Economic activity is being constrained by great uncertainty. In the short term, Euro Area inflation is impacted negatively by tariffs due to reduced demand.
Contrary to most expectations, the euro has not weakened with the introduction of tariffs. If China shifts its exports to Europe, energy prices decrease, and the euro strengthens, inflation may not rise in the Euro Area despite tariffs.
The Trade War’s Impact
The trade war initiated by President Trump has created exceptional uncertainty, affecting economic growth in the euro area. Lessons from the 2018 trade conflict show tariffs can cause temporary inflation but also hinder growth, which eventually impacts inflation negatively.
The current situation differs from past experiences, and its evolution remains to be seen.
In essence, the piece outlines how tariffs—particularly those borne out of trade tensions led by the United States—may paradoxically result in lower inflation inside the Euro Area, rather than higher prices, which would normally be expected. This stems largely from reduced demand due to economic strain, along with possibilities like Chinese exports being diverted into Europe. Surprisingly, the euro has strengthened, defying expectations that trade disruptions would drag it down. As we’ve seen in earlier episodes, most notably back in 2018, early-stage inflationary effects from tariffs tend not to last. Ultimately, diminished trade hurts economic output, which in turn weighs more heavily on inflation figures.
These developments carry meaningful implications for the positioning of short- and medium-dated instruments. With signs pointing to downward pressure on households and businesses alike, there may be less risk of abrupt tightening moves by authorities. Volatility, meanwhile, is being shaped more by global political action than by macroeconomic trends alone, which narrows the range of scenarios in which inflation would catch markets off-guard.
Market Reactions and Strategies
What’s especially notable now is not just the defensive behaviour in consumer demand, but the currency’s resistance to devaluation in the face of friction. This change challenges older assumptions baked into pricing models and value-at-risk estimates. German data due in the coming weeks will shed light on whether this firm euro narrative sustains, but we should already be attuned to recalibrating bets that relied on pass-through inflation being automatic when tariffs are introduced.
As ever, positioning will have to shift ahead of the curve. We’re watching closely for inventory readings across key sectors, especially those exposed to redirected Asian goods. If European ports begin to show traffic consistent with diverted Chinese exports, hedging strategies linked to energy inputs and transport could see material shifts in pricing behaviour.
Options markets will tell us the next part of the story. Pay special attention to whether skew develops around currency moves, because if policymakers intervene—verbally or otherwise—the present steadiness of the euro could give way faster than many models reflect. With volatility being driven less by economic prints and more by strategic trade redirection, spreads could widen unpredictably, but not necessarily uniformly.
The historical relationship between trade shocks and consumer prices has been altered. We are now in a situation where output indicators deserve more focus than price data. If industrial production metrics stall, that alone would justify a defensive footing when considering derivatives linked to rate forwards or inflation curves. In many ways, inflation appears to be fading as a predictive signal for how central banks may act this season, which means greater emphasis must fall on volume and sentiment indicators to guide exposure.
So, while much of the broader market may remain fixated on high-level macro forecasts, adjustments initiated through lower demand and stable currency performance provide a narrow but useful window to refine short-term risk positioning. We will be especially sensitive to backward-looking inflation surprises being ignored if forward-looking growth expectations deteriorate.
