ur US economists recently revised their growth forecasts and are now below consensus for the first time in almost three years. At the same time, our European economists responded to the unprecedented German spending plans by upgrading their Euro area growth forecasts despite the looming tariff threats.
OAs a result, we are also revising our FX forecasts to show less appreciation from spot levels, as we acknowledge that a portion of the market reset in recent weeks is a fair reflection of this news flow. The seismic changes on both sides of the Atlantic underscore the challenges facing FX markets—and reinforce our longstanding view that there is value in both tails of the Dollar distribution.
We think of the FX outlook as a balance between US policy changes—which themselves can cut in both directions for the Dollar—and the foreign response. With both sides on the move like this, shifts in the expected balance can be large and sudden. But, the details of these changes are important and in our view continue to warrant Dollar appreciation over time. We see three main factors that warrant special consideration for FX: the role of tariffs, the size of the moves so far versus fundamentals, and the Dollar-specific misalignment in FX valuations. First, on the role of tariffs, the reason why we have lowered our growth forecast matters—our economists more than doubled their tariff baseline as the Trump Administration has so far shown a higher tolerance for lower equity prices. This would be the biggest change in the tariff rate in about 100 years (Exhibit 1).
As a rough rule of thumb, the 10pp increase in the effective tariff rate we expect should be worth around 5% on the broad Dollar. However, there are wide error bands around that estimate, it is not that large relative to other sources of FX volatility, and there are many reasons why the impact could be—and so far has been—smaller. So, we think of it as a significant “head start” for the Dollar, but not an insurmountable lead. And it is important to keep in mind that so far the vast majority of actual tariff increases have been focused on China, which has kept tight control over its currency (see CNY bullet).
But the future tariff increases we expect should not be as easy for other countries to brush off. It is clear that weaker growth because of coming tariffs is not a reason to be negative on the currency by itself, even as some other policy changes have been a negative catalyst. Second, as we noted last week, the surge in European currencies over the last few weeks has been meaningfully larger than the typical relationship with growth expectations (even if we allow for a more frontloaded shift than our economists expect).
As a result, there is likely some room for disappointment once we move into the implementation phase, and it is worth noting that our economists are also below consensus for Euro area growth this year. Third, from a valuation perspective, European currencies actually appear overvalued on a trade-weighted basis. The valuation case then has to come from the Dollar leg. While this is a significant risk because of the potential magnitude of the flows should the dynamics that have underpinned the strong Dollar reverse, it does not align with our central case (though it admittedly has become more plausible).
Our growth downgrades so far have been mainly on the back of trade policy, but we think investors with a more bearish view are likely placing a greater weight on other areas of policy uncertainty, such as the labor market or fiscal restraint, where we have made more limited changes but do agree that would create a more bearish Dollar environment if it materializes.
