The changing world order: The impact on rates and FX

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Boris Sender: Hello, and welcome to the Scotiabank Market Points podcast. My name is Boris Sender. I’m director of U.S. Rates Strategy at Scotiabank. We are recording this episode on March 31^st, 2025, and today we will be discussing how our 2025 rates and FX forecast have performed so far to date and the potential implications of what we see as a changing world order on the FX and rates markets going forward.

Joining me on this episode we have from London, Gabriel Buteler, Managing Director and Head, Global Rates Trading. Great to have you Gabs.

Gabriel Buteler: Thank you, Boris. Happy to be here.

BS: And from our Toronto office, we have Shaun Osborne, Managing Director of FX Strategy. Shaun, thanks for joining.

Shaun Osborne: Pleasure Boris. Really nice to be here.

BS: Okay, let’s jump right into it.

One of the things that the market probably had wrong to start the year is everyone was in the camp of that Trump 2.0 would just be Trump 1.0 on steroids. So, more growth, more inflation. You know, the right trade is to be short bonds and long stocks. And in fact, the price action in Q1 has actually proven to be the reverse and it seems like from a policy perspective, they’re pursuing the growth negative things first.

BS: The tariffs thus far have proven to be certainly market moving from an equity bond market perspective. But the inflation markets have been pretty skeptical that tariffs will have a long run impact, and we’ll certainly dive into those themes.

Now, the spate of policy announcements and prescriptions has not just been limited to the U.S., Europe has seen its own share of monumental shifts. Gabs, do you want to walk us through what we’ve seen in Europe the last few months?

GB: Oh wow, European rates have definitely been interesting. Let’s focus on Germany. I’ve been in this market in Europe for 20 years now, and the Bund has only been going one way, which is higher, for pretty much every year, apart from two or three occasions.

But what we have seen over the last several months, and especially when we had the announcement obviously of more spending, and spending in defense, et cetera. We had the biggest move in German yields since the fall of the Berlin Wall. That market to move, I think it was 35, 40 basis points in one day is unseen.

The reality is we're still richer than most other countries. If we look at bund spreads, for example, we were at levels that were 100 basis points, if not richer than in other markets. Well, that has corrected, but they’re still richer, both on an outright level as in the outer level of rates, which now is stand at 150 basis points below the 10-year bund below the 10-year treasury and the bund spreads, which are at negative levels versus your IBOR. But if you compare it versus the OIS, it’s about minus 20, which is still a little bit richer than the other markets. It has more to go. I wouldn’t be surprised if you asked me and try to do some futurology, I think those things would converge and I we’ll see some of these long dated German rates converge to the rest, especially the U.S. So yes, you know, it’s been something that has been super interesting to watch. Not just this day that we’ve seen a few weeks ago, but what we have seen over the last year or so.

BS: It’s been quite remarkable. But, you know, zooming out there’s still a lot of convergence left to happen.

You know, most people would attribute 25 basis points for every single point of GDP of additional spending for a low debt country like Germany.

If the three percentage points of GDP that’s being floated between infrastructure and military, that should probably equate to something like 75-ish basis points. And so, we’ve only really seen half of that materialized, and certainly if that 3% is going to become reality that we should see at least 40 basis points in that cross market potentially.

Rates markets are not the only ones that have seen their share of dramatic moves. The FX markets particularly in Euro and Sterling have moved a lot. Interestingly, the FX pairs that are kind of near and dear to our hearts at Scotiabank, USD/CAD and USD/MXN, have been surprisingly range bound in the Q1 period.

And with that, I wanted to bring Shaun into the conversation. Perhaps you could shed some light on, on this dichotomy.

SO: Clearly the tariff news has roiled the FX markets quite significantly, but you’re right to point out that a lot of the volatility that we’ve seen in FX has really washed over the CAD and the Mexican peso. And I think, you know, we have to maybe take a bit of a setback and think about what happened in the second half of last year.

Overall when we saw the Mexican peso weakened significantly, a couple of reasons for that, I think interest rates in Mexico have obviously been falling, so that’s eroded the attraction of the Mexican peso and left it a bit more vulnerable to losses against the US dollar, but more significantly perhaps was the correction, the carry trade that washed out a lot of long Mexican dollar short yen positioning last year, and we did see the yen strengthen significantly, the Mexican peso underperform through the second half of last year. The Mexican peso was the worst performing major currency in the second half of last year. It’s down about 12% against the US dollar, maybe a little bit more than that.

And the Canadian dollar also not a great performer either. Really reflecting the fact that the Bank of Canada was a bit more aggressive in cutting interest rates relative to the Fed. So, we saw interest rate differentials move significantly against the Canadian dollar last year.

So, although the news on tariffs and the trade threats that we’ve seen emerge over the past few weeks, on the face of it, potentially more significant in terms of the economic impact to the Mexican economy and the Canadian economy, clearly. A lot of bad news was already priced into both of those pairs given the price action we had last year. So, we did see some volatility in the Mexican peso over around the initial tariff announcements, and of course USD/CAD jumped up to close to 148, which is the lowest in a number of years for the Canadian dollar around the initial tariff announcement. But you’re right in your observation that things have been very subdued in the past few weeks.

Markets have settled down just really waiting for this tariff announcement to come through to see exactly what we are getting, which industries are going to be hurt, and what hope or potential there is for these tariffs to eventually get rolled back to some extent.

BS: Absolutely, and any insights on Euro and Sterling, obviously with the bund move that we’ve seen, do you expect the outperformance of some of those European currencies to continue?

SO: As Gabriel mentioned, you know, the significance of, the fiscal moves both in the timing and the consequence of this decision, this lifting of the debt break and the promise of hundreds of billions of euros in increased spending in defense and infrastructure in Germany, which is going to have to be mirrored, I think to some extent by other countries in Europe, is really quite a significant, long-term change for the European economy, we’re going to have to see more spending on defense and infrastructure across the European Union.

And not just from an interest rate point of view, but the contrast between pro-growth policies, so fiscal expansion in Europe, against some of those steps and measures going on in the U.S. certainly right now, that kind of look more like austerity light in terms of reduced government spending, government job cuts, that kind of thing. I think the contrast does set up the euro for more gains going forward.

For sterling, I think slightly different in the sense that there is potentially a bit more constraint on the UK economy and the UK government in terms of what exactly they can bring to the table in terms of fiscal policy. We know that the Labour government there is kind of bumping up against the limits of their fiscal margin of maneuver, I guess. That may limit the kind of fiscal response we see in the UK, certainly for now.

But I think the Pound advantage is twofold. Firstly, it’s still very cheap against some range of currencies. Secondly the UK is very low trade exposure to the U.S. The U.S. runs a small trade surplus with the UK which I think leaves it potentially, you know, relatively underexposed to tariff risks.

Clearly there will be an impact, in certain sectors, but I think the relative hit to the UK economy from higher tariffs generally will be somewhat less. I’m still quite bullish on the pound from a longer run point of view. I think it can pick up a bit more ground against a soft and maybe increasingly vulnerable looking U.S. dollar over the course of the next few quarters.

BS: Agreed. And you know, when I think about, and not just the last quarter, but the last fifteen years, this era of U.S. exceptionalism that’s led to such dramatic outperformance in the U.S. equity market, I think one of those drivers behind that was excess deficits of the U.S. was running, especially compared to Europe. So, when I think about the potential unwind of a 15-year trade that could certainly benefit markets in Europe, the UK, and as well as their currencies.

Now, a lot of, you know, what we discussed is obviously, especially as it relates to tariffs, is premised on what’s likely to happen or what's likely to be announced on Wednesday April 2^nd. A lot of news will come on that day and the initial indications are that the U.S. is approaching this in a sort of two-pronged fashion.

There are the sectoral tariffs that appear to be somewhat non-negotiable, and that’s on autos and supposedly sectoral tariffs on pharmaceuticals and semiconductors are coming up in short order. And for the rest of the trade universe, it looks like they will pursue a reciprocal framework where they’ll try to match the trade barriers that the U.S. faces on those products and put some reciprocity behind it, which I think will certainly put incentives, carrots and sticks, in place to potentially bring down global trade barriers and that’s been behind some of my more optimistic views around what the long-term end game looks like. But certainly, those sectoral tariffs seem like they’re going to be a fixture and they're here to stay.

So, with that, a lot of uncertainty, obviously coming on April 2^nd. Gabs, how do you think the rates markets are likely to evolve over the course of the week?

GB: You know Boris, I think that it’s very tricky to trade binary events. You know, I don’t think it’s really, it’s worth it. It's much more interesting to see how you position the book, the portfolio, medium term views.

So how the rates are going to evolve the next four days, I will probably think in the next few days, we're going to sell off. I think a lot of negativity being priced in. I think you we have rallied for different reasons, today's month end. I think, you know, we'll do probably a bit of a pullback, but I wouldn’t put a massive amount of risk into that trade.

I think, you know, it’s more interesting to see what comes next. And I guess we’ll talk about that in the remainder of the podcast.

BS: Absolutely. And so, you know, you would expect that if the administration follows its approach, they’re not going to unleash all of their measures on Wednesday. So, I do agree.

I think there’s room for the market to kind of have a bit of a relief and have with the uncertainty behind it, you know, there could, it could be an equity positive, bond negative, rates sell off as you described over the course of the week, if that were to materialize. We do have, you know, a lot of tier one economic data that could also be the arbiter of direction, particularly payrolls on Friday. But you know, certainly once this week’s out of the way I'm thinking about will some of these short-term trends reassert themselves?

Shaun, how do you think about the rest of Q2 as it relates to your world in FX?

SO: You know, I’m still struck by this rather curious pattern of trade that we have in the dollar at the moment.

We saw the dollar rally late last year around the election and into the inauguration. Since then, it’s just traded South. It’s almost move for move. It’s uncanny how closely that pattern of trade is following what we saw in 2016 and 2017. Now, that should not really colour my expectations for how the dollar's going to trade over the balance of the next few quarters.

But the fact that that is tracking so closely is something that I find very curious, often say to clients, you know, history doesn't repeat, but it does sometimes rhyme. I think we have to be cautious of the fact that beyond maybe a bit of a relief trade, once we get some clarity on tariffs and maybe equity markets recover and the dollar picks up a little bit of ground on that because we’re trading a little more positively, again, unusually in terms of the correlation between the U.S. dollar and stocks right now.

So maybe the dollar can pick up a little bit of ground, but I don't think the dollar’s going to pick up an awful lot of ground really right now, because I think understood in this push to reorganize the global trade regime that we've been living under for the past few decades is that a weaker U.S. dollar is going to be helpful for the U.S. administration to achieve some of their goals.

So, we’re not at a point yet where I think, you know, U.S. officials are explicitly calling for a weaker U.S. dollar. But a weaker dollar I think is going to be a consequence of the trade policies that the U.S. is pursuing at the moment.

BS: Agreed, and the trade policy is sort of one dynamic, but the yield convergence story that we discussed also certainly will be dollar negative if that were to continue to come about in Q2.

You know, but that notwithstanding, you know, the Bank of Canada and the Fed will also be a likely arbiter of kind of whether this yield convergence story and ultimately these FX moves that we’re expecting in terms of dollar weaker, materializes. And so, from that perspective, Shaun how do you think the April and June Bank of Canada meetings are likely to go?

SO: So, I should say the house call is no further rate cuts from the Bank of Canada at this point. My own sense is that it's probably a little too early from my point of view in terms of the bank being able to take a strong view on the need for low interest rates in April. We also have an election coming up at the end of the month here in Canada. That shouldn't really impact what the Bank does or thinks about interest rates, but it may be something else that just at the margin if the bank is equivocating over whether to go or not in April, it could mean that they sit on the hands for a little longer.  

BS: With that view that the Bank of Canada may strike a more cautious tone and wait for economic data to come in to show whether or not these retaliatory measures are inflationary and the ultimate growth impact of the trade measures that are likely to be put in place on Wednesday, Gabs, do you think that the Bank of Canada is more likely to act in Q3 than in Q2?

GB: I think yes, I believe that the Bank of Canada will, probably what's priced in the markets, which is 50 basis points by year end. But I believe that they’re going to do it at the backend as opposed to in the very near future or, or even at the beginning of next year.

And the reason I think that is that I believe that it is the Fed that is going to probably end up cutting more than what is priced in. And if we’re pricing 75 basis points for the end of the year, I wouldn’t be surprised if instead of three we end up getting five cuts, to be honest with you.

And if we do that, then probably the Bank of Canada will go a bit further, but not a lot more. But you know, probably what's priced in, in 50 basis points is fair. So that’s my view in rates.

BS: So, Gabs, your view on the Fed nicely aligns with mine. You know, I was in the four camp ever since December.

I thought that given the likely policy sequencing that we’ll see there is going to be a slowdown in the U.S. and you know, if the Fed has already guided us towards two cuts premised under only a very modest cooling in the labor market, I think their forecast only have a tenth cooling from here, then I wonder what happens if the unemployment rate jumps four tenths or five tenths potentially on the back of some of these cuts that we're seeing in D.C., and I think that will be the grand reveal over the course of the year when we get those negative payroll prints where the market I think starts to align itself closer to our view Gabs, where from the three cuts that are currently priced now the market will price in four, to potentially five, as you're suggesting with some chances of potentially 50s being in play in Q4.  

I think certainly there’s a lot of debate as to how Europe is also going to trade for the rest of the year. Gabs, how do you see Q2 and potentially the rest of 2025 in terms of, you know, what is the best way to really trade these markets?  

GB: One thing that has been very interesting lately is the inflation markets. That’s core to my heart. I’m Argentinian, you know, I’ve lived inflation all my life and this market is, it’s all over the place, you know, and the very front end has rallied significantly in the past few weeks.

For example, 1-year, it’s about 30 or 40 basis points higher than it used to be. It’s pricing inflation of 3.3% at the moment for a year ahead. And some people think it maybe even higher. But I believe that there’s going to be so much noise in this number, you know? If you look at the forwards, they actually haven't moved or have gone even lower, five years forward in TIPS, like a measure that everyone looks at, it's about 210, it's not moving. Why is that happening? Well, purely because the front end is going higher. The rest is either not moving or going higher, by less. And what that tells you is that the market is expecting precisely what you guys said before, which is, if there’s going to be inflation because of the tariffs, that's going to be a one-off step adjustment higher, and what comes next.

So, what comes next and what really matters there is the expectations that people are going to have on inflation. Boris, you and I have been speaking about things like true inflation and other measures that are showing us that inflation has been slowing down.

If you go a bit further out, my personal view is that broad inflation will average a bit higher than it has been over our careers really, you know, we’ve seen inflation between 0% and 2%. I wouldn’t be surprised if the average that we observe for the remainders of our careers is on the 2-3% or maybe 2-3.5%.

Your question about the next few months and then the remainder of the year I think you, you see a slow down in the economy, you see broad inflation ticking higher on the tariffs, and if not, well actually think about if there is a backpedaling of the tariffs, you know, how that market would react in inflation in the front end and how that is going to go. So, yes, something like TIPS, real yields in 5-years at one and a quarter as a very attractive proposition.

BS: I’m really glad you brought up longer term inflation expectations because Jay Powell actually alluded to those measures during the March FOMC press conference, and it did feel like compared to the press conference in December, the fact that they were able to observe how anchored those long-term inflation expectations are over the period where tariffs were put in place, maybe some were taken off, some were put on, but those long-term inflation expectations were anchored throughout the whole process, I think has given them some conviction about that hypothesis they had, that this is going to be a one-off price move.  

So, this has been entirely a real yield story so far this year. If I were to put some of these views together is that, you know, that story continues. That, that the rest of the year remains a real yield lower story, that the rally that we’re expecting is in the back of Central Bank accommodation and growth slowdown, which is typically most acutely felt in real yields, and I think what's in my mind, what's likely to, to play out in Q2.

Shaun and any views on FX in terms of Q2 and the rest of the year? Any standouts that you have your eyes on?

SO: Yeah, I think I'm, you know, coming away from this conversation probably with a bit more conviction myself, that the U.S. dollar is going to weaken over the course of the next few quarters.

I think, you know, the kind of scenarios that we’re talking about here is slower growth in U.S., lower interest rates, you know, the U.S. dollar is slowly but surely slipping down to the low end, the middle point of that old dollar smile framework. The low point of that curve is when the Fed’s easing, U.S. growth is not all that attractive, and investors take money out of the U.S. and try and put it to work in other parts of the world that are offering better, better return. So, we certainly seem to be moving to that kind of environment.

I think along with that is this idea that you know, the U.S. is just becoming a less friendly place to invest these days. It's becoming more isolationist, more protectionist, more mercantilist. Investors, I think have been on the bandwagon of this U.S. market rally over the past fifteen years. I think many accounts, from an institutional investor right down to probably the retail investor are heavily exposed to U.S. equities and we’ve seen over the past three months that you know, European markets do have a bit of a life in them, they can outperform. And that’s a situation of higher rates, relatively speaking perhaps in Europe, stronger growth potentially in Europe, more fiscal expansion in Europe, relatively cheap currencies in Europe against a relatively expensive U.S. dollar.

A lot of these things are coming together to suggest to me that you know, what we are looking at here is a very strong U.S. dollar that is prone to a bit of a correction. I’m at risk myself of probably being, you know, the stopped clock that eventually will be right, because I’ve been, maybe banging on about an overvalued U.S. dollar for quite some time, and it's been a core part of my thinking on the U.S. dollar. But I do think finally things are coming together here that will push us a little bit lower in terms of the dollar and maybe from a medium-term point of view, a bit more meaningfully lower in the dollar of the course of the next few quarters, the next couple of years. It certainly seems to be a trade that has potential. We can see from positioning and sentiment these are very fast-moving signals that we get from markets anyway, but there’s been a bit of a flip in terms of market sentiment just over the past couple of weeks.

Traders, generally net short U.S. dollars now for the first time in a few months. It’s a trade that has got, I think, legs in the short run and the potential to move quite significantly in the medium term as well.

BS: Yeah, I couldn't agree more and I’ve recently done a lot of analysis in terms of, you know, what is global positioning really look like.

And since we’ve had fifteen years of the U.S. outperformance, you know, there’s so much capital, global capital in the U.S. over-allocated likely to U.S. risky assets as you’re suggesting.

Most international investors find it to be mean-variance optimal to leave a lot of their U.S. asset exposure unhedged. Not only is it risk reducing, but also given the fact that long dollars is positive carry hedging actually reduces some of your, some of your returns in this particular backdrop.

SO: Right, right. This is another big risk I think, Boris, in the sense that investors are under-hedged significantly to the potential for a sharp fall in the U.S. dollar. That could accelerate any significant market shift that we do see, I think has the potential to become, you know, a fast move in adjustment in the value of the U.S. dollar.

BS: So, if you just do the simple exercise of looking at cross-border ownership and what those mean-variance optimal FX hedge ratios are, we're talking about potential over allocation of dollars that’s in the units of the trillions. So, you know, that's, I think that speaks to, Shaun, exactly the dynamic of, you know, this idea that the dollar has peaked, the dollar peak is behind us, and then the potential fall could be massive going forward.

I do want to close out our conversation getting some forecasts from you both. Gabs, how many rate cuts do you expect out of the Bank of Canada and the Fed for this year?

GB: I’m going to be myself a bit of leeway, you know, not just December, maybe a year from now. And again, this is my personal view and not everyone in my team agrees to it, but I would say Bank of Canada is two times, which is what’s been priced in for the end of the year, but I think it’s going to be probably closer to the end of the year rather than in the next few meetings.

I think the Fed even get probably five cuts as opposed to the three that are being priced at the moment.

BS: And when do you think they start that cutting cycle? The Fed.

GB: I don't have a predetermined view on that one. I would say maybe some time in the summer, you know, we’re pricing what the first cut back for June. That’s probably accurate.

BS: That certainly fits my view too with some of the Fed cuts being backloaded, given the fact that it’ll take some time for this labor market cooling to show up in the official data.

How about for U.S. Treasuries? What do you think will be the low, high, and close for 2025 and the 10-year yield, we know the 10-year peaked at 480 back in January, I believe the trough was somewhere in 415. Do you think we’ll see higher highs and lower lows for the year?

GB: Well, I think we’re going to move a lot. I believe we’re going to end up the year a lot lower, but I wouldn’t rule out that would go back to the high. So, I don’t know if 480, I was thinking 475 is something I don’t rule out, I’m not necessarily saying we’re going to get there, but as I said, we’re going to move so much that you could easily get there at some point.

You know, if, especially, if they don’t happen to hike in June or if you start to have some nasty data in inflation, et cetera. But I think that eventually we're going to rally, I think that eventually you’re going to get, you’re going to have 10-year rates close in the year, probably in the low threes.

You know, I, I’d say 325, how about that?

BS: Wow. Okay.

GB: Punch, punchy.

BS: I like it. It is, it is definitely punchy. I was, I had 375 pencilled in for the end of the year, but 325 will be quite a move.

GB: But Boris, 375, when you’re at 425, it’s like, you know, a choice price in these markets.

BS: And that, that’s exactly right.

Especially when you annualized volatility is a hundred basis points, right?  

And Shaun bringing you back into the conversation, USD/CAD, so we’ve been pretty range bound so far this year. Where do you think the low high in close will be in USD/CAD for 2025?

SO: So pretty range bound and bang on our forecast, I should say. So, we haven’t changed our USD/CAD forecast for a number of months. We’ve had 143 for Q1, 143 for Q2 as well.

When we put the forecast together, we did expect a bit more CAD softness into the end of this year. So, the second half, more like 145 as the forecast stands at the moment. But given everything that's gone on clearly that's subject to change and probably will change I think once we a bit of clarity around the tariff situation.

I’m leaning towards a bit more dollar weakness overall here. I think in terms of the high we’ve seen it 148, unless or until we get back to a situation where we're talking about 25% tariffs applied across the board to Canada, we're not going to get back to those kinds of levels. So, 148 I think is the high for this year at the moment. The low end of the range probably around 140. The big impediment for the Canadian dollar right now is the fact that we still have very wide interest rate differentials at the short end of the curve, the policy rate spread historic wide, certainly by any recent memory. If we get the kind of moves in interest rates that Gabs is talking about that could facilitate a bit more CAD strength into the end of the year and potentially a push below 140.

I think it’s not just about tariffs, although is that’s a big, an important part of the story for the Canadian dollar right now, but it's also about monetary policy and interest rate differentials. We need to see that short term spread, that policy gap narrows considerably to see the Canadian dollar strengthen much beyond the 140 points.

BS: That's great and, and I'm sure our listeners also would want to know what conditions are required to get USD/CAD to the 150s.

SO: Well, I, I think if we’re back into some sort of extremely punitive tariff regime of the kind that was feared at least in that initial announcement in February when the sort of threat of 25% tariffs across the board was dangled over us for a period of time at least.

So, that kind of situation would be immensely painful for the Canadian dollar, but hopefully we can avoid that.

BS: So, given our views on the U.S. Rates, market Canada rates, and FX what are the implications for our institutional and corporate clients?

GB: I'll take that one. So, look, it depends on who you are, and I think the world is pretty wild out there now, and let's start with if you’re a corporate client. If you’re a corporate client, in my humble opinion, you have to focus on what you are good at. Focus on your industry and leave those financial risks to the hedgers to give you the right answers.

But I will go even further, there are other instruments that our corporate clients could potentially use and they're having, you know, underutilized, for example, inflation swaps. Again, you know, that's part of what I've done most of my career. But a lot of people have inflation exposures underlying to all the contracts they may have with all sorts of stakeholders.

And the opportunity there to hedge these exposures and inflation swaps provide a very good avenue to do that. But I mean, if you’re a corporate client, the message is look at the exposures, make sure your hedged and focus on what you're good at.

If you're institutional client and if you have a real money mandate and you have your investors' money with a, with a clear remit, I think you should stick to that remit and if you have the ability to have a bit of an active exposure against your mandate, there are opportunities, but I wouldn't deviate too much of what you are trying to achieve for your investor.

Now, if you are fast money, more absolute return, hedge fund type of investor, happy days. This is the environment you want. This is where opportunities arise all day long. And this is what I'm saying that it's important to have a core view, to have an idea of where the world is going.

There are, there are a lot of arbitrage opportunities and things that get dislocated that are there to take advantage of.  

BS: And I love your point on inflation swaps because that is one of the more precise instruments, we have to hedge the potential inflationary impact of tariff measures and then retaliatory tariff measures. So, that’s obviously a great point. And I think there's plenty in this conversation that gives food for thought. 

If one sentence can sum up 2025 so far is expect the unexpected. So, we'll certainly have to do this again in coming months and kind of mark-to-market some of our calls. So, with that, Shaun, thanks for joining us today.

SO: My pleasure, Boris.

BS: And Gabs, thanks for joining the conversation as well.

GB: Pleasure Boris, anytime. 

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