Roller Coasters

The macro point

It was another turbulent week in the financial markets. Much was said, sometimes a bit too quickly. For example, less than a week ago, investment bank Goldman Sachs predicted a sharp recession in the American economy due to the new wave of protectionism. Then, a few days later, following the White House's moratorium, we shifted from a recession to an economic slowdown. Let's try to sort out fact from fiction.

1/ After "Liberation Day," US tariffs were multiplied tenfold compared to their pre-Trump level. If they remain at this new level—meaning if still uncertain negotiations do not begin and conclude quickly—the impact on consumer purchasing power, business margins, and consequently, investment could push the American economy towards zero growth in the second half of the year. Obviously, the extent of the slowdown will depend on the attitude of the US Federal Reserve (Fed). We do not doubt that once the US labor market shows clear signs of weakness, the Fed will act. However, it should not push rates very low, due to the need to consider inflationary pressures related to the trade war and the real estate market (strong price tensions). Market operators and analysts are wrong to think that the central bank will act urgently to save the Trump administration, in our opinion. It is about its credibility. It should not overreact to events as long as there is no liquidity problem in the financial markets.

2/ Europe will also be severely affected no matter what people say. Even if the shock is less significant than in the United States, the euro zone economy was already fragile before "Liberation Day." The additional blow to exports and confidence could push growth towards zero in the second half of the year. However, the European Central Bank (ECB) has more leeway than the Fed to intervene. Inflation is slowing, and even if inflationary pressures may arise, the disinflation process should continue.

3/ The American decision to increase tariffs naturally recalls historically troubling precedents, like the 1930 Smoot-Hawley tariffs, which prolonged the Great Depression and hindered global trade. However, the protectionist spiral of the 1930s was largely explained by the constraints of the gold standard. Today, governments have more choices and more leeway. If they keep their cool, there will still be room for free trade to persist and to avoid a recession spiral or entry into stagflation.

4/ The trade war between China and the United States is likely to last a very long time. For now, it concerns tariffs and the control of certain trade routes, like the Panama Canal. But this conflict will expand and can have significant repercussions on exchange rates. The Chinese government was the first to threaten to durably influence the yuan's exchange rate against the dollar, which is, as we know, administered. Last week, Beijing asked public banks to temporarily stop buying dollars. In the short term, our main concern is the USD/CNY pair. On one side, Washington increasingly talks about the possibility of a dollar devaluation (which would have consequences on all financial markets). On the other side, Beijing has not closed the door on a very controlled devaluation of its currency, if necessary.

How to react in these circumstances? Keep your cool, avoid jumping to conclusions (currently, there are more questions than answers), and absolutely think about hedging your exchange rate risk in case of exposure to the dollar and the yuan.

Technical point

The highlight of the past week is clearly the surge in the euro and the incredible volatility in major currencies, which is entirely unusual. During last Thursday's session, EUR/USD soared by 2.6%—a rise we haven't seen in years. As a result, the pair is now at a three-year high. This may only be the beginning, as markets have become unpredictable. Similar scale fluctuations are also noticeable on EUR/GBP or most pairs in USD. It's a new paradigm. Under these circumstances, one must be humble and acknowledge that it is very difficult to make long-term forecasts. Many American banks expect the EUR/USD to consolidate around 1.09-1.11. But it only takes the Trump administration announcing a new unexpected measure for the pair to soar to 1.15. Caution. It’s a roller coaster.

Announcements to follow

What we are certain of at the beginning of the week is that volatility will once again be present. The theme of tariffs will remain a major focus for operators. Initially, the money market was rather skeptical about a new rate cut from the ECB. That was before several members of the institution argued for a 25 basis point easing in April (Rehn, Villeroy). This is certainly an opportune time to do so. It will send a very positive signal to the market and surely support the euro in the short term, which—quite oddly in recent weeks—seems to be considered a safe haven by traders.

As for the Bank of Canada (BoC), monetary status quo should prevail even though the probability of a rate cut has increased in recent days due to the tariff policy of the Trump administration. The equation for the BoC is more complicated than for the ECB because it has to deal with already existing inflationary pressures. Lowering rates could reinforce them. We remain very cautious regarding the Canadian dollar. We consider it the major currency most likely to be affected by the trade war. Speculators agree. Short positions on the CAD are increasing day by day.

The information presented in this publication is provided for informational purposes only and does not constitute investment advice, a sale offer, or a solicitation to buy and should not be used as or considered as an encouragement to engage in any investment.