Market Brief: Currencies trade through geopolitical and tariff threats

The dollar is holding firm, Treasury yields are steadying, and oil prices are inching higher as investors try to look through a raft of worrisome headlines. Foreign-exchange markets have become less sensitive to the daily rhythm of geopolitical escalation, focusing instead on monetary policy after lower-than-expected inflation data last week prompted traders to scale back expectations for US rate hikes. The Federal Reserve is now seen tightening policy by less than many of its global counterparts over the next year*.

The war in the Middle East continues to reverberate across the global economy, lifting energy prices and stirring inflation fears. Mediators are reportedly working to push the United States and Iran into a new ceasefire after Washington carried out a tenth consecutive night of strikes and Tehran retaliated against US allies in the region. But no meaningful oil and gas volumes are moving through the Strait of Hormuz, and Yemen's Houthis said yesterday they would impose a naval blockade on Saudi Arabia, potentially disrupting a second major supply channel. Global benchmarks are up 20% this month and average US retail gasoline prices are back above $4 a gallon.

The Canadian dollar is recovering from a one-week low after Donald Trump threatened to impose another round of punishing tariffs on America's erstwhile ally to the north. The president yesterday signed three proclamations imposing levies of up to 50% on a broad range of Canadian goods under Section 338 of the 1930 Tariff Act*, with the duties set to take effect in 30 days. Energy, potash, critical minerals, fish, and goods already subject to national security duties on steel and aluminium will be exempted. But imports that comply with the terms of the USMCA will not be spared, despite previously being offered carve-outs from the administration's ‘reciprocal’ tariffs—a significant escalation that strips Canadian exporters of a protection they had relied on throughout the dispute. If implemented, we estimate the duties would affect roughly 4.6% of Canadian exports to the United States, inflicting serious damage on a number of industries and lifting the average tariff rate on Canadian goods by approximately 2.3 percentage points.

Currency markets seem remarkably calm. 3-month implied volatility levels—a proxy for expected turbulence—in the US-Canadian dollar pair are still near the bottom of the advanced-economy league table, suggesting that many investors see the tariff announcement as a prelude to negotiations, not a material peril to the Canadian economy. This would, indeed, fit with prior history—after a series of hyperbolic threats in the last year, average effective tariff rates have remained low relative to other major economies—but nonetheless represents a gamble on the administration following its TACO*** playbook once again.

The action against Canada may be a prelude to something broader. US officials are reportedly preparing options for the president to reimpose tariffs on dozens of countries as his 10% global duties expire later this week—even as the midterms approach and his polling numbers remain dismal. The Supreme Court struck down the reciprocal levies that followed last year's ‘Liberation Day’ announcement, but the administration appears determined to find an alternative legal framework for a similar policy.

The backdrop to all of this is a US economy operating under what might be called ‘stagflation-lite’ conditions: headline inflation remaining firm, driven by energy costs and tariff passthrough, while underlying growth remains fragile. The war in Iran, the tariff escalation and the prospect of further trade barriers are all pulling in the same direction—toward higher prices and lower confidence—even as a speculative frenzy in the technology sector keeps share prices elevated. In an echo of the run-up to the 2008 crisis, the artificial intelligence boom is keeping the music playing; the worry is how many are still dancing when it stops.

Across the Atlantic, the pound is holding steady after new Prime Minister Andy Burnham appointed former defence secretary John Healey as chancellor. This came as a surprise after weeks of speculation involving other candidates, but Healey is seen as an experienced centrist with fiscally orthodox instincts, and Burnham has repeatedly pledged to maintain the existing fiscal rules. Data published this morning reinforced the case for a hold from the Bank of England later this month: payrolled employment was little changed in June, and private-sector pay growth slowed to 2.9% in the three months to May, the weakest since 2020. Investors are pricing in one, possibly two, quarter-point hikes by year-end.

*Note that starting levels are important: US rates remain well above those prevailing in most other advanced economies, meaning that rate differentials are still helping to support the dollar.

**Yes Bueller, that one: "In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the Great Depression, passed the Hawley-Smoot Tariff Act, which raised tariffs to collect more revenue for the federal government. Anyone? Anyone know the effects? The Act did not work, and the United States sank deeper into the Great Depression."

***Welcome to our hipster gastropub, where we have poutine tacos on the menu.

Market Overview

Data as of 7:15 AM EDT

Notes: DXY: Dollar index, DMA: Daily Moving Average, Pivot points are calculated on a one-month basis, 3-month and 10-year spreads are against USD, Implied V.: implied at-the-money option volatility

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