The second half of 2025 begins not with optimism, but with fatigue. The global economy is not collapsing, but it is clearly bending under strain—economic, geopolitical, and institutional. What is taking shape is not a soft landing, but something more sobering: a slower, structurally weaker cycle in a more dangerous and fragile world.
Three developments define this uneasy moment. First, is the looming end of postponement of the US so-called reciprocal tariffs. Second is China’s demonstration that it dominates the supply chain for rare earths and magnets with the same iron grip the US maintains over semiconductors. Washington may soon learn that China also controls key elements in drone production and the US gets an estimated 90% of its drones from China. Third is domestic developments in the US, including the reduction in the Supplementary Leverage Ratio, an expected endorsement of dollar stable coins that require Treasury backing, and continued efforts by the White House to drive monetary policy.
Tariffs and Trade Turbulence
The Trump administration’s tariff policy is a source of much angst and uncertainty. July 9 is ostensibly the end of the postponement of the “reciprocal tariffs”. The number of deals struck during the 90-day hiatus has been dismally low, and the decision to double the steel and aluminum tariffs during the period was unsettling. Moreover, the tariffs were broadened to include not only the raw materials but consumer products that contain the metals, such as dishwashers, dryers, and washing machines. Still, the administration has dangled the possibility of a longer postponement, and Treasury Secretary Bessent now holds out the possibility that everything will be resolved by early September.
We are not convinced that the higher tariff regime will bring back manufacturing jobs to the US. To the extent that manufacturing capacity is expanded, it will likely be highly automated, including robotics, limiting scope for direct employment. The promised revival of blue-collar employment may prove to be little more than political theater.
We find ourselves positioned much like our great-grandparents in the late 19th century, witnessing a fundamental economic transition—then from agriculture to industry, now from manufacturing to services. There were countless romantic and moralistic narratives crafted, mourning the loss of the yeoman farmer, the backbone of democracy, they claimed, who provided literal sustenance. There was, they argued, no more important work than theirs, and the closeness to nature and hard work was the essence of virtue. As agriculture output continued to rise even with fewer people employed on farms, so too with manufacturing. As its workforce has fallen, overall output has increased.
The nomenclature of economic development turns precisely on this progression. Countries with large agricultural workforces are often associated with frontier economies or developing economies. Nations where a significant part of their labor employed in manufacturing is common in middle-tier countries. The vast majority of employment in high-income countries is in the service sector.
Beyond the “reciprocal tariffs” that will come into effect, it is possible that the results of the US Commerce Department’s investigations into sectors identified as critical to national security will be announced. These investigations under Section 232 of the Trade Expansion Act (which is the authorization for the tariffs on steel, aluminum, and autos) cover semiconductors, pharmaceuticals, critical minerals, heavy trucks, timber and lumber, copper, commercial aircraft, and jet engines.
The shock and uncertainty have forced many US major trading partners to adjust either monetary and/or fiscal policy to cushion the coming blow. The eurozone, UK, and Canadian economies appear to have slowed in Q2. On the other hand, the trade distortions that saw the US economy contract in Q1 likely exaggerated growth in Q2 to the upside.
U.S. Slowdown and Fed's Dilemma
A key measure that Federal Reserve Chair Powell often cites is final sales to private domestic purchasers, which has risen by at least 5% (annual nominal pace) for the past seven quarters. In the seven quarters before the pandemic, it averaged a little less than 4%.
Nevertheless, we are concerned that the US economy has begun to slow sharply. US retail sales fell for the second consecutive month in May for the first time since the end of 2023. Real consumption through the first five months of the year is flat. This disappointing showing is taking place in the context of weaker consumer confidence, rising weekly jobless claims, the resumption of student loan servicing, and heightened household debt-stress levels. Industrial output fell in May for the second time in three months.
The Federal Reserve last cut rates in December 2024. At the time, growth was stronger (Q3 GDP was 3.1% and Q4 GDP was 2.4) and inflation (personal consumption expenditure deflator) was higher (headline was at 2.6% in December and the core was at 2.8%). Chair Powell explained that the tariffs are considerably higher than any one anticipated. Fed officials see a substantial risk that of a meaningful rise in inflation. Target and Walmart, for example, have warned of higher prices soon. We think that the Fed’s next cut will likely be in September.
Geopolitical Flashpoints and Economic Weaponization
Israel decimated Iran’s proxies, Hamas and Hezbollah, and Tehran’s failure to comply with the UN watchdog limiting its uranium enrichment triggered a new phase in the conflict. Israel’s quickly secured air superiority and proceeded to inflict much damage to Tehran's power project capability. There are different assessments of how long the attack, including the US "bunker-buster bombs" setback Iran's nuclear program but there seems to a loose agreement that it is at least a few years. At the same time, Russia's war on Ukraine, and the vulnerability of Iran demonstrated by Israel, who is widely believed to have nuclear weapons, will likely make them even more desirable. In this context, and seeing the way North Korea is treated, incentives to possess nuclear weapons have increased. Non-proliferation has been undermined.
China demonstrated its ability to weaponize the rare earths and magnets supply chain in a similar way the US has done in semiconductor technology. Yet, it is not symmetrical. The White House crypto and AI czar David Sachs warned that China figured out ways around the chip curbs, and that it may be only two years behind the US chip design capabilities. By some estimates, the US is 10-15 years behind China in the technology to process rare earths and 15-20 years behind China in industrial-scale rare earth magnet manufacturing and ecosystem maturity.
Confirmation of the understanding reached in London, China's rare earth and magnet shipments to the US appear set to resume. The US will retract some of the measures it announced since the meeting in Geneva in May, including control of ethane, a key feedstock for modern plastics, for which the US dominates. Half of US ethane exports go to China, which is about 250k barrels a day. Arguably more than developments in the capital markets, the domination of various supply chains illustrates changing power dynamics.
China first weaponized rare earths when it banned exports to Japan over a fishing trawler dispute in 2010. Between 2023 and 2025, China began imposing export restrictions of strategic materials to the United States, including gallium, germanium, antimony, graphite, and tungsten. However, the “Sputnik moment” (and there have been several recently, including Deep Seek AI breakthrough) came when auto assembly lines in the US and Europe were forced to stop due to the lack of rare earth magnets. Moreover, the US may soon be reminded that China dominates key elements of drone production. It accounts for 70-80% of the world's commercial drones and as much as 90% of America's. After the US sold arms to Taiwan last year, Beijing sanctioned US manufacturer of drones, denying it the ability to source parts in China.
Independence of the Federal Reserve
The Trump administration has not only transformed the international economic and military discussions, but he is challenging domestic norms as well. The one that the markets are most sensitive to is the independence of the Federal Reserve. Two Fed governors, both of whom were appointed, indicated that a July rate cut may be appropriate. A few days later, President Trump indicated he was considering nominating Chair Powell's replacement in September or October.
Since Powell's term does not end until next May, such an early nomination is widely seen as a tactic to add pressure on the Federal Reserve to cut rates. We suspect it could backfire. There have been very few dissents under Powell's leadership, including by nominations made during Trump's first term. A nominee could reveal how isolated he/she is if they were to argue against a position that carried the Fed unanimously or with an overwhelming majority.
Yet, with a September rate cut a high probability scenario, an appointment shortly before the meeting would make for poor optics, which may translate into a steeper curve. It might not be offset by the planned reduction in the Supplementary Leverage Ratio (ostensibly freeing up $210 bln of capital at the largest banks) or the regulations intended for stable coins backed by the dollar (US Treasuries). This is especially true of the rising supply necessitated by the growing deficit. The OECD estimates the shortfall will reach 7.5% of GDP this year and 8.1% of GDP next year. It averaged 6.6% in 2023 and 2024.
Bannockburn’s World Currency Index
As the US dollar has trended lower, Bannockburn's World Currency Index, a GDP-weighted basket of the currencies of the largest 12 economies, which are split between high-income and developing countries, has trended higher. It is reached its best level since last September. BWCI bottomed in early January near 87.70 and was approaching 92.00 in late June. It has pushed above the down trendline drawn off the 2023 highs and came in around 91.20 when it was penetrated. It looks poised to rise toward 93.00 in near-term and 95.00. in the slightly longer-term.
Among the G10 currencies, the euro fared best, with a nearly 3.3% rise. It has the highest weighting after the dollar and Chinese yuan at about 18.6%. Sterling rose by about 1.9% and the Australian dollar by 1.6%. Together they account for a little more than 6% of the BWCI. The yen was the only G10 currency to have fallen against the dollar -0.5%). It has a 5% weight.
For the index as a whole, the Brazilian real's 4.4% gain was the best, but its weighting is a modest 2.6%. The Russian ruble joined the yen as the only components not to have gained on the dollar in June. It fell 1.7%. The Chinese yuan, which has a 21.4% weight in the index, rose by a modest 0.4%. The Indian rupee, which makes up 4.3% of the BWCI, eked out a 0.1% gain. The Mexican peso rose by about 3% and the South Korean won gained 1.6%. The two combined account for a little more than 4% of the index.
U.S. Dollar: Dollar sentiment remains poor, and positioning in the futures market and bank surveys of asset managers show that the adjustment is well advanced. Real sector data are surprising on the downside, though Q2 GDP, which will be reported a few hours before the FOMC meeting concludes on July 30 will likely be distorted in a similar but opposite way that Q1 GDP. We have been expecting the labor market and economy to begin a more palpable deterioration around midyear, and it appears to be at hand. The nearly real-time weekly jobless claims have risen and the four-week moving average rise to its highest level since August 2023 and continuing claims are approaching the two million mark, a level not have not seen since November 2021. June nonfarm payrolls (July 3) look soft, and job growth likely slowed for the second consecutive month. Assuming about a 110k increase in June, the monthly average in H1 25 would be about 122k, about a quarter less than the H1 24 average. The unemployment rate is likely to rise to a new post-pandemic high of 4.3%. The groundwork for a September rate cut may be laid. There is a risk of a dissent at this month’s meeting. The dollar has generally weakened when tariffs are threatened or imposed. It is not yet clear what happens on July 9 when the postponement of the "reciprocal tariffs" ends. And there have been hints that the postponement may be extended for at least a couple of months.
Euro: The euro was among the strongest G10 currencies in June, rising by about 3.3%, which brought the year-to-date appreciation to almost 13.2%. The ECB's easing cycle, which began last June, is likely to pause for the next several months, with the deposit rate at 2.0%, slightly above what is estimated to be the neutral rate. The swaps market is discounting about an 85% chance of another cut toward the end of the year. Yet, the economy appears to have slowed considerably after the 0.6% quarter-over-quarter expansion in Q1 25, which was the strongest since Q2 22. Indeed, the median forecast in Bloomberg's survey is for the regional economy to have stagnated, and the outlook for Q3 is only marginally better. If sustained, the rise in oil prices could lift eurozone inflation, and this would have the effect of lowering real rates in the eurozone. We have suggested the euro could toward $1.20 by the end of the year, which may prove to be conservative.
(As of June 27, indicative closing prices, previous in parentheses)
Spot: $1.1718 ($1.1345) Median Bloomberg One-month forecast: $1.1635 ($1.1300) One-month forward: $1.1743 ($1.1370) One-month implied vol: 8.3% (7.9%)
Japanese Yen: The Japanese yen was the only G10 currencies to have fallen against the dollar in June even though the loss was minor (~0.55%). With the economy likely to have eked out minor growth in Q2 after contracting by 0.2% (annualized pace) in Q1, and the shock of the US tariffs (Japan's auto sector accounts for an estimated 10% of GDP and more than 8% of the workforce), the Bank of Japan sounds somewhat less hawkish. The market recognizes that the BOJ's attempt to normalize monetary policy is stalling. The swaps market now prices in 14 bp higher rates at the end of the year than the current 0.50% target. This is down from 30 bp at the end of Q1 25. Meanwhile, to help take pressure off the long-end of the Japanese yield curve, the BOJ announced it will slow the run-off of maturing bonds from its portfolio starting in the next fiscal year (April 2026) and the Ministry of Finance plans on reducing the issues of 20-40 year bonds and boost shorter-end issuance and bills to compensate. The exchange rate's sensitivity to the changes in the US 10-year yield reached a two-year low in May (rolling 30-day correlation <0.10) but rebounded in recent weeks is now near 0.50. Japan goes to the polls on July 19 to elect have of the House of Councillors (upper house). A poor showing by the Liberal Democrats will boost the chances that Prime Minister Ishiba faces a leadership challenge later this year. Rice prices have more than doubled this year (boosting CPI by about 0.6%) and easing the problem could help boost the profile of Shinjiro Koizumi, who became the agricultural minister in May, is the former prime minister's son.
Spot: JPY144.65 (JPY144.00) Median Bloomberg One-month forecast: JPY143.65 (JPY144.80) One-month forward: JPY144.15 (JPY143.55). One-month implied vol: 10% (11.1%)
British Pound: Sterling extended its advance against the US dollar, rising for the fifth consecutive month, matching the longest advance since 2003/2004. In the first six months of the year, sterling appreciated by about 9.6%. The weak US dollar environment masks the underlying vulnerability of sterling. The economy is soft in Q2 after leading the G7 with a 0.7% quarter-over-quarter expansion in Q1 24. The slowdown in the labor market is accelerating. The number of employees payrolled fell by almost 200k in the three months through May compared with a loss of nearly 51k in the previous three months. The economy contracted by 0.3% in April (-0.1%) expected. Manufacturing output fell by 0.9% in April, which was the third decline in four months. The 0.4% decline in the index of services matched the largest since the end of 2022. The weakness appears to have carried into May, when retail sales increased by 2.7% in volume terms, more than five-times greater than the decline projected in the Bloomberg survey. The Bank of England held its base rate steady at 4.25%, but the divided Monetary Policy Committee (6-3) in the context of the disappointing data boosted confidence of a cut at the next meeting in August. The swaps market has another cut discounted in Q4. Leaving aside short-term countertrend moves, over the next six-to-twelve months, a move into the $1.4000-$1.4200 area seems reasonable. The OECD estimates fair-value (purchasing power parity) is $1.47.
Spot: $1.3715 ($1.3460) Median Bloomberg One-month forecast: $1.3635 ($1.3300) One-month forward: $1.3720 ($1.3465) One-month implied vol: 7.6% (7.6%)
Canadian Dollar: The US dollar has trended lower against the Canadian dollar snice spiking to almost CAD1.48 in early February. It recorded a 10-month low near CAD1.3540 in mid-June. The reactive bounce was capped at CAD1.3800. The next important technical target is the CAD1.3400 area. The driving force has been the US dollar's broad decline, and the correlation of changes in the Canadian dollar's exchange rate and the Dollar Index is near an 18-month high above 0.70. The Bank of Canada has front-loaded the rate cuts, though there may still be scope another but not until Q4, according to the swaps market. Economists in Bloomberg's survey are concerned that the impact of the US tariffs is only beginning to be evident, and an economic contraction could encourage the central bank to cut rates twice to a terminal rate of 2.25%. Meanwhile, Canada established a new tariff-quota to limit imports of steel from countries with which it does not have a trade agreement. It has also threatened to increase tariffs on US steel and aluminum on July 21 if trade talks with the US stall.
Spot: CAD1.3690 (CAD 1.3740) Median Bloomberg One-month forecast: CAD1.3695 (CAD1.3900) One-month forward: CAD1.3670 (CAD1.3720) One-month implied vol: 6.1% (6.1%)
Australian Dollar: The Australian dollar reached a seven-month high, slightly above $0.6560 in late June. It appreciated by about 1.6% in June, but with a four-month advance, it is up almost 5.6% this year, the least after the Canadian dollar's 5.3% gain, among the G10. In the coming months, a $0.6800 target seems reasonable. The Reserve Bank of Australia began an easing cycle in February and cut rates in May. The cash target rate is 3.85%. The derivatives market is discounting around a 95% chance of a rate cut at the July 8 meeting, and two more this year. This is to say that the RBA is seen one of the most aggressive G10 central bank in H2 25. The market expects another cut in early 2026. The US and Australia's free-trade agreement has been in place since early 2005 and the US ran a goods surplus with Australia of about $18 bln in 2024. Australia was not given an added "reciprocal tariff" but is subject to the 10% universal tariff and the sectoral tariffs on steel, aluminum, light vehicles, and parts. Lastly, we note that the Trump administration is reviewing the US commitment under the 2021 AUKUS agreement. The risk seems to be growing that the US seeks to modify or abrogate the agreement ostensibly because of the US own military needs.
Spot: $0.6530 ($0.6395) Median Bloomberg One-month forecast: $0.6520 ($0.6350) One-month forward: $0.6535 ($0.6400) One-month implied vol: 10.1% (11.0%)
Mexican Peso: The dollar was sold to its lowest level against the peso since last August. It reached almost MXXN18.81, the day after the central bank delivered its fourth consecutive 50 bp rate cut on June 26. The decision to cut by a half-point was taken despite inflation rising above the upper end of the target range of 4%. The central bank is more concerned about economic weakness. The economy contracted by 0.6% (quarter-over-quarter) in Q4 24 before rebounding by 0.2% in Q1 25. The median forecast in Bloomberg's survey is for a 0.1% contraction in Q2 25. The pressure on Mexico from shift in US policy is profound. Onshoring, for example, challenges the near- and friend-shoring, which has helped Mexico modernize. The US is threatening to tax worker remittances sent by non-citizens. Worker remittances are the top source of hard currency inflow to Mexico, exceeding foreign direct investment, tourism, and oil exports. The long peso, short dollar trades, especially in the levered community, remains popular. In the futures market, non-commercials (speculators) have had one of the largest net long peso positions since last August.
Spot: MXN18.8240 (MXN19.4375) Median Bloomberg One-month forecast: MXN19.10 (MXN19.5285) One-month forward: MXN18.89 (MXN19.5125) One-month implied vol: 9.6% (10.6%)
Chinese Yuan: Beijing maintains a firm hand on the yuan's exchange rate. In June, the dollar traded in around a 0.6% range against the yuan (~CNY7.1575-CNY7.20) and not quite twice as much against the offshore yuan (~CNH7.1525-CNH7.2240). The onshore yuan has appreciated by an inconsequential 1.75% against the dollar so far this year, and offshore yuan has risen by around 2.3%. Shadowing the dollar means the yuan has depreciated against the G10 currencies and most emerging market currencies. The People's Bank of China continues to move the daily dollar reference rate more than they did at the start of the year. By setting the reference rate lower, the PBOC effectively lowers the dollar's cap. However, we suspect that with deflationary forces still gripping the economy, there may limited appetite for further yuan appreciation against the dollar. At the same time, the economy seems to be struggling to sustain forward momentum, and additional stimulus may be necessary. The most officials may be prepared to do is moderate the pace of the dollar's decline and yuan's appreciation; not reverse it.
Spot: CNY7.1725 (CNY7.1990) Median Bloomberg One-month forecast: CNY7.1830 (CNY7.2500) One-month forward: CNY7.1475 (CNY7.1725) One-month implied vol: 4.8% (4.6%)
Reviewed by Marc Chandler
on
June 28, 2025
Rating:
