Dollar Undervalues Trade War Risk, Economists Warn

Image: Photo by Anthony Quintano. Licensing: CC 2.0. Sourced: Flickr.

Despite recent gains, the US dollar (USD) is not fully reflecting the potential risk of renewed trade tensions, according to Vasileios Gkionakis, Senior Economist & Strategist at Aviva Investors.

Gkionakis argues that "only some – and likely much less than you imagine – policy-risk premium is embedded in [the] dollar’s value so far."

His analysis, based on AI models, suggests that fundamental factors like economic data and interest rate differentials account for 50% to 90% of the recent USD appreciation.

This leaves only 1% to 1.5% attributable to non-fundamental factors, including potential trade war risks.

Gkionakis believes that this undervaluation leaves "plenty of USD upside to manifest" if the US implements protectionist trade policies.

He outlines two potential scenarios:

Scenario 1: Permanent Shift: If tariffs are used to permanently shift away from globalisation, the USD could see a "material" appreciation.

The scale and speed of this appreciation would depend on the size and implementation timing of the tariffs. Larger tariffs implemented quickly would have a greater impact than smaller tariffs phased in gradually.

Scenario 2: Negotiating Tactic: If tariffs are primarily used as a negotiating tool, the USD appreciation would likely be smaller and shorter-lived.

In this case, markets might anticipate a less aggressive Federal Reserve and less severe global growth impacts.

Gkionakis acknowledges that the actual outcome could be a mix of these scenarios, with different countries experiencing varying effects. He expects the USD to strengthen further overall, but not necessarily in a linear fashion.

He singles out the Euro (EUR) as likely to weaken initially but believes a rebound is possible if trade negotiations take place and the European Central Bank remains hawkish.

Elsewhere, Adam Slater, Lead Economist at Oxford Economics, says he thinks currency markets aren't yet priced for tariffs.

"It's far from clear that the full potential impact of tariff increases has been priced into FX markets, especially for Mexico, Canada, and China. Our analysis suggests further depreciations of 5% or more are likely in these cases if tariff threats are carried through," he says in a new note.

Although financial market pricing has already shifted considerably in response to the U.S. election result, Oxford Economics thinks further significant moves are likely in the weeks ahead, especially as the policy position of the new administration takes shape