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MARKETS

US stocks mostly edged higher on Friday as the S&P 500 flirted with fresh record highs, capping off a week packed with tariff hikes, inflation updates, and a retail sales miss that threw a curveball at growth expectations.

Retail sales saw their sharpest monthly drop in a year, down 0.9% in January—far worse than the flat reading expected. The weak consumer spending data wrapped up a week where inflation concerns dominated headlines, with hotter-than-expected CPI and PPI readings dampening hopes for early Fed rate cuts.

Meanwhile, President Trump is taking his tariff war into uncharted territory. He’s expanding his calculus, not just targeting trade imbalances but also turning his attention to how other nations tax, regulate, and manage currency policies. On Thursday, he ordered top economic officials to calculate new U.S. tariffs based on the total cost of tariffs, VAT, regulatory barriers, and other trade distortions that impact U.S. exports. These “reciprocal” tariffs will be detailed in a series of reports due by April 1, focusing first on economies with the largest U.S. trade deficits.

Markets are cautiously optimistic that these tariff headwinds won’t be as economically damaging as once feared, but for Europe, the bigger story this week is the potential for a Russia-Ukraine ceasefire. Optimism around peace talks is creating a positive ripple effect across European currencies and broader risk sentiment.

Nowhere is this shift more evident than in oil markets. Crude prices are starting to turn the corner as a potential U.S.-Russia peace deal eases supply worries. That said, oil traders know better than to count their chickens before the eggs hatch. If negotiations gain further traction, Brent could slide back toward $72.50 as the Russia sanction premium erodes. But expecting an immediate freefall below the critical $71.25-$75 support zone would be a mistake—securing a deal is far from a slam dunk, and bearish oil traders have been banking on a Trump-led Russia-Ukraine peace play since his election victory.

In FX markets, the long EUR/USD trade delivered solid returns, but while we’re playing the hand we’re dealt—a softer U.S. macro backdrop and geopolitical tailwinds—it would be foolish to count the dollar out just yet. If anything, peak dollar strength could align with peak tariff pressure in Q2, making April 1 a key date to watch.

Mark your calendars: the Commerce Department’s upcoming report on why the U.S. runs structural trade deficits is expected to add fresh layers to the dollar’s resurgence. This should coincide with the ECB considering rate cuts below 2%, which could send EUR/USD toward parity.

Every time the dollar dips, there’s a rush to call the top in media circles. But from a currency trader’s lens, the tariff threat is still looming large, and timing its impact remains tricky. My base case? A pivot back to long dollar positions in early March, with a high probability (90%) that Q2 will see the most intense tariff-driven pressure once the Commerce Department's findings hit.

If Trump’s tariffs turn out to be less aggressive than feared and employment softens, we could see a shift toward multiple Fed rate cuts( The Dollar Bearish Tail Risk) . But if trade tensions escalate as expected, EUR/USD is on track for a trip toward parity, with the U.S. rate differential keeping the “Atlantic” rates gap firmly in the dollar’s favour. ( The Dollar Bullish Tail Risk)

"Dealmaker in Chief" or "Tariff Man"—whatever you call him, one thing is certain: when it comes to trading the dollar, there’s a fortune to be made (and lost) in the space between those extremes.

WEEKLY RECAP

Markets Push Higher, But Tariff Storm Clouds Linger

Equity markets continued to climb this week as investors put on their "tariff blinders" and tuned out the noise. The S&P 500 rose 1.5%, with technology and communication services leading the charge, while health care lagged.

The tariff drumbeat, however, isn’t fading. The White House has set its sights on reciprocal tariffs, pledging to examine all trade relationships where barriers exist against U.S. goods. A full report is due by April 1st, meaning markets could be in for a reality check in the coming weeks.

Meanwhile, the data flow this week wasn’t exactly equity-friendly, with inflation staying firm and retail sales falling short.

U.S. headline inflation edged up to 3.0% year-over-year in January, with core inflation accelerating to 3.3%. More concerning, the shorter-term momentum is picking up, with the three- and six-month annualized core inflation rates running at 3.8% and 3.7%, respectively. While the Fed’s preferred core PCE measure remains a bit calmer, these CPI readings were undeniably hot.

That said, there’s a seasonal wrinkle to keep in mind. Strong early-year inflation prints have been a recurring theme since 2022. Historically, January and February CPI tend to run hotter than the rest of the year—something that should start tapering off by March. But that doesn’t erase the bigger issue: inflation remains stubborn, and the Fed is unlikely to cut rates anytime soon. The market is now penciling in the first cut in September, with just 50 basis points of easing expected in 2025.

On the consumer front, January retail sales were a disappointment, falling 0.9% month-over-month—much worse than expected. Core sales (excluding autos, gas, and building materials) also slid 0.5%. Some of the weakness may be weather-related, and December’s figures were revised higher, which softens the blow somewhat. Still, the bigger takeaway is that consumers aren’t exactly rushing to stock up ahead of Trump’s impending tariffs. That hints at a growing sense of economic fragility, even as markets press higher.

For now, investors are staying bullish, banking on strong corporate earnings and continued resilience in risk assets. But with tariffs still lurking in the background and inflation proving sticky, the road ahead remains anything but smooth.

VAT TARIFF EFFECT

Just adding the average most-favored nation (MFN) tariff rate of countries to their VATs would lead to significant reciprocal U.S. tariffs on some of America’s top trading partners. This could turn Trump’s tariff playbook from a tactical bargaining tool into a full-scale economic weapon.

If executed, this approach would dramatically escalate trade tensions, particularly with economies that rely heavily on VAT as a cornerstone of their tax structure. Countries like the EU nations, China, and Mexico, which impose substantial VATs on imports while benefiting from relatively low U.S. tariffs, could suddenly find themselves facing a far steeper cost for access to the U.S. market.

The implications would be far-reaching. On one hand, it could serve as a powerful negotiating lever to force trading partners to lower their own tariffs and trade barriers. On the other, it risks triggering an all-out trade war, further fueling inflationary pressures at a time when the Fed is already struggling to keep rate cuts on the table.

For markets, the biggest question now is how aggressive the administration will be in enforcing this new tariff structure. If the U.S. moves ahead with broad-based levies, expect sharp currency moves, particularly in USD/CNH and EUR/USD, as well as heightened volatility across global equity and commodity markets. But if Trump’s history as the “Deal Maker in Chief” is any guide, the real goal here might be to push trade partners into preemptive concessions—offering up olive branches before the tariffs take full effect.

Either way, brace for turbulence. Markets love certainty, and this latest tariff calculus is injecting anything but.

NUTS & BOLTS

What was incredibly weird this week was how the market completely shrugged off troubling inflation signals, instead hunting for loopholes and rationalizations to keep the bullish momentum alive. And to be fair, there were some caveats—seasonality effects, base-year distortions, and a forward-looking energy component that softened the broader picture. But history tells us that once the inflation genie escapes, she doesn’t go back into the bottle without a fight—usually requiring higher-for-longer interest rates to chase her away.

Indeed, once inflation expectations become entrenched, extinguishing them without significant economic pain becomes nearly impossible. While the Fed has managed to bring inflation down significantly since 2022 without triggering a recession, that victory is looking increasingly fragile. Consumer inflation is still stubbornly hovering above target, with little sign of a clean break toward the Fed’s 2% goal

The market remains laser-focused on core PCE inflation, the Fed’s preferred measure of consumer prices ex-food and energy. January’s number is expected to show a relatively tame 0.3% increase, with the yearly pace easing to 2.6% from December’s 2.8%. But this might be as good as it gets for a while.

My baseline forecast for 2025—before factoring in major tariff and trade war disruptions—sees core PCE inflation stuck around 2.6% y/y. Markets risk missing the bigger picture by fixating on near-term data points. There is mounting evidence that a shift back toward higher inflation may already be underway, even before Trump’s steep import tariffs on major trading partners take effect. If the inflationary impulse regains traction, the Fed’s margin for error shrinks dramatically, and any rate-cut and falling yield euphoria could unravel in a hurry.

The Fed came dangerously close to declaring ‘mission accomplished’ on inflation last summer when consumer price inflation seemed to vanish for several months. CPI remained flat in May and June, followed by a meager 0.1% rise in July. But fast forward to today, and that illusion has been shattered. Since then, the unemployment rate has dipped two-tenths, the Fed has cut rates by 100 basis points, and inflation has come roaring back—accelerating at a blistering 5.7% annualized pace in January.

What’s even more concerning is that inflation is creeping back in at every level of the supply chain. Producer price final demand inflation bottomed out at 0.3% y/y in June 2023, but as of last month, it’s surging at 3.5% y/y. Even more alarming, producer prices for finished goods—historically a reliable source of disinflation—have skyrocketed at an 8.3% annualized pace over the past three months. And as any seasoned trader knows, steep producer price increases rarely stay contained—they inevitably seep into consumer prices as businesses pass costs downstream.

The numbers speak for themselves: CPI, core CPI, and supercore CPI have risen at 4.5%, 3.8%, and 5.3% annualized rates over the past three months—well above their 6-month and 12-month averages. The trend is not your friend.

Just this week, Chair Powell testified to Congress that “inflation has eased but remains somewhat elevated.” While he acknowledged that the Fed still has work to do, he soothed markets by suggesting that the labor market is no longer fueling inflation and that long-term inflation expectations remain “well-anchored.” But are they, really?

Wage pressures tell a different story. Average hourly earnings have heated back up to a 4.5% annualized pace over the past three months. Meanwhile, the New York Fed’s January Survey of Consumer Expectations showed sharp increases in year-ahead inflation expectations for gasoline, food, medical care, college tuition, and rent. The University of Michigan sentiment survey’s inflation expectations also jumped in February, with the 1-year outlook surging from 2.6% in November to 4.3%, while the crucial 5-10 year outlook spiked to 3.3%—its highest reading since June 2008.

These readings suggest something much bigger is at play: tariff fears could already be destabilizing inflation expectations, chipping away at the “good vibrations” Powell hopes to maintain. If inflation expectations become unanchored, the Fed’s rate-cut timeline could go up in smoke, and the market's dovish bets could unravel fast.

CHART OF THE WEEK

China's advances could boost AI's impact on global GDP

DeepSeek and a handful of other Chinese companies have reportedly developed sophisticated generative artificial intelligence (AI) models at a lower cost than existing offerings. These developments may spur faster adoption of AI and help the technology have a larger impact on global economic growth, according to Goldman Sachs Research.

"The [Chinese] breakthrough could raise macroeconomic upside over the medium term if its cost reductions help increase competition around the development of platforms and applications," Joseph Briggs, co-leader of Goldman Sachs Research's Global Economics team, writes in the report. "Limited adoption is still the main bottleneck to unlocking AI-related productivity gains, and adoption would benefit from competition-induced acceleration in the buildout of AI platforms and applications."

"That said, the near-term adoption impact is probably limited since cost itself is not currently the main barrier to adoption," he adds.

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