Dollar Caught Between Trade Tensions and Q1 Economic Slowdown

Impact on GBP: Cable trading just below the $1.2700 mark, near three-month highs

GBP/USD pulls back after previous session gains, trading around $1.2680 early this morning. Technical analysis of the daily chart suggests a continued bullish bias, with the pair remaining within an ascending channel. The 14-day Relative Strength Index (RSI) stays above 50, signalling sustained bullish momentum, while the pair holds above the nine- and 14-day Exponential Moving Averages (EMAs), reinforcing short-term strength.

GBP/USD faces immediate resistance at the three-month high of $1.2724, with a potential move toward the channel’s upper boundary near $1.2780. A breakout above this level could push the pair toward the psychological resistance at $1.2800.

On the downside, initial support lies at the nine-day EMA of $1.2639, followed by the 14-day EMA at $1.2613. A break below these levels could weaken momentum, bringing the channel’s lower boundary near $1.2560 into focus. A decisive break below the channel may shift the bias bearish, exposing the pair to the February low of $1.2249.

No Major Data.

Impact on EUR: European defence spending narrative appears exaggerated

EUR/USD advanced yesterday, supported by a sharp rally in European defence stocks. While increased defence spending in Europe is widely expected, the key question is its impact on FX markets. Can it significantly influence European growth and alter the ECB’s easing path?

Many economists remain sceptical that defence spending has a meaningful effect on economic growth. Notably, Germany has only used about a quarter of its €100 billion Special Defense Fund, established in 2022. While European defence stocks and bond curves have reacted positively, the case for sustained Euro strength on this narrative appears uncertain.

Instead, the primary driver of EUR/USD gains has been weaker US economic data and shifting Fed expectations. The US-European two-year yield spread has narrowed by 35 basis points in less than a month, driven entirely by Fed repricing. Further movement in this spread may depend on how US equities respond to the latest tariff developments.

Overall, EUR/USD remains in a delicate position, with trade policy risks challenging the Eurozone’s open economy. Even if the pair breaks above resistance at $1.0535/50, such gains may prove difficult to sustain.

No Major Data.

Impact on USD: Tariffs support the Dollar, but an equity correction does not

During President Trump's first term, the sequencing of tax cuts (late 2017) followed by tariffs (March 2018–August 2019) played a significant role in strengthening the Dollar, as fiscal support was in place before trade tensions escalated. In contrast, the current administration is implementing protectionist measures early on without comparable domestic economic backing. While the US has expanded tariffs to include Canada and Mexico, weak domestic activity has led markets to price in 75 basis points of Federal Reserve easing this year, up from 50 basis points, limiting the Dollar's upside potential from tariff developments.

Near-term Dollar movements may depend on US equity market performance. Historically, trade wars have weighed on equities, and 25% tariffs on key trading partners could prompt a defensive shift among investors. This could support safe-haven currencies like the Japanese yen and Swiss franc, potentially driving USD/JPY and USD/CHF lower if US equities decline.

Additionally, the implementation of tariffs highlights Washington's reliance on tariff revenue for fiscal policy. This suggests that current tariffs may not be reversed quickly and could expand into broader measures by April. President Trump is expected to outline related policy initiatives in his speech to Congress at 9 p.m. ET (2 a.m. GMT). Given the administration’s focus on bringing high-paying manufacturing jobs back to the US, currencies tied to commodity exports or highly open economies may face ongoing pressure.

Despite near-term volatility, the Dollar is still expected to strengthen in the first half of the year. However, the path may be uneven. The DXY index, which is heavily influenced by European currencies, remains caught between tariff-related pressures and increased defence spending in Europe. Unless US equities see a significant decline, support for DXY around 106.15/35 could hold.

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