MARKET TONE
The outcome of the November US elections prompted a paradigm shift in our thinking on the outlook for the US dollar (USD). Ahead of the election, we had anticipated a gradual softening in the USD in 2025 as US growth moderated and US interest rates declined—taming the concept of “US exceptionalism” that has been the essential prop of bullish USD sentiment.
President Trump’s return to the White House and the Republican sweep of the House and Senate, change the calculus for the USD significantly. The USD responded positively to the prospect of a second Trump term but there is still a huge amount of uncertainty about how and when the new administration’s policies will be rolled out. Uncertainty is adding to the increase in FX volatility seen since mid-2024.
The anticipation of tax cuts and deregulation policies are supporting US growth expectations while the implementation of tariffs will support the USD and inflation risks in the US. At the same time, the Fed is adopting a more cautious approach to the policy outlook. Progress on inflation has stalled and policymakers may want time to assess the consequences of President Trump’s policies for the US economy.
We adjusted our outlook for the USD in the wake of the election. The changes are material and reflect our view that the USD’s recent dominant performance relative to its major currency peers will continue while investors focus on US cyclical positives—US economic outperformance and relatively high interest rates. The “exceptionalism” factor is expected to be a primary source of USD support in the coming months. In truth, these dynamics were already at play before the presidential election. Resilient US growth data forced markets to reconsider how far and how quickly the Fed would relax policy in late 2024 and 2025 and the election outcome has only served to reinforce those trends.
Our revised outlook for the USD anticipates recent strength persisting in 2025 as the new administration moves quickly to implement its policy priorities. The USD is likely to strengthen to (and potentially through) 1.00 versus the euro (EUR) in the coming months and retest recent peaks around 160 against the Japanese yen (JPY). The Canadian dollar (CAD) may trade back to near the low reached during the pandemic in 2020 (just under 1.47). Trade friction risks slowing growth in Europe and Asia relative to the US, adding to fundamental headwinds for the major currencies. The CAD may be severely affected by tariffs, of course, but slow global growth may also weigh on industrial commodities and energy prices, keeping already soft Canadian terms of trade weak.
Confidence around the bullish outlook for the USD should remain suitably measured, however. While aggressive tariff measures applied broadly will lift the USD materially, there are more than a few potential constraints on the USD’s ability to strengthen sustainably. Firstly, markets have already discounted stiff tariffs being implemented quickly in the second Trump term, but early indications suggest a more considered approach may emerge. Too much “good” (i.e., bullish) news may be priced into the USD at this point. It is also unclear how economies that are subject to US tariffs will respond. Secondly, there were reports during the campaign that prominent figures in the Trump team were considering ways of using the (generally highly valued) USD exchange rate to help reshape global trade. President-elect Trump himself remarked on the “big currency problem” that the US has in the form of the super-strong USD (mainly focussing on the Chinese yuan—CNY—and JPY). Thirdly, a robust immigration programme could constrain US growth and drive wages and inflation up in the longer run. Finally, investors may start to question US fiscal policy sustainability as the new administration pursues lower personal and corporate taxes.
While investors are primarily focused on the USD’s cyclical advantages now, developing structural imbalances—and the prospect for that trend to accelerate if fiscal policy is loosened significantly in President Trump’s second term—do represent a potential challenge to the USD’s longer run performance. Investors may demand higher compensation if President Trump’s policies (tax cuts) prompt a significant increase in the US national debt. That compensation could come in the form of higher US yields on Treasury debt or a weaker USD or a combination of the two.
History suggests that US deficits (current account and fiscal) as a share of the overall economy do impact the performance of the USD, albeit with a lag. That history also suggests that the window for a negative reaction to rising deficits may open a little wider in the next year or two, especially if debt dynamics deteriorate significantly and growth momentum disappoints.
Shaun Osborne, Canada 416.945.4538
FX FORECASTS
CAD FX FORECASTS
FEDERAL RESERVE AND BANK OF CANADA MONETARY POLICY OUTLOOK
FEDERAL RESERVE—MODEST FURTHER CUTS IN 2025
We forecast two more quarter point cuts by the Federal Reserve in 2025. That would leave the rate around 100bps above the upper end of the estimated neutral rate range.
Key is the starting point whereby the US economy remains in excess aggregate demand. Applying fiscal and regulatory easing including for US banks could inflame imbalances and add to inflation risk. Immigration policies are expected to shrink the US population over the administration’s four-year term, creating labour shortages that drive a stable to lower unemployment rate and support wage pressures. Tariffs on imports and retaliation by other countries would amplify inflationary pressures as capacity and labour shortages amplify passthrough risk.
In this context, Treasury yields and the dollar have been tightening financial conditions. For yields, this process may be interrupted by the debt ceiling negotiations, but higher yields are expected to resume thereafter. The Federal Reserve is expected to do likewise by sterilizing stimulus applied to excess demand conditions.
BANK OF CANADA—A FORK IN THE ROAD
The Bank of Canada is at a fork in the road that requires preserving policy optionality. Our current forecast is for one more cut to a 3% policy rate that could arrive with the first meeting of the new year. Such a move would bring the rate 200bps below the peak and into the Bank of Canada’s estimated long-run neutral rate range of 2.25%–3.25%.
Chief among the risks now are trade wars. Global supply chains remain at only a nascent stage of being revamped while posing structural long-run inflation risk. There is a small amount of excess capacity. Tariffs imposed on Canadian exports with no carve-outs for a meaningful period of time and—this is key—with no retaliation by Canada invite further easing. The economy would be tossed into recession, unemployment would rise, pricing power would be crushed, taking inflation down with it. That’s a recipe for combined monetary, fiscal and regulatory easing. The Canadian dollar would tumble. In such a case, the policy rate could easily go below neutral and below anybody’s present forecast depending in part on the degree of fiscal easing.
With retaliation? Now that’s a different tale, depending upon the form of retaliation. Import tariffs applied by Canada would raise prices paid by Canadians. A tumbling currency would add price pressures. Supply chains that are still at a nascent stage of being revamped at home and globally would be severely disrupted in a version of the pandemic. Tariffs rippling through US industry in the context of capacity pressures would result in pass through stateside and create trickle through effects across supply chains into Canada. The outcome would strain the ability of the BoC to achieve 2% inflation, thereby requiring incremental tightening especially with signs core inflation and wages remain hot at the margin. Export taxes instead of import tariffs could change the calculus somewhat depending upon what happens with the proceeds.
If trade wars persist for a lengthy period—à la McKinley, or Smoot-Hawley—then it is probably long-term deflationary. We are assuming that ‘the art of the deal’ will settle long before then; hello mid-terms. The intervening path requires the Bank of Canada to maintain maximum optionality.
Derek Holt, Canada 416.863.7707
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
LATIN AMERICA (continued...)
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FOREIGN EXCHANGE STRATEGY
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