut odds in gambling, financial markets require traders to make educated guesses based on incomplete information, a skill that is critical for gaining an edge. As we navigate these uncharted waters filled with probability gaps, one thing becomes increasingly clear: FX traders must brace for 'Trump’s Manic Mondays' and the erratic policy shifts that come with them.

We still think the outlook for the Euro remains bearish. The European Central Bank is poised to cut rates more aggressively than the Federal Reserve even in a toned-down trade war scenario and the persistent narrative of U.S. exceptionalism. President-elect Trump's potential shift of focus to the European auto sector in the coming months extends the downside risk to the Euro.

USDJPY bulls encountered resistance as Japan's Finance Minister, Katsunobu Kato, warned against speculative yen selling. This caution comes as the yen nears the critical 160-per-dollar mark, which triggered yen-buying interventions six months ago. Kato reiterated his concerns at a regular press conference, stating, "As I have said previously, we've been seeing one-sided, sharp moves in foreign exchange development," emphasizing the government's stance on recent currency market trends.

However, without a hawkish pivot from the Bank of Japan (BoJ) and against the backdrop of rising US yields and a more hawkish Federal Reserve, the verbal warning might only offer better levels for dollar bulls to sell the yen.

The market and the BoJ are closely watching to see if the People's Bank of China (PBOC) will adjust its currency fixing as depreciation pressure mounts. China's yield discount to the US has reached a new high, posing a significant challenge for a central bank already striving to support the yuan amid mounting economic pressures.

Overall, we think it is premature to wave green flags for currencies that Trump might target as his trade policy agenda unfolds. This backdrop suggests continued vigilance in the forex markets, as shifts in U.S. policy could prompt significant currency volatility.

This week, U.S. long-end yields catapulted to a 13-month zenith, with the 30-year bond cresting at 4.85%—a level not seen since November 2023. This sharp rise is more than just numbers; it's a clarion call from bond vigilantes who are increasingly alarmed by what they see as the U.S.'s reckless fiscal indulgence.

Looking back to the pre-September FOMC meeting—when the Fed implemented a 50 basis point cut—30-year yields were markedly lower at 3.96%. In the ensuing months, we've witnessed an explosive rise of nearly 100 basis points, spotlighting deep-seated concerns that transcend the immediate jitters around upcoming tariffs. This is not merely about tariff threats; it’s a profound unease about the broader implications for dollar strength and the potential necessity for aggressive rate cuts by major central banks like the ECB and PBoC. These moves are anticipated as preemptive strikes to foster domestic growth amid the hammer of Trump-administration tariffs.

This week's narrative is punctuated by the need to digest a significant bond supply, complicated by a holiday-shortened schedule in honour of President Carter. Yet the larger story unfolding is one of fiscal trepidation and the inflationary consequences of America's assertive economic policies, now under the intensifying spotlight of "Trump 2.0."

Amid this backdrop, the Fed's hawkish pivot—unusual within a rate-cutting cycle—paints a complex financial landscape.

With term premiums at their widest since 2015, the argument intensifies that they should, perhaps, be even wider given the myriad of risks looming over the U.S. rates market as we venture deeper into 2025. This scenario suggests the bond market may be bracing for further turbulence as fiscal anxieties loom large over investor horizons.