No Laughing Matter

By Bas van Geffen, senior macro strategist at Rabobank

In her State of the Union speech, European Commission President Von Der Leyen summarized that the European Union is stronger than ever, but that the state of the Union is also as precarious as it has ever been. Speeding up the overhaul of the Single Market is an imperative in this context. She acknowledged that the European Union is under attack, both economically and physically: “hybrid threats facing Europe are less and less hybrid and less and less threats.

The European Commission is increasingly aware of the interconnectedness of different themes and challenges –e.g., industrial policy, energy security, defense, and capital markets– that must be overcome to face these attacks. And, as Von der Leyen noted, this requires more alignment within the bloc. The Commission can achieve only so much without the support from, and complimentary actions by, the member states.

Indeed, internal divisions and national interest remain a challenge in key policy areas, such as deregulation, or foreign and trade policy.

The Commission is taking a tougher stance on trade policy, and specifically the EU’s trade relation with China. But Brussels is mindful of the challenges and risks of retaliation. So, they are advancing with small but tangible steps. The Commission has asked China to voluntarily restrict exports of hybrid cars – which do not fall under the ~40-45% tariff on electric vehicles. Imports of these cars have soared this year, undoubtedly also due to high fuel costs.

The FT also reports that Germany and France increasingly agree on more forceful action against China – after years of division over the appropriate approach. However, this ‘unity’ is often hard to find. If member states continue to protect domestic champions within the bloc, then it’s also easy for adversaries to drive a wedge between the member states.

On top of Von der Leyen’s call for internal unity, the Commission realizes that it cannot achieve its goals without international partnerships. The president of the European Commission proposed an associate membership for Canada – a status which is yet to be defined. In her State of the Union, she suggested the bloc and the country “will integrate defence industrial bases. We will make the Arctic a flagship joint project. We will work on energy, critical materials and batteries. On AI, quantum, cyber and economic security.”

Von der Leyen continued that “this is a partnership not against anyone else, but for our common strength.” That may be the EU’s intention, but in the current world order, other countries may not perceive it that way. These partnerships could be construed as a threat to their relative power and influence.

Indeed, President Trump called Canada’s associate membership “laughable,” before adding that he might consider it a “hostile act” if the EU approves this. The threat of tariffs, and the potential withdrawal of US troops and security guarantees will probably force some EU members to think twice about the Commission’s plans.

Similarly, stronger cooperation could antagonize other world powers. Russia may not like the joint Arctic project, and advancements on battery technology and critical raw materials would compete with China’s interests.

The plan for a stronger EU-Canada alliance wasn’t the only thing that displeased Trump yesterday.

The FOMC unanimously voted to increase the target range for the Federal funds rate by 25 basis points. And, as our US strategist notes, we got more than we bargained for. The Fed’s new set of economic projections essentially shows a new reaction function. The projections indicate that a much higher policy rate trajectory is required to reach a similar inflation outcome.

This new reaction function does not necessarily mean more hikes will follow. FOMC Chair Warsh acknowledged that yesterday’s rate hike cannot address the supply shock that caused high inflation, but he stressed that the Fed can prevent second-order effects.

The FOMC members project one additional hike before the end of the year, but we still have our doubts about that. We fear that the stagflationary impact could ultimately also affect the real economy, and not just inflation. Therefore, we still believe it is more likely that yesterday’s decision turns out to be a one-and-done hike and we think that the Fed may be forced to cut earlier next year than they expect.

However, the new reaction function did force a rethink of that subsequent cutting cycle. We now only expect one cut in 2027 and one in 2028, as we shift our assumption for the terminal rate from 3.00-3.25% to 3.25-3.50%.

Overall, the FOMC sent a clear message that it is committed to defend its monetary policy independence. In fact, their projections suggest that by the time President Trump leaves office, the policy rate may be higher than when Warsh took the helm at the central bank.

That’s already drawing some ire from President Trump – albeit directed at the other FOMC members, and not at Warsh. The president said he had spoken to Warsh prior, but “didn’t try to convince him.” Trump still relies on Warsh, but “no matter how good a job, he’s got a hostile board.”