FX Update: FX Update: The volatile road ahead in 2025

Top of mind in the transition to 2025:
Normally I reserve considerable space for a rundown for the week ahead in event risks. But given we are on the other side of all of the urgent event risks for the year, there is little point, and I will return with the FX Update on January 3 or January 6. Rather, I’ll leave 2024 asking a couple of what I feel are the most important questions for the coming weeks and the coming year as a whole.

The key for 2024: Trump agenda and what comes first?

Most urgently suddenly is the US government shutdown risk. US president-elect Trump is making increasingly large waves in setting the agenda even a month before his inauguration. In the last couple of days Trump demanded that Republicans vote down a bi-partisan spending bill that was set to pass a vote in the House. In part egged on by Elon Musk, Trump argued that the bill included too many wasteful spending measures to please Democrats and he demanded a “clean” bill and – a kicker – that Congress also vote to raise the US’ self-imposed debt ceiling to get it one “on Joe Biden’s watch”. A new bill was floated yesterday but was rejected by the Democrats and a minority of Republicans.

Longer term: DOGE and deregulation, tax cuts and tariffs.
There are three possible factors that can theoretically support the US dollar with the incoming Trump administration. These are tariffs, which in theory make access to US dollar abroad more difficult and raise the odds that US inflation will remain high, obviating further Fed easing. Deregulation and tax cuts should juice growth, likewise keeping Fed policy rates higher than otherwise. Then there is the DOGE, or Musk/Ramaswamy’s Department of Government Efficiency, which seems to have made its first coup in striking down a spending bill even before Trump becomes president. If the DOGE proves a wrecking ball upon Trump taking office, striking down considerable Biden-era green- and other spending, this is a powerful USD negative, depending on the net scale of fiscal spending reduction (i.e., vs. the tax cuts and deregulation, which are less directly stimulative in the case of the former.) By the way, one of the interesting watchwords in this regard is “impoundment”, whether the Trump administration can stop funds that have been committed to specific Biden initiatives from being spent.

US Treasury yields are another existentially important factor for the US dollar and an independent variable that will require a policy response if they get disorderly. Intervention to keep the treasury market orderly could disrupt any USD-positive effects of new supply-side reform or tariffs.

How especially China responds to the arrival of Trump.
No visibility here, but there are very different directions that the policies of what Trump calls the “G2” (US and China as the only important players on the global stage) can take from Trump’s January 20 inauguration. Do we get an immediate and rapidly deepening trade war if Trump imposes massive tariffs against China and China retaliates in kind and even devalues its currency? Or do we see a period of negotiations and headline threats followed by real attempts a deal-making. What could this look like? Possibly a revaluation higher in the renminbi in exchange for Trump not imposing tariffs and some kind of coordinated devaluation of the US dollar (the so-called Mar-a-Lago accord approach). The latter, by the way, is the best way to fulfill US Treasury Secretary’s vision of keeping the US dollar’s status as the primary global reserve currency – a stronger and weaponized US dollar accelerates the motivation to find alternatives.

Other urgent issues:

CAD weakness. It’s easy to support the case for a weak CAD when we note the BoC’s more dovish path, Canada’s weak growth and the risks of the imposition of tariffs. From the rate spread angle, I don’t see much further more room for a widening of the spread, especially with BoC’s Macklem now waxing far more cautious on the rate path. On the 25% tariff against both Canada and Mexico that Trump floated, could Trump’s bark prove worse than his bite? Unknown, although Trudeau folding his tent and a snap election would put Canada in a much better place politically for the Trump era, as the Conservatives are polling strongly and their leader Poilievre is sending the right signals on deal-making. So by February, USDCAD could be above 1.5000 or sub 1.40 depending on how all the above chips fall. Positioning is very stretched short the loonie – call and put spreads possibly the only way to trade a view in USDCAD, given volatility risks from headlines in the coming few weeks.

Sterling turning lower? The Bank of England made it clear that it intends to continue for now with an gradual easing path and UK short rates judged this dovish as noted above. EURGBP has staged an interesting recovery, once again, from critical levels just ahead of the 0.8200 post-Brexit referendum vote low. Watching early days of 2025 for whether this holds and sterling risks downside on a more stagflationary outlook while Europe stumbles along or even sees its outlook brighten.

Watching Germany and Eurozone ahead of Feb 23 Germany election.
The CDU/CSU opposition to the current government has been making some of the “right” noises on the need to change the attitude on fiscal policy and open up for more investment, but are we set for a real revolution in Germany’s stance on fiscal stimulus and striking out on a new path now that its old industrial/export model has been completely disrupted, or do we get cautious incrementalism? I hope for the former, but fear the latter, especially if the CDU continues to see the AfD as untouchable, requiring it to partner with the left-centre SPD in an unwieldy coalition. Then there’s France…no clarity coming there any time soon – keeping an eye on Germany-France spreads. The single Eurozone-wide issue of greatest interest is whether there is a path to opening up for proper Eurozone bonds to fund defense spending, possibly on the order of EUR 1 trillion. And then there is dealing with Trump tariff threats and wherever the Ukraine-Russia war is going.

Table: FX Board of G10 and CNH trend evolution and strength.
Note: the FX Board trend indicators are only on a relative scale and are volatility adjusted. Readings below an absolute value of 2 are fairly weak, while a reading above 3 is quite strong and above 6 very strong.

The USD strength and NZD weakness has made for spectacular moves in NZDUSD as seen in the individual pairs below. Silver weakness sticks out and fits with the Aussie weakness as well as the market has given up on China stimulus hopes for now.

Table: FX Board Trend Scoreboard for individual pairs.
Some spectacular trend readings in the USD/commodity dollar pairs – these are looking very stretched, but if the current bout of risk aversion deepens badly, the US dollar can continue to extend before something gives.