Summary
- U.S. trade policy continues to create economic uncertainty, and it has increased the chance of a recession in the next 12 months.
- U.S. Trade policy has increased the perceived risk premium priced into U.S. securities.
- The U.S. dollar drop almost 1% this week on the back of capital flows away from dollar-denominated assets.
- The European Central Bank cut rates by 25bps this week.
- The euro reached a three-year high of $1.1473 last week and is closing the week at 1.1383.
- The British pound reached a six-month high of 1.3286.
- The Japanese yen reached a seven-month high of 141.64 against the U.S. dollar.
U.S. Trade Policy, Inflation Dynamics and the U.S. Dollar
The U.S. economy continues to face high uncertainty stemming from the aggressive trade policy measures enacted by the Trump administration. These developments, alongside persistent inflationary concerns have reshaped the market outlook on economic performance. Currently the U.S. is facing a situation where consumer confidence is dropping and inflation expectations are rising, this combination signals the possibility of stagflation in coming months. The consensus forecast for U.S. GDP growth in 2025 has dropped from 2.2% to 1.4%, with many economists estimating the probability of a recession within the next 12 months above 45%.
NY Fed Inflation Expectations 1 year ahead
This conditions, in addition to the uncertainty created by U.S. trade policy, increased the risk premium for U.S. assets, driving capital flow out of dollar-denominated securities, and decreasing the value of the U.S. currency. The flip side of this dynamic was a strong rally in several currencies, but particularly noteworthy were the moves in the euro currency, the British pound, the Canadian dollar and the Japanese yen.
U.S. Dollar Index (DXY)
In terms of U.S. monetary policy, this week, Federal Reserve Chair Jerome Powell acknowledged that the magnitude of the announced tariffs exceeded the central bank’s expectations and noted that the full impact of these policies on prices remains difficult to quantify in the near term. Mr. Powell restated the Fed’s commitment to fight the inflationary pressure that tariffs may produce.
The recent increase in inflation expectations, is complicating the Federal Reserve’s policy path forward. Market participants now expect fewer interest rate cuts this year, with most now anticipating no more than two reductions in 2025. However, if tariffs end up producing a supply shock in 2025, the Fed may turn even more hawkish and may be forced to hike interest rates.
ECB Meeting and the Euro
This week the European Central Bank (ECB) announced another 25-basis point rate cut, bringing the deposit facility rate down to 2.25%. This was the seventh consecutive cut since mid-2024, and it was unanimously supported by the Governing Council, reflecting the ECB’s concern over the impact of escalating global trade tensions with the United States.
President Christine Lagarde highlighted the risk of a negative demand shock stemming from new U.S. tariffs and indicating that fiscal and structural reforms are critical to support the euro-zone’s long-term economic performance. She also mentioned that lower energy prices and a stronger euro are putting downward pressure on inflation.
Data continues to point to weak economic performance across the euro area, with no GDP growth in Q4 2024. Meanwhile, inflation in March came at 2.2%, remaining close to the ECB’s target.
With weakening external demand due to US tariffs, and a strengthening currency, the baseline scenario in the EU is one of further disinflation in the coming months.
Like the Fed in recent meetings, the ECB reiterated that its approach would continue to be data-dependent and signaled the possibility of additional rate cuts if incoming data point to further economic weakness.
In terms of price action, the euro dropped by 0.35% to $1.1383 after peaking at a three-year high of $1.1473 last week. As mentioned earlier, the euro’s recent rally has been supported by flows into European assets given economic uncertainty in the U.S.
British Pound (GBP)
The British pound posted notable gains this week, strengthening to a six-month high of 1.3286 against the U.S. dollar. Like the euro, this appreciation was driven by money flows leaving U.S. assets in the last few days, but it was also supported by market optimism regarding the trajectory of UK-U.S. trade negotiations.
Domestically, U.K. inflation eased to 2.6% in March 2025, primarily due to declining fuel prices and stabilizing food costs. This unexpected moderation increased expectations of monetary policy easing. Market participants now anticipate up to four rate cuts over the course of the year. The Bank of England, which previously reduced its policy rate to 4.5% in February, is scheduled to hold its next monetary policy meeting on May 8.
Japanese Yen (JPY)
The yen appreciated sharply earlier in the week, reaching a seven-month high of 141.64 against the U.S. dollar. Like the currency of other developed nations, the movement was also driven by concerns of a global economic slowdown. However, the currency's gains were tempered following President Trump's unexpected participation in U.S.-Japan trade talks, where he reported "big progress".
The narrowing interest rate differential between the U.S. and Japan has contributed to the yen's strength. The U.S.-Japan yield spread to 2.86% from 3.20% over the past three months. This compression supports further appreciation of the yen.
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