Why FX Volatility Will Dominate Markets In 2025 | Brent Donnelly

Episode Summary

Executive Summary: Brent Donnelly argues that markets overreacted to tariff fears and that the dollar’s recent strength is driven more by sticky inflation, higher yields, and extreme positioning than by tariffs alone. He expects slower, smaller tariff implementation, which could support bonds, weaken the dollar, and be constructive for risk assets. He also lays out FX fundamentals—rates, flows, and central-bank signaling—as the main drivers across G10 and EM.

Main Topics: Tariffs, Trump policy, and FX reaction (Priority: 5/5): Donnelly compares the current Trump administration to 2017-2018, arguing that actual tariff implementation has been slower than expected and that markets may be pricing too much tariff risk into FX. Dollar strength, yields, and Fed policy (Priority: 5/5): He says most of the dollar rally reflects higher US yields, sticky inflation, and hawkish Fed expectations rather than tariffs alone; if yields ease, the dollar may roll over. How to trade currencies: rates, flows, and country specifics (Priority: 5/5): He explains his FX framework: interest-rate differentials come first, capital flows act as an accelerant, and country-specific factors like commodities, housing leverage, or policy regimes shape individual currency behavior. Carry trades and volatility (Priority: 4/5): He discusses carry as a crowded, convex trade that works best in low-volatility environments; after the yen carry unwind, he sees fewer attractive classic carry setups. Bank of Japan and yen dynamics (Priority: 5/5): Using the upcoming BOJ meeting as a case study, he stresses that the market already prices in most of the hike and that the real trade depends on the central bank’s guidance, not the hike itself. Canada and housing/debt fragility (Priority: 4/5): He remains cautious on Canada due to high household debt, mortgage resets, weak GDP per capita, and rising unemployment, though he thinks tariff fears have already pushed CAD near fair value. China as a managed/stable-system story (Priority: 4/5): He argues China is not failing to stimulate because of USD strength, but because it prefers stability and gradual adjustment, effectively managing the yuan as a quasi-peg rather than using it as a growth tool.

Key Arguments: Tariff rhetoric has outpaced actual implementation; the market is likely pricing too much immediate tariff shock into USD and CAD. The dollar’s rise is better explained by sticky inflation, hawkish Fed expectations, and higher yields than by tariffs alone. US inflation remains above target, so the Fed has little room to hike but also little urgency to cut; that support for high rates helps maintain a strong dollar. Tariffs are usually a one-time price level shock, not persistent inflation, and may be net disinflationary through weaker confidence and growth. FX is primarily driven by interest-rate differentials, then by capital flows and country-specific macro/technical factors. Carry trades thrive in low-volatility environments; after the August yen carry unwind, carry remains less crowded and somewhat safer in principle, but few trades are attractive now. The BOJ hike is already largely priced in; the bigger move will come from the tone of guidance and whether markets perceive more hikes ahead. Canada faces structural headwinds from mortgage resets, leverage, and softer labor markets, making CAD vulnerable once tariff uncertainty clears. China is managed for stability, not aggressive growth; the yuan is effectively pegged within a basket framework and devaluation is unlikely unless trade tensions force it. The dollar remains a long-term reserve currency winner, even as cyclical strength may eventually fade when US growth/capex peaks.

Data Points: Expected tariff odds on Polymarket: 10%–15% - Speaker cites odds for a large tariff on Canada and Mexico after the inauguration, down from about 45%. Earlier tariff odds on Polymarket: ~45% - Referenced as the market’s earlier estimate before the post-inauguration reversal. Canadian dollar move: Rallied back after getting smoked - CAD sold off on tariff remarks, then recovered by end of day. FX volatility: Near highs - He notes FX vol remains elevated while VIX and MOVE are near lows. Inflation above target: 44 months - US inflation has stayed above the Fed’s target for 44 consecutive months. US services inflation: ~4% - Used to argue inflation remains sticky because services dominate consumption. Fed funds level: 4.5%–5% - Referenced as a range that suggests neutral may be higher than the Fed wants to admit. Inflation metric range: 2.3%–3% - He cites the current inflation range depending on the measure used. Dollar positioning: One of the most extreme times since 1995 - He says the market has a large, crowded long-dollar position. BOJ priced hike: 22 bps priced in - He says the market is effectively pricing a BOJ hike close to 25 bps. BOJ expected move: 25 bps - Expected hike at the upcoming Bank of Japan meeting. Recent BOJ hikes: 15 bps and 20 bps - He notes the BOJ has recently used non-standard increments. Canadian dollar fair value premium: ~3% tariff premium - He thinks CAD still embeds a modest tariff risk premium. Canada household debt: Very high / still rising historically - Used to explain Canadian vulnerability to higher rates and mortgage resets. US household debt pattern: Peaked in 2007–08 - Contrasted with Canada’s continued rise, making US consumers comparatively more resilient. Japan debt-to-GDP: ~200% - Used to explain why Japan cannot easily tolerate much higher rates. Goldilocks environment: 2023–2024 style - He argues a strong economy with a Fed unable to hike is favorable for risky assets. Currency peg reference for China: ~730 CNH / ~7.18 CNY - He describes the yuan as being managed tightly around these levels.

Pivotal Quotes: "the dollar is great again" — Brent Donnelly: He says FX has become much more interesting again because tariff risk and rate uncertainty have increased volatility. "the negative shock to confidence is larger than the one-time upward shock to prices" — Brent Donnelly: His explanation for why tariffs often hurt markets more through sentiment and growth than through direct inflation effects. "central banks on hold... is a pretty good setup for long risky assets and long carry" — Brent Donnelly: He argues that policy stability reduces volatility and supports equities and carry trades.

Implications: Listeners should expect FX to remain a leading macro battleground in 2025, with tariffs, central-bank guidance, and yields driving moves. If tariffs come in slowly or not at all, bonds and risk assets may benefit, while the dollar’s extreme positioning leaves room for reversal.