Morning Bid: Dollar slides on trade and tax fears

Reuters

2 days ago

A look at what matters in U.S. and global markets today from Mike Dolan, opens new tab, Editor-At-Large, Finance and Markets
LONDON, June 2 (Reuters) - The U.S. dollar plunged anew (.DXY), opens new tab to its lowest level in six weeks on Monday as June got underway, with U.S. tariff concerns back on the boil after last week's legal confusion and military tensions rising across the globe.
The euro led the charge, undaunted by the prospect of another interest rate cut from the European Central Bank on Thursday. Germany's new chancellor, Friedrich Merz, will travel to Washington to meet U.S. President Donald Trump on Thursday as trade talks between Europe and America are watched closely.
With markets still on edge about elements of the U.S. fiscal bill going through the Senate that give the administration the option of taxing companies and investors from countries deemed to have 'unfair foreign taxes', the dollar is vulnerable to worries about foreign capital flight.
But the attention on Monday seemed back on the tariff push, with an assumption President Donald Trump will push through levies one way or another despite the legal pushback last week.
The greenback was hit after the weekend by Trump's plan to double duties on imported steel and aluminum to 50% from Wednesday and as Beijing hit back against accusations it violated an agreement on critical minerals shipments.
It was also a weekend of significant geopolitical tensions and bellicose warnings. Gold crept higher.
U.S. Defense Secretary Pete Hegseth warned on Saturday that the threat from China was real and potentially imminent as he pushed allies in the Indo-Pacific to spend more on their own defence needs. The Ukraine-Russia war continued to rage, with Ukrainian drones hitting dozens of Russian bombers deep inside Russian territory. The Gaza conflict shows no sign of ending.
Major countries are building armaments at pace. Britain will expand its nuclear-powered attack submarine fleet as part of a defence review, one designed to prepare the country for modern war and counter the Russian threat.
Oil prices jumped by about 3% on Monday after producer group OPEC+ kept output increases in July at the same level as the previous two months.
In a big week for U.S. labor market data, there was some encouragement on the interest rate front.
Federal Reserve Governor Christopher Waller said on Monday that rate cuts remain possible in the second half of the year. Given that a rise in inflation pressures tied to Trump's import tax increases is unlikely to be persistent, "I support looking through any tariff effects on near term-inflation when setting the policy rate," Waller told a gathering in South Korea.
Elsewhere, China's manufacturing activity shrank for a second month in May, as expected.
Stocks in Poland .WIG20 fell 1.4%, after nationalist opposition candidate Karol Nawrocki won the second round of the country's presidential election.
Ahead of Monday's bell, U.S. stock futures were down about half a percent, with stocks in Europe and Japan down too. U.S. Treasury yields nudged back higher.
Today's column looks at the week's big monetary decision in Europe, with the European Central Bank widely expected to lower rates for the eighth time in the cycle and the euro rising regardless.
While the European Central Bank keeps cutting interest rates, the euro keeps rising, as a transatlantic capital reversal upends relative rate shifts and threatens to force the ECB into further easing.
The ECB is widely expected to lower its main borrowing rate on Thursday to 2%, half what it was at its peak a year ago and less than half the Federal Reserve equivalent. It's also back to what the central bank broadly considers a 'neutral' level, meaning it neither spurs nor reins in the economy.
Real, or inflation-adjusted, ECB rates will be back to zero for the first time in almost two years.
What's remarkable is that after eight consecutive ECB cuts and with the prospect of zero or even negative real rates ahead, the euro has surged more than 10% against the dollar in just four months and 5% against a trade-weighted currency basket of the euro zone's major trading partners.
That nominal effective euro index is now at record highs, with the 'real' version at its strongest level in more than 10 years.
The currency has surged even though there has been no net change in the gap between two-year government bond yields on either side of the Atlantic - usually a reliable indicator of shifts in the euro/dollar exchange rate.
The culprits behind this trend are pretty clear: Donald Trump's tariff wars, fears of capital flight from dollar assets due to a host of concerns about U.S. policies and institutions, and Germany's historic fiscal boost that has transformed the continent's outlook.
But if even a fraction of the trillions of dollars of European investment capital in the United States is indeed coming back home as many suspect, the ECB has a curious conundrum ahead. How does it handle both the disinflationary effects of such a rapid currency rise alongside the domestic demand it could catalyse?
Lower rates with the prospect of further easing ahead are clearly having little impact on the euro. Most ECB watchers expect one or two more cuts after Thursday while money markets have a 'terminal rate' around 1.75%, the low end of the ECB's estimated range of 'neutral'.
Indeed, if much of the capital repatriation from overweight U.S. holdings is in equity investments, then lower ECB rates may even accelerate the outflows from the U.S. by lifting growth prospects for cheaper stocks in Europe.
The prospect of higher German and pan-European borrowing should sustain longer-term fixed income returns as well, expanding the pool of 'safe' investments.
The ECB could revert to protesting about 'excessive' euro gains, although the impact might be limited unless it is prepared to back its words with action, and there is a risk it could backfire for the reasons just mentioned.
If anything, the ECB appears to be encouraging the investment shift and the euro's role as a reserve currency - in part to help with the bloc's massive capital needs in retooling its military, digital and energy sectors.
In a pointed speech in Berlin last week, ECB chief Christine Lagarde insisted there was an opening for a "global euro moment", where the single currency becomes a viable alternative to the dollar, earning the region immense benefits if governments can strengthen the bloc's financial and security architecture.
The scenario may be seen as a nice problem to have, but there will be more than a little disquiet among the region's big exporting nations about a soaring exchange rate in the middle of a trade war.
ECB hawks and doves will also have to thrash out whether continued easing to offset disinflationary currency risks only stokes domestic inflation over the longer term - not least with a fiscal lift coming down the road into next year.
What seems clear is that the ECB's new economic forecasts due for release on Thursday will have taken into account the 7% euro/dollar gain and near 10% drop in global oil prices since its last set of projections in early March.
Morgan Stanley economists reckon that even if the central bank tweaks its core inflation forecasts higher, the new outlook could well show headline inflation undershooting its 2% target from mid-2025 to early 2027 - even while nudging up 2025's GDP growth view.
In truth, any forecasts at this point are fingers in the wind with few central banks or major investors having a clue where U.S. tariffs or retaliatory trade war actions will end up.
But while global trade and investment nerves abound, the ECB may be relatively powerless to cap the euro. Whether that argues for stasis or even more easing is the big headache it faces.
Chart of the day
U.S. gross domestic product readings have been bamboozled this year by tariff-related import skews. Again last week, models tracking GDP inputs were jarred by a sharp contraction in the goods trade deficit for April as front-running of imports to beat tariffs in the first quarter faded. With many tariffs in place, imports plunged and helping to compress the goods trade deficit by 46% to $88 billion, according to the Commerce Department's Census Bureau. Imports fell $68 billion to $276 billion while exports rose $6.3 billion to $188.5 billion. The shrinking goods deficit, if sustained, suggests the net trade component of GDP calculations will spur a significant rebound in growth this quarter, much like it sliced a record 4.9 percentage points from Q1 GDP - leading to a headline contraction in the overall economy. Flattered by the trade numbers, the Atlanta Federal Reserve's 'GDPNow' tracker now sees a whopping Q2 real GDP rebound of 3.8%. However, there is caution. Businesses do not appear to be restocking, with wholesale inventories unchanged last month and stocks at retailers down 0.1% and there is concern stockpiles may well drop sharply over the remainder of the quarter.
Today's events to watch
* US May manufacturing surveys from S&P Global (0930EDT) and ISM (1000EDT), April construction spending (1000EDT)
* Federal Reserve Chair Jerome Powell gives opening remarks at Fed event in Washington; Fed Board Governor Christopher Waller, Dallas Fed President Lorie Logan and Chicago Fed President Austan Goolsbee all speak; Bank of England policymaker Catherine Mann speaks
* US corporate earnings: Campbell's
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