Canadian 5 Bank Forecast, January 2025

Trump 2.0

The USD experienced strong post-election momentum, bolstered by a consensus belief in the continuation of U.S. exceptionalism. This sentiment is reflected in a significant shift towards long USD positioning, especially within G10 currencies. Much of this optimism is tied to Trump's policy agenda, which is widely viewed as growth-positive, inflationary, or both. While some argue that the "good news" for USD is already priced in, there is limited bearish sentiment among investors, with many waiting for a dip to increase their USD positions. This positioning dynamic and a lack of significant changes in US or global data make a substantial pullback in USD unlikely without new catalysts.

Looking ahead, the next three months will reveal the extent of Trump's commitment to tariffs, which could have an immediate impact on foreign exchange markets. During his first term, Trump implemented targeted tariffs rather than broad measures, and while some speculate this could change, global election outcomes in 2024 highlighted voters' aversion to inflation. This makes it unlikely that policies severely impacting real US incomes will be pursued. However, even the threat of tariffs can dampen investor and consumer sentiment in the rest of the world, potentially weighing growth.

What comes next for Canada?

In 2024, falling inflation and weak economic growth prompted the Bank of Canada to aggressively cut its overnight rate by 175 basis points, including two consecutive half-point reductions in Q4. This monetary easing widened Canada's discount to US two-year yields by 130 basis points, the largest since 1997, and contributed to an 8% decline in the Canadian dollar against the US dollar. While the easing cycle is not over, it was heavily front-loaded. Prime Minister Justin Trudeau announced his resignation and suspended Parliament until March 24. While elections are officially set for October, they could be called as early as May. A Conservative-led government is likely to take over, but Trudeau’s departure has created a political vacuum just as Trump’s administration assumes power in the US and considers imposing tariffs. More drama that Canada does not need.

Canada faces significant risks from potential US tariffs, with ~80% of its goods exports heading to the US and 12% of its workforce engaged in export-dependent industries. While the implementation of 25% tariffs could hurt both countries—given price inelastic demand for energy (30% of Canada's exports) and the tightly integrated auto sector—severe, long-term measures appear less likely due to their reciprocal negative impact on the US economy. Nonetheless, tariff-related headlines could further weigh on the Canadian dollar.

The euro ended 2024 marginally above its lowest settlement of the year, reflecting stark macroeconomic divergence from the US. Despite a slight narrowing, the US two-year premium over Germany remained substantial at 216 basis points, highlighting the euro's challenges. The swaps market anticipates over 100 basis points of ECB rate cuts in 2025, compared to just under 45 basis points for the Federal Reserve. While eurozone growth remains lacklustre, there is cautious optimism for improvement in the absence of new shocks. However, the political landscape complicates the outlook. France continues to struggle with political instability, as the lack of parliamentary support for budgetary reforms may require yet another prime minister. In Germany, a vote of no confidence has triggered a February election likely to result in a right-wing CDU-led government.

Geopolitical tensions are adding to the eurozone's difficulties. Ukraine's refusal to renew a gas transit agreement with Russia has disrupted natural gas flows to central Europe, pushing benchmark prices to new highs at the end of 2024. This exacerbates Europe's energy challenges and raises concerns about economic recovery. Additionally, the eurozone's significant bilateral trade surplus with the US could become a point of contention with the new US administration. While ECB President Christine Lagarde has urged caution against retaliating to proposed US tariffs, weak political leadership across Europe may feel pressured to respond, potentially escalating tensions. This could coincide with increased defence spending commitments, further straining budgets amid a challenging economic environment.

The pound started 2025 as the worst-performing G10 currency, falling by as much as 1.25% amid persistent concerns over growth in Europe. These fears were amplified by the UK PMI manufacturing index, which fell more than expected in its advance reading, dropping to 47.0—the lowest level since January 2024. This marked the fourth consecutive month of decline, with the cumulative drop being the steepest since the energy price shock of 2022 triggered by Russia’s invasion of Ukraine. Weakness in UK manufacturing adds to the broader economic concerns weighing on investor sentiment.

Energy prices have again taken center stage, with a sharp rise in natural gas prices following the cessation of gas supplies through Ukraine. Ukraine’s refusal to renew a transit agreement with Russia has disrupted a key channel for Russian energy exports, potentially exacerbating Europe’s energy crisis and lifting energy costs further. This development underscores the ongoing geopolitical and economic tensions influencing market dynamics and investor outlooks in 2025.