Trade Wars to Play Negative for US Dollar say Analysts

© Nazli Sart, Adobe Stock

The US Dollar started Monday marginally lower on trade war fears yet the evolving drama could also be positive for USD in the long run.

The Dollar was seen mixed at the start of the new trading week as concerns about the impact of a trade war weigh; the Pound-to-Dollar exchange rate was quoted higher at 1.3808 while the Dollar was actually seen lower against the Euro which is a poor performance considering the uncertainties in Italian politics following the weekend's vote.

It would appear that the prospect of a global trade war is what markets are truly concerned about.

The US government has proposed putting tariffs on imported steel and aluminum of 25% and 10% respectively for "national security" reasons, although an ancillary reason, no doubt, is to prop up their beleaguered domestic industry which has been battered for decades by cheap imports. 

Nations affected by the tariffs have hinted at retaliation, with the EU suggesting items from the United States such as motorcycles, clothing and whiskey could find import tariffs raised. US President Donald Trump fired back immediately with a threat to increase imports on European vehicles.

The European Commission could launch tit-for-tat measures as soon as Wednesday having drawn up an EUR2.8 billion list of proposed counter-measures.

US tariff measures on metals is still in the proposal stage with final details yet to be delivered, but an official outline is likely to be published this week.

There has been some debate about whether the market reaction - to sell the US Dollar - is the right one.

It seems the selling of Dollars has less to do with the US decision per se and more to do with the negative reaction it has elicited from the rest of the world.

On its own, the imposition of tariffs by the US would be expected to be US Dollar positive as it would reduce demand for foreign steel and aluminum imports, thereby also reducing the aggregate sale of US Dollars to purchase them.

This also explains the anomalous gain made by the US Dollar against the Canadian Dollar which was 0.09% higher this morning at the same time as the broader index has down, since most US steel imports come from Canada and the US market accounts for 80% of all Canadian steel exports.

"US import duties principally strengthen the Dollar as the US, as the embodiment of a large economy, is able to affect world prices through changes in its demand structure," says Commerzbank analyst Esther Reichelt.

The Dollar's subsequent weakness is therefore not necessarily linked directly to the decision by the US administration, rather to the fear of tit-for-tat reprisals and the imposition of tariffs by the rest of the world on US exports, says the analyst.

"Only the EU’s announcement to implement countermeasures brought some movement for the FX markets and caused the Dollar to depreciate," says Reichelt. Of course, things could get worse and a full-blown trade war could erupt, with more aggressive measures taken by both sides and the number of products included widening.

"This escalation can continue forever more and in the end, we can have a recession on both sides of the Atlantic," warns Reichelt's colleague at Commerzbank, Ulrich Leuchtmann, although he notes that his bank's research department does not, in fact, expect such an outcome as their base case scenario as yet.

Viraj Patel, an analyst with ING Bank N.V. in London believes a trade war is likely to be negative for the Dollar saying any shift towards a global trade war would see their central assumption over the state of the global economy moving away from a positive reflationary story to a negative stagflationary. 

In such a scenario rising cost-push inflation and lower global growth would emerge as the global economic backdrop.

"For currency markets, ‘America First’ policies in our view equates to ‘Dollar Last’ – with the USD pricing in a greater US trade policy and political uncertainty premium in the run-up to the Nov midterms. Risks are that we see another 5-10% decline in the trade-weighted USD in 2018," says Patel.

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