We cannot ignore when the facts change, especially when they relate to politics. Some of the biggest impacts on major exchange rates have come through this channel (eg, Trump, Brexit, Japan Abe’s Three Arrows, Eurozone sovereign crisis). Having had a pessimistic view on EUR-USD since September 2023, we need to recalibrate in response to the German election result and fiscal change. At this stage, it is not straightforward to decipher how much of the German political change is in the EUR’s price. Longer-term interest rate differentials suggest there is room for EUR- USD to rise further towards 1.11 (Chart 1).
However, when looking at a shorter yield differential with the exchange rate, which better captures the market’s expectation for relative growth, inflation and monetary policies over our forecast horizon, EUR-USD should be close to 1.08, all things being equal (Chart 2).
In the coming weeks, there will be an ongoing assessment on how Germany’s coalition government implements its new fiscal plan and whether the real economy could benefit. We also expect heightened sensitivity to the German survey data to understand how business confidence readings versus market expectations evolve and if the greater foreign demand for European equities – in contrast to the US – continues (Chart 3).
Germany’s political change is in the spotlight for important reasons, but there is more to the USD’s lacklustre performance.
The backdrop of significant US policy uncertainty has shifted from being a source of expected USD strength, to one of fatigue and, more recently, a negative driver (Chart 4). At the start of the year, there were expectations that US tariffs would be implemented quickly, leading the broad USD to trade stronger than what its weighted rate differential would imply. However, that gap has disappeared. Although US policy uncertainty is high, the USD is softer (Chart 5). This points to the market having reservations about the US growth outlook and treating this as USD negative, even though tariff risks have not gone away, and nor have the downside risks to other economies from rising trade tensions.
This draws out how the USD’s poor showing is not just a function of Germany’s new government. Instead, it is being tested through interconnected channels – a US growth debate, lower UST yields versus elsewhere, and equity underperformance versus the rest of the world. In sum, the US exceptionalism narrative that served the USD well is being questioned. This warrants toning down how much the USD can strengthen in the coming quarters (see page 8 for FX forecasts). However, are we facing a bigger USD decline or is this a correction from an overexuberant state? We believe in the latter.
The idea of the US economy losing momentum has some validity, but it needs to be put into perspective. Some survey and hard data have shown weakness, but other indicators do not. US growth surprises are also not deteriorating as in mid-2024 (the last period of growth worries), while the other large economies like China and the Eurozone are not giving a much better impression (Chart 6). Nonetheless, we still come across the line of thinking of what might cause the USD to repeat its dismal performance in 2017, the first year of Trump’s prior administration.
We have disagreed with the argument that the USD is set to follow a similar path to 2017 (Chart 7). Our main reason comes down to global growth. Back then, it was in a strong synchronous upturn, which supported risk appetite (ie, global equity market performance) at the USD’s expense (Chart 8). We do not have these conditions in place for the USD to weaken as it did in 2017.
This time round, the global growth setting is not accelerating, with the manufacturing cycle sluggish and signs that the service sector is losing momentum. If we also consider how global trade tensions could still get worse, then it contradicts the buoyancy that was evident in 2017. One should not assume that US trade policy will be benign when there are many indications of the opposite.
The “America First Trade Policy” memorandum ordered a comprehensive review of US trade and economic policies, which is due 1 April this year. This is expected to focus on existing trade agreements, unfair practices thereof, and “recommend appropriate measures, such as a global supplemental tariff or other policies, to remedy such [trade] deficits”. As this deadline nears, the market could begin to refocus on how President Trump’s policies should create a stronger USD again. It has been less sensitive to US tariff threats more recently, but we are hesitant to downplay these risks entirely.
