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The Fall-Out from the Trade War and its Effect on the USD

The Fall-Out from the Trade War and its Effect on the USD

The US-China trade war is showing no signs of de-escalation, and this could very well take the world economy into a phase of slow growth. After a pivotal round of trade talks in Washington in May 2019, President Trump decided to raise the existing tariffs to 25%, on an additional $325 billion worth of Chinese goods and services. This accounts for one-third of all Chinese products used by US consumers, including seafood, electronics and luggage. This rise in tariffs will now force manufacturing companies to increase prices, so it is the consumer that stands to lose.

In retaliation, China has also increased tariffs on practically all US exports (worth $60 billion), including agricultural products.

This jump to 25% tariffs can no longer be ignored, say economists. It might drive up the inflation levels in the US, while tightening financial conditions in the near future. How will the USD fare amidst all this aggression? Has its world dominance been affected in any way? Let’s find out.

USD Suffers Short-Term Surge in Volatility

What usually follows after a trade war is currency devaluation, in order to fuel economic growth, much like what we saw in July 2018. The Chinese government and the People’s Bank of China decreased the reference rate of the Yuan Renminbi, with respect to the USD. Shortly after one of President Trump’s explosive tweets, regarding this devaluation, the USD index fell more than 1%.

But, apart from periodic spikes in volatility, the USD didn’t suffer any negative repercussions at that time. The US economy showed a favourable increase in GDP growth, at 4.1% during the period, with an unemployment rate of 3.9%.

Even after the meeting in May 2019, the currency and equity markets showed opposing results. While US equities drastically dipped after the news of tariff escalation started pouring in, USD rates showed little reaction with respect to other currencies, such as the EUR and GBP.

Equities are closely related to the Sino-US trade talks, since many large and mid-sized US companies manufacture and assemble in China. Many other companies distribute and sell these products in the US markets. All these companies will see impacts on their bottom lines, owing to the escalation in the trade war.

With respect to currencies, however, the repercussions are more complex. The decrease in equity values of a large number of firms definitely has an effect on the US GDP, and in that way, is likely to affect the USE as well. But the valuation has to be done in relation to other economies.

In Q1 2019, the US economy expanded 3.2%, far ahead of Europe and Japan. The US Federal Reserve, with its interest rate stable at 2.5%, showed greater resilience in supporting the probability of a weakened economy than the ECB or the Bank of Japan. The US markets are also less dependent on exports, than any other major industrial economy. Overall, the USD acts as a safe haven for currency traders worldwide, whenever a slowdown is projected, or economic uncertainties are expected. For instance, uncertain economic and political conditions in the UK have affected the GBP to USD rate, in favour of the latter.

All this had kept the USD stable for a couple of weeks, but, for how long? The long-term effects of the trade war are likely to be more pronounced on currencies, rather than equities.

The Current Scenario

Since the start of June 2019, the USD has declined against each of the seven major currencies, leading to a significant gold price rally. The USD suffered from weakened economic data momentum, with higher expectations of Fed rate cuts in July, sparked especially after statements made by Fed Chair Powell in the first week of June 2019.

But, the USD has started soaring again, almost to a two-week high, due to expectations associated with the upcoming Fed meeting on June 19, 2019. Among the many reasons for the USD stability has been an increasing dovish stance of the ECB, the Brexit chaos and the Italian economic crisis.

A lot will depend on prospective US-China talks at the end of the G20 summit in late June 2019. If de-escalation of the crisis takes place, Fed rate cuts seem improbable.

What Can Happen in the Near Future?

It won’t be long before the retaliatory tariffs imposed by the US and China on each other’s goods start affecting import prices. A prolonged trade war with China will cause a huge surge in demand for resources on US soil, not to mention a depreciation in commodity currency values, such as the Australian and Canadian Dollars. Countries that are able to provide substitutes for US products in China will have an advantage, but global demand for commodities like oil and soybean will drop. This could be good for the USD.

In other parts of the world, particularly in the Asian economies, significant efforts have been ongoing to reduce the US Dollar’s dominance, on expectations that a continuation of the trade wars would shift investment and consumption patterns away from globalisation. The Association of Southeast Asian Nations, called Asean+3, are considering adding the Chinese Yuan and Japanese Yen to their framework for multi-currency swap arrangements (CMIM). This would definitely give China a boost, in its attempt to promote wider use of its currency.

For now, the US Dollar remains the world’s reserve currency, accounting for 63% of the global reserves. However, the ongoing efforts could soon decrease that share and promote greater adoption of local currencies.

However, since the tariffs have been imposed, China has been experiencing unexpected levels of low growth. It is being projected that the Chinese government might not have enough US Dollars to support its own currency, in case of a long drawn out trade war.

The Chinese Yuan is backed by its foreign exchange reserves, particularly invested in US treasury securities worth $3.1 trillion. In case of rising trade tensions in the future, there would be reduced supply of the US Dollar in the Chinese economy.

The threat to the US Dollar will also come from the Fed’s monetary policies, currency devaluation and impending inflation hikes. In addition, a weakened US Dollar would make imports into the US more expensive, encouraging import substitution by domestic manufacturing. US exports will become cheaper around the world too. This will be favourable in terms of keeping the trade balance sheets intact.

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