The dollar is caught between tariffs and a slowdown in the first quarter, causing the euro/dollar exchange rate to rebound sharply

Today marks another big step in Mr. Trump's "America First" agenda, with steep tariffs being imposed on Canada and Mexico and additional duties on China.AUSFOREX official websiteCanada and China have announced retaliatory tariffs. Surprisingly,foreign exchange marketThe response has been muted, mainly because weak economic activity in the United States is weakening the dollar.

Dollar: Tariffs are good for the dollar, but the stock market correction is not

During President Trump's first term, we believe that the sequencing of tax cuts (end of 2017) and subsequent tariffs (March 2018-August 2019) was a key reason for the dollar's strength. In other words, the US economy received some fiscal support before launching the tariff war. What seems to be happening now is that the US government adopted protectionist measures early in the new administration, but there was no domestic support. This means that while the US is now extending tariffs to Canada and Mexico, domestic economic activity is weak, leading to market expectations that the Federal Reserve will cut interest rates by 75 basis points this year instead of 50 basis points. This has kept the dollar from strengthening on the tariff news.

The dollar's near-term path may depend on how the U.S. stock market performs. A 25% tariff on major trading partners could be a shock, and historically, trade frictions have been bad news for stocks. It's no surprise that investors are now adopting a more defensive investment strategy, which will allow the yen and Swiss franc to continue to perform well in the cross exchange rate. If the U.S. stock market moves worse, then the dollar/yen and dollar/Swiss franc exchange rates could also fall sharply.

The imposition of tariffs now also serves as a reminder that the administration's fiscal agenda requires tariff revenue. This could mean that the current tariffs are unlikely to be lifted anytime soon, and are likely to be expanded to full-blown tariffs in April. President Trump is expected to outline this agenda in a speech to a joint session of Congress at 21:00 EST. With tariffs at the heart of his agenda to bring well-paying manufacturing jobs back to the US, the environment will remain difficult for currencies in countries that rely on exports of goods or have more open economies.

Ultimately, we still expect the dollar to strengthen overall in the first half of the year, but the process could be bumpy.

The Dollar Index (DXY) is heavily weighted against European currencies, which are being buffeted by tariff news and aggressive European defense spending plans. It's hard to tell, but the tariff factor is likely to keep the Dollar Index's support at 106.15-106, unless U.S. stocks crash.

Euro: Claims of increased defense spending in Europe are overstated

The euro rallied sharply against the dollar yesterday as investors focused on the sharp rise in European defence stocks. There is no doubt that Europe now needs a significant increase in defence spending. But the question is, what does this mean for the exchange rate? Can European defence spending boost European economic growth and reduce the European Central Bank's easing cycle?

After all, in the wake of the 2022 Russian-Ukrainian conflict, Germany established a special defense fund of 100 billion euros, but has now spent only about a quarter of it. We certainly don't want to hinder the rise in European defense stocks and the steepening yield curve on European government bonds, but we do doubt that buying euros based on this claim makes sense.

Instead, it was the weakening of US data and the repricing of Fed expectations that largely drove the rise in the euro/dollar exchange rate. In less than a month, the spread between two-year Treasury yields on both sides of the Atlantic has narrowed by a staggering 35 basis points, driven entirely by the repricing of the Fed. Whether the spread narrows further may depend on how US equities react to the tariff news.

The EUR/USD exchange rate is difficult to judge at the moment, but looming tariffs pose a real threat to open economies like the Eurozone. If for some reason the EUR/USD exchange rate breaks through the resistance level of 0535-1.0550, we doubt whether this rally is sustainable.

Yen: One of the few beneficiaries

The shift to defensive allocations in the foreign exchange market is good for the yen. Similarly, the threat of global trade friction and its impact on growth prospects could move global interest rates closer to Japan's low levels, which is also good for the yen. The belief that the yen will do well in cross rates is currently a common view. Currency pairs such as the euro/yen, the Australian dollar/yen and the Canadian dollar/yen are expected to fall as valuations of economically sensitive currencies decline.

The dollar/yen situation is slightly more complicated. A decisive fall below 148.50-148 would probably require a stock market sell-off or a sharply bearish US jobs report on Friday - in which case President Trump would probably prefer the Fed to lower its policy rate.