USD, CAD, EUR, JPY flows: USD and JPY strength to be sustained near term

The introduction of US tariffs on Canada, Mexico and China has triggered general USD gains, with only the JPY holding its own. The CHF and GBP also outperformed, but the EUR has fallen with the CAD, AUD and NZD, while the NOK has also outperformed the other risky currencies.

Clearly, the markets weren’t fully pricing in the imposition of tariffs, with most apparently expecting some last minute deal. Equity markets are generally sharply lower, losing around 2%, and this supports the strength of the JPY and USD against the riskier currencies. From here the outlook depends on whether the trade/tariff war escalates or whether the negative impact on equities persuades Trump to reconsider. Many expect the tariffs to be short-lived, but there is no safe assumption at this point. There is a risk of a much larger equity market decline from here if the tariffs remain in place, especially if Trump now extends tariffs to the EU. The US market is extremely expensive and a 10% decline in equities would barely make a dent in the valuation, so from here we see significant further potential downside. Things looks likely to get worse before they get better, given the retaliatory tariffs being imposed by Canada.

We wouldn’t necessarily rely on previous correlations holding up well in this environment, but the yield spread relationships suggests that USD/CAD will hold here or even go a little higher, while USD/JPY looks overvalued and has potential to fall back to 153. This is more likely if we see equities weaken further, especially if the weakness is concentrated in the US. However, in the short term the tendency is for any weakness in the US market to be at least equalled in foreign markets, and this will tend to mean that EUR/USD holds at the lower levels which look to be in line with our model.

There has so far been a fairly modest move in yields, but the US curve has flattened, with higher front end yields reflecting expectations of a less easy Fed against the background of likely higher inflation as a result of tariffs, while the back end has declined to reflect the negative growth implications of tariffs, both directly and as a result of a tighter Fed. Further weakness in equities could be expected to lead to further declines in back end yields. A flattening curve tends to favour the JPY, which benefits from declining US 10 year yields, while the EUR will tend to suffer from rising US front end yields.