The turn if of the year is at hand, but the forces shaping the business and investment climate remain familiar. One of the chief characteristics has been the outperformance of the US economy, fueled by an historically large budget deficit, productivity gains, and robust consumption. President-elect Trump has not been inaugurated but he is already a force to be reckoned with, as various tariff threats, and parries over the Panama Canal and Greenland illustrate.

The eurozone never fully recovered from the Great Financial Crisis and subsequent sovereign debt crisis before being hit by the pandemic, and then Russia's second invasion of Ukraine. The absence of full monetary union, let alone the lack of much progress on fiscal integration act as a comorbidity in the face of economic and political challenges. Four different people served as French prime minister in 2024 and three since President Macron called the snap election after his party did poorly in the European Parliament election. The lack of French parliament support for the fiscal consolidation Macron seeks is unresolved as the new year begins. The rainbow coalition in Germany has failed to deliver the goods. Europe's largest economy has not grown for two years.

The US budget deficit appears to be about 7% of GDP in 2024, and near 6.5% in 2025, according to the bipartisan Congressional Budget Office, while the economy experiences above trend growth. The eurozone is a mirror image. Despite the weak growth impulses, most eurozone members are committed to fiscal consolidation in 2025. The European Commission projects the aggregate budget deficit may slip to 2.9% this year from 3.1% anticipated in 2024 and 3.6% in 2023.

The  IMF forecast that the Japanese economy expanded by 0.3%, but the Bank of Japan is more optimistic, and its latest projection is for the world's third largest economy to have grown by 0.6%. In 2025, the IMF and BOJ anticipate growth will accelerate to 1.1%. The fiscal shortfall is estimated to be around 2.4% in 2024 and 2.2% in 2025. The Bank of Japan lifted its overnight rate twice in 2024 from -0.10% to 0.25%. The central bank anticipates core inflation, which excludes fresh food, to slow to below the 2% target for the first time since 2021. If this is borne out, it will limit the ability of the BOJ to normalize monetary policy. The swaps market is discounting a policy rate near 0.75% at the end of 2025, which may prove too aggressive.

It is not just that Japan's interest rates will remain low throughout this cycle, but rather it may reflect a larger development for which it and Switzerland may be the proverbial canary in the coal mine. The large fiscal expansion in response to Covid, the series of other disruptions, from Russia's war on Ukraine to trade fragmentation and de-risking from China was to absorb the world's surplus saving and lead to higher inflation and interest rates.

Yet, inflation looks to have peaked in most high-income countries, and China continues to experience disinflation/deflation. Switzerland's CPI fell below 1% in September 2024 and the Swiss National Bank projects it will be below 0.5% in 2025. The SNB slashed its policy rate in the middle of December to 0.50%. The swaps market anticipates the key rate will slip back into negative territory by mid-2025. The two-year note yield is already below zero.

Despite a series of supportive measures and lower interest rates, the Chinese economy has continued to disappoint. The last time producer prices were higher year-over-year was in September 2022. Deflation in CPI ended in January 2024 but averaged less than 0.5% year-over-year in the six months through November. The decline in house prices accelerated in 2024. Through November, existing home prices have fallen by nearly 0.75% on average per month compared with -0.31% average in the first 11 months of 2023. New house prices fell by 0.53% on average a month through November. In January-November 2023, new house prices slipped by an average of 0.04% per month. Although Beijing purposely popped the property bubble, its efforts to stabilize the sector intensified in recent months and we expect some positive results to begin emerging.

China's exports remain a source of consternation. China exports about a fifth of its GDP. This is lower than most European countries. Germany, for example exports more than 40% of its GDP, while France, Italy, and UK, export a little more than a third, as does Canada and Mexico. China is below the near 30% estimated by the World Bank of the countries' average exports. It is China's sheer size that is the challenge. Even if China were a robust democracy, this would be disruptive.

China's consumption as a percentage of GDP is modest at a little less than 55%. Many observers cite this as evidence of China's underconsumption and reliance on exports. China's per capita consumption has roughly doubled over the past decade. What consumption as a percentage of GDP really illustrates is the continued strong investment. Still, it was a decade ago that Beijing launched the "Made in China 2025" campaign, and by most reckoning it has been highly successful. China now dominates several key industries, including electric vehicles, lithium batteries, solar panels, graphene, and critical mineral processing.

Some countries, including several EU members, and other US allies are open to Chinese direct investment. In addition to than exporting goods, Chinese companies are building productive capacity inside the protectionist walls, and/or offshoring production to third countries to avoid tariffs levied on Chinese production. This too offers a stark contrast to the US path. For the incoming Trump administration, near-shoring and friend-shoring is not good enough. Re-shoring is the declaratory goal. Moreover, as Trump threatens tariffs on the world, China says it will abolish tariffs on all goods from the poorest countries and is terminating its tax subsidy for exporters.

The China Trump will confront is better prepared than in 2016. As the US weaponized semiconductors and their fabrication, so too has China weaponized gallium, germanium, antimony, graphite, super-hard materials, and key components to build drones. Beijing is not only limiting sales but is also replicating the extraterritorial reach of US and EU by applying the restrictions to third parties.

Meanwhile, China continues to harass its neighbors, including Japan, Taiwan, India, the Philippines, Vietnam, Nepal, and Bhutan. There is little reason to expect a change in tactics in the new year. There is a somewhat better chance of a negotiated settlement in Ukraine, which may entail more territorial loss for Kyiv. A security guarantee may look too much like NATO membership to be acceptable in Moscow as well as Washington. In the Middle East, Israel's willingness to use overwhelming force and the fall of the house of Assad in Syria may paradoxically boost the chances of regional stability, but to secure it may require the confrontation of the Houthis, who have chased US Navy carrier strike groups from Red Sea. 

After faltering in Q3, the US dollar came roaring back in Q4. Indeed, the Federal Reserve's 50 bp cut in late September marked a bottom for the greenback. The Dollar Index rose every week in Q4 but one. Its 7.6% rise in Q4 24 was the best since Q1 15 (9.0%). The widespread between two-year interest rate differentials reflect the market discounting the divergence of monetary policy, and particularly a less dovish Federal Reserve. 

The weakness of most of the world's currencies translated into new lows for Bannockburn World Currency Index, a GDP-weighted basket of a dozen currencies representing the largest economies. It is split evenly between high-income and emerging market countries. The 1.6% decline in December brought the Q4 24 decline to nearly 5%, the largest since Q3 08. It finished the year slightly below 87.90. The post-pandemic downtrend began near midyear 2021 (from a little above 102.00). The trendline is found near 91.50 in mid-2025 and slightly above 90.00 at the end of the year.

Of the major currencies, the Antipodeans were the weakest performers in December.  The New Zealand dollar fell almost 5.5%.  The Reserve Bank of New Zealand slashed its target rate by 125 bp starting last August. The swaps market is discounting another 100 bp of cuts through H1 25. Counter-intuitively, the Australian dollar, where the central bank is one three G10 central banks that did not to cut rates in 2024, was the next weakest performer, losing nearly 5.0%. 

The Bank of Canada was among the most aggressive in cutting interest rates in 2024, and this included two half-point cuts in Q4 24. The Canadian dollar fell 2.6% in December. Ironically, its 6% loss in Q4 24 made it the strongest of the major currencies after the greenback itself. The euro fell by 2.1% in December and sterling declined by about 1.7% in December, even though the European Central Bank cut rates twice in Q4 and the Bank of England only once. 

All of the currency components from the high-income countries fell against the dollar, and so did all of the emerging market currencies in the Bannockburn World Currency Index. The closely managed Chinese yuan was the best performer in the basket, falling slightly less than 0.75% in December. The Indian rupee was the second-best performer in the BWCI in December, easing 1.3%. The Russian ruble, a special case, was the worst performer, tumbling nearly 6.2%, followed by almost 5.1% decline of the South Korean won, which was hampered by the political turmoil.   

U.S. Dollar: In the first ten months of 2024, the Dollar Index appreciated by 2.6%. Since the election, it has risen by nearly 5% and ended the year at a two-year high. The Dollar Index briefly slipped below the support we identified near 105.50 and did not quite meet our 109.00 target, but surpassed it on January 2. Although stretched from a valuation point of view, the bulls remain in control. Amid the great uncertainty of the policies of the incoming Trump administration, the interest rate differentials mean that one is paid to be long dollars. In late September, when the Federal Reserve initiated the easing cycle with a 50 bp cut, it had become more concerned about the trajectory of the labor market than inflation, but alongside the second quarter-point cut in December, the Fed had pivoted back to emphasize the price stability mandate. We do not expect it to last past the first quarter and expect further slowing of the labor market, where the monthly nonfarm payrolls estimate seems to continue to exaggerate job growth. Lower benchmark revisions are expected to be announced later in Q1. At the same time, the base effect suggest price pressures will ease in Q1. In Q1 24, CPI rose at an annualized rate of 4.4%. The rolling three-month annualized pace has been below 2.5% since April 2024. The core rate rose at an annualized rate of 4.8% in Q1 24. The rolling three-month annualized pace has been 3.6% or below since then. We do not put much emphasis on the rotation of the vote among regional Fed presidents, though some see it as a more hawkish configuration. There seems to be little doubt that the 2017 Tax Cuts and Jobs Act will be renewed before it expires at the end of 2025. The rhetoric from officials suggest it could be funded by cuts in government spending and tariff increases. The tariff hikes in Trump's first term were not inflationary as they were concentrated on intermediate goods or consumers goods for which there were clear alternatives. Secondary impacts from retaliation complicate the analysis. The 100 bp rise in US Treasury yields since late September leave the financial sector vulnerable. Commercial Mortgage-Backed Securities (CMBS) spiked to record highs (11%), and credit card defaults are at 14-year highs. We note that although the Fed has begun an easing cycle, it continues to unwind its balance sheet, which in 2024, fell by an unprecedented 10.7%. That continued roll-off, and risk that the criticism of Yellen's T-bill issuance leads the new Treasury Secretary to issue more coupons may produce a steeper yield curve. A steeper yield curve could encourage the purchase of US Treasuries on a currency-hedged basis. 

Euro:  The euro ended 2024 1/100 of a cent above its lowest settlement of the year. The macroeconomic divergence from the US is stark. The US two-year premium over Germany has pulled back from near 240 bp in late November, but near 216 bp at the end of 2024, it is still more than all of 2023. The swaps market has a little more than 100 bp of ECB cuts discounted for 2025 and slightly less than 45 bp from the Federal Reserve. Growth remains lackluster, but barring a new shock, growth may strengthen in the year ahead. The political backdrop is not helpful. France's politics have yet to stabilize. There does not seem to a parliamentary majority for the kind of budget cuts necessary to appease President Macron and the European Commission. It may take yet another prime minister. The German government lost a vote of confidence. An election in February will lead to a new government led by the right-wing of the CDU. Meanwhile, Ukraine has refused to renew an agreement that permitted the shipment of Russian gas through its territory to central Europe (especially, Hungary, Slovakia, Moldova, and Austria). The expiration of the contract was anticipated, but the benchmark price for natural gas rose to new highs for the year at the end of 2024. The eurozone runs a substantial bilateral trade surplus with the US and this may be a source of friction with the new US administration. Some, like ECB President Lagarde, caution Europe from retaliating against the threatened US tariffs, but the risk is that the mostly weak political leadership in Europe feels compelled to respond in kind, even as it may agree to more defense spending. While there may be an upside correction in the euro following a test on $1.02, we think the risk is of a break of parity in H125, but suspect that the cyclical low from September 2022 near $0.9535 will hold. 

(As of January 3, indicative closing prices, previous in parentheses) 

Spot: $1.0310 ($1.0575) Median Bloomberg One-month forecast: $1.0345 ($1.0600) One-month forward: $1.0320 ($1.0590) One-month implied vol: 8.7% (8.0%) 

Japanese Yen:  The dollar rose by about 11.5% against the yen in 2024. It was the fourth consecutive annual advance, during which time the greenback has appreciated by more than 52%. Although Japan records an overall trade deficit, its trade surplus with the US may become a source of friction with the new US administration. The Bank of Japan is committed to normalizing monetary policy and lifted the overnight call rate in March out of negative territory where it had been since 2016. It raised rates again in July to 0.25%. The swaps market has almost another 50 bp discounted for 2025. Yet, the market has downgraded the likelihood of a hike at the January 24 meeting. In early December, swaps market had 20 bp priced in, and now 10 bp. The BOJ may look through the rise in the December national CPI that has already been foretold by the Tokyo report. The increase (to 2.6% from 1.8% at the headline level and 2.2% from 1.8% at the core level, which excludes fresh food) was a function of the expiration of the government's subsides for gas and electricity. The subsidies will be back in place in Q1 25. Barring new shocks, the Japanese economy appears to be settling in at around a 0.2%-0.3% quarterly growth pace. The exchange rate is slightly more sensitive (higher rolling 60-day correlation) with changes in the 10-year US yield than the 10-year interest rate differential. It also more sensitive to the dollar's overall direction (DXY) than to US equities (risk proxy). As the dollar appreciated in December, Japanese officials threatened action. Unilateral Japanese intervention appears to be the most effective when it coincides with a top in US Treasury yields. The US 10-year yield has risen by a little more than 100 bp since the Federal Reserve's 50 bp cut in late September. Given the uncertainty about the substance and sequence of US policy going forward, it is not clear that the yield has peaked. 

Spot: JPY157.25 (JPY149.75) Median Bloomberg One-month forecast: JPY154.95 (JPY152.00) One-month forward: JPY156.80 (JPY149.05) One-month implied vol: 10.5% (12.2%)  

British Pound: All the G10 currencies fell against the dollar in 2024, but sterling's loss of almost 1.7% was the least. Still, in the face of the surging greenback, sterling tumbled 6.4% in Q4. We suspect that the $1.2000 area will be tested. Of the G10 central banks that reduced rates in 2024, the Bank of England cut the least, delivering two-quarter point cuts starting in August. The swaps market has about 60 bp of cuts in 2025 discounted, which seems on the low side, given the weak growth impulses, slowing labor market, what we expect to be a sharp fall in CPI in February and March. The economy unexpected stagnated in Q3 and the Bank of England expects the same for Q4. At 4.75%, its policy rate is the highest among the G10. Labour ended 14-years of Tory rule in July, but between the petty corruption, infighting, and the backlash against its first budget, which contained GBP40 bln in tax increases, Prime Minister Starmer's public support has collapsed. The Reform Party, led by Brexiter Farage, has moved into ascendancy, apparently drawing support from the Conservatives, Liberal Democrats, and Greens. 

Spot: $1.2425 ($1.2735) Median Bloomberg One-month forecast: $1.2490 ($1.2800) One-month forward:  $1.2420 ($1.2730) One-month implied vol: 8.6% (7.5%)  

Canadian Dollar:  Falling inflation and weak economic impulses spurred the Bank of Canada to slash the overnight rate by 175 bp in 2024, including back-to-back half-point moves in Q4. Canada's discount to the US two-year rose 130 at the end of 2024, the most since 1997. The Canadian dollar fell by about 8% against the US dollar in 2024, though outperformed the other dollar-bloc currencies and the Scandis. The monetary easing cycle is not complete, but it was front-loaded. The swaps market 70 bp of cuts discounted for 2025. Canada's political situation deteriorated at the end of year. Finance Minister Freeland resigned, the fifth minister to do so in the year, Trudeau's Liberals lost three "safe" seats in byelections, and the New Democratic Party withdrew support for the minority government and indicated it would support a no-confidence vote when Parliament returned in late January. This will set the stage for an early election (late February?) and a Conservative victory. Trudeau's weak domestic standing may have encouraged the attempt to appease the incoming US administration, and a Poilievre-led government may take a different tact. Canada's critical minerals may offer leverage given China's export restrictions. The greenback's upside does not appear exhausted. The next target is the Covid-high from 2020 near CAD1.4670. 

Spot: CAD1.4450 (CAD 1.4005) Median Bloomberg One-month forecast: CAD1.4355 (CAD1.4000) One-month forward: CAD1.4430 (CAD1.3990) One-month implied vol: 6.9% (5.5%)   

Australian Dollar:  The Reserve Bank of Australia was one of three G10 central banks that did not cut rates in 2024. Yet, the Australian dollar was not rewarded. It slumped a little more than 9.1%; losing a little more than 1.25% more than the Canadian dollar and about 2.3% less than the New Zealand dollar, where both central banks pursued among the most aggressive easing of monetary policy among the high-income countries. The economy has slowed, and inflation is moderating. This will allow the RBA to initiate an easing cycle. The odds have increased of a move at the first meeting in 2025 (February 18). The swaps market has about 80 bp of cuts discounted for the new year. The 50-day moving average fell below the 200-day moving average ("dead man's cross") in early December and the Australian dollar did not look back. It set new 2024 lows, near $0.6180 at the end of the year. A break of $0.6170 targets $0.6100, and possible $0.6000. A move above $0.6300 would help stabilize the technical tone. 

Spot: $0.6215 ($0.6510) Median Bloomberg One-month forecast: $0.6285 ($0.6600) One-month forward: $0.6220 ($0.6515)    One-month implied vol: 10.5% (9.2%) 

Mexican Peso:  The peso held its own against the dollar in the first five months of the year but fell out of a favor in the run-up to Mexico's national elections in July and has not returned to the good graces of investors and speculators. Mexico's government has not won over investors, while the tariff threats by the incoming Trump administration provides an additional deterrent. The dollar has not traded below MXN20.00 since a few days after the US election (and a day after the Federal Reserve's quarter-point cut). The organization of production on a continental basis and outsourcing much of its banking system has been vital to Mexico's modernization. The new administration threatens this, and pressure is likely to mount on Mexico to either adopt US trade restrictions or face risk of significant disruption as the USMCA treaty Trump initially negotiated comes up for formal review in 2026. Meanwhile, the central bank's easing cycle is well underway, with five quarter-point cuts in 2024 (to 10%). Assuming inflation continues to ease toward target, there may be scope for another 100-125 bp reduction this year. We suspect that over the course of the year, the dollar can rise to MXN22.00-MXXN22.20. 

Spot: MXN20.6335 (MXN20.38) Median Bloomberg One-month forecast: MXN20.6650 (MXN20.32) One-month forward: MXN20.7565 (MXN20.48) One-month implied vol: 12.3% (13.6%) 

Chinese Yuan:  After falling 4% against the offshore yuan in Q3 24, the dollar rose 4.7% in Q4, of which 1.2% was registered in December. For the year as whole, the dollar rose by about 3% against the yuan. Through formal and informal mechanisms, Beijing limited the onshore yuan's depreciation to about 2.8% in 2024. The yuan outperformed all the G10 currencies, but sterling, and among emerging market currencies, was in the top seven performers. Still, the price of dollar-yuan stability has been the decoupling of offshore yuan from the yen. The rolling 60-day correlation of changes in the exchange rates was halved from a record above 0.80 at the peak of the carry trades in July by late October and has vacillated 0.40-0.50 for the past two months. In contrast, the yuan seems more sensitive the dollar's general movement. The rolling 60-day correlation between changes in the Dollar Index and offshore yuan set an eight-year high in late November slightly below 0.80 and is hovering near 0.75 now. Beijing is expected to provide more stimulus and the PBOC has scope to cut rates and reduce reserve requirements. The 10-year yield has fallen to a record low below 1.60%.  China's 30-year yield is near 1.85%, putting it below Japan. Through formal and informal mechanisms, the PBOC capped the greenback below CNY7.30 in the second half of December, but let it go at the start of the New Year.  It reached CNY7.32. The dollar's high in 2022 was about CNY7.3275 and the 2023 high was almost CNY7.35. US-China tensions are likely to rise in the coming months. Whether it is a prelude to de-escalation later is still an open question, but we are skeptical of some grand deal or a Mar-a-Lago accord, ostensibly modeled on the 1985 Plaza Agreement. 

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