EUR/USD muted despite tariff headlines - Commerzbank

Since the middle of the year, EUR/USD has essentially been trading within a range of roughly 1.15-1.18, and the US currency has reacted little to the recent tariff news in particular, Commerzbank's Head of FX and Commodity Research Thu Lan Nguyen notes.

US terms of trade improved, but Fed easing offsets USD strength

"In theory, US tariffs improve the US terms of trade because they increase demand for US goods compared to foreign goods. This also increases the prices of US goods compared to foreign goods. This happens either through rising US inflation or through an appreciation of the US dollar. The extent to which inflation rises or the dollar appreciates depends largely on the response of the US Federal Reserve."

"What have we seen so far? The US terms of trade have improved significantly since the beginning of the year. The real effective US dollar exchange rate, on the other hand, has fallen significantly. We know why: instead of responding to US tariffs with a restrictive monetary policy, the US Federal Reserve has started to cut interest rates. This means that an improvement in the terms of trade is primarily brought about by rising inflation, not by a stronger dollar. On the contrary, the weaker currency actually increases inflationary pressure."

"In economics, the exchange rate is often referred to as an 'automatic stabilizer'. This is not least because it can adjust much more quickly than other macroeconomic variables, which are typically rather sluggish. Normally, one would assume that the central bank would limit inflation and that the exchange rate would adjust the terms of trade. However, this is not currently the case. The US Federal Reserve has signaled that it intends to look through the inflationary effect of US tariffs. In other words, instead of allowing the exchange rate to fluctuate in response to the terms of trade shock, it is allowing inflation to fluctuate. In my opinion, this explains, at least in part, why the exchange rate is reacting so little to the news about tariffs."