Sovereign International Weekly Market Report
European currencies explode as Germany embraces fiscal stimulus
We saw truly massive shifts in the FX market last week, with moves not seen since the early chaotic days of the COVID-19 pandemic.
Highlights:
President Trump's apparent demolition of the post-war European security architecture is having a paradoxical impact on currency markets. It's forcing Europe, and Germany in particular, to embrace massive increases in defence spending, to be financed apparently by deficit spending and additional debt. European bonds sold-off sharply on the news, and European currencies soared, notably the euro, which astonishingly posted one of its biggest weekly gains since the Global Financial Crisis in 2009.
Investors are also pricing in a high degree of damage to the US economy from both the substance of Trump's tariff policies and their amateurish implementation. One of our favoured barometers of US growth, the Atlanta Fed GDPNow estimate, is even pointing to a contraction in excess of 2% annualised in the first quarter of the year. The dollar subsequently lost ground against more or less every currency worldwide, with the US Dollar Index ending the week around 3% lower.
The macroeconomic calendar this week serves up the US inflation report for February. Markets are not really expecting further progress towards the Fed's target level, with the consensus eying an monthly annualised rate of nearly 4%. However, it is likely that once again macroeconomic information will be overshadowed by the chaos emanating out of the White House, any signs of resulting damage for the US economy, and further announcements of defence spending initiatives out of European countries.
USD
The February payrolls report temporarily calmed fears that the chaos emanating out of the White House will damage US growth, coming in more or less as expected, and still consistent with steady though unspectacular job creation. While this report stabilised the dollar after its dramatic weekly fall, it could not get a rebound going, as US stocks continue to underperform those of the rest of the world in an apparent no confidence vote on Trump's policies.
February inflation should be the economic focus this week, but news on tariffs, the war in Ukraine or frankly any other random occurrence in Trump's social media timeline may well overshadow it. Once again, Trump last week delayed tariffs for Canada and Mexico that fall under USMCA, in another sign that a dilution of the levies is highly likely. This can partly explain the extent of the move lower in the greenback last week.
EUR
The German stimulus package unveiled last week removes the debt brake for most defence spending and launches a 500 billion euro financing vehicle to pay for infrastructure. This “whatever it takes” moment lifted the euro above the 1.08 level, and markets no longer expect the ECB to cut rates below 2%, with a pause at the bank’s next meeting in April now looking like the base case scenario for markets.
We note that potential negatives for the euro remain. Tariff uncertainty remains significant, and the substantial weakening of American commitment to the defence of Europe cannot be counted as a long-term positive. The sharp move in EUR/USD in the past week has also left it prime for a reversal, particularly should upcoming US data suggest that fears over an imminent contraction in the world’s largest economy are perhaps slightly overdone.
GBP
While sterling also soared against the dollar last week, it lagged a little behind other European currencies, particularly the euro. For now traders like the idea of fiscal stimulus in Germany, whereas the UK is in the process of budget consolidation given its much higher debt. Reports suggesting that Chancellor Reeves will be forced into spending cuts in the Spring will not have gone down well with investors.
Nevertheless, we think that the pound underperformance versus the euro may reverse. The UK economy is relatively less exposed to Trump's tariffs, as it actually runs a deficit with the US. Further, economic and business newsflow has turned more positive of late, and Bank of England communications remain relatively hawkish, with most MPC members stressing that no more than “gradual” cuts are likely during the remainder of the year. We look forward to monthly GDP numbers on Friday to confirm the trend of slightly better than expected economic news.
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