Markets have been reacting to the return of Donald Trump to the White House by pushing up the dollar. One of the main reasons for that is an expectation of increasing the intensity of trade wars. While that might fuel the greenback in the short term, there are some reasons to suspect traders have been a little too hasty in their assumption.
Conventional thinking is that applying tariffs increases the value of a currency. There are two mechanisms for that to happen. The first is that by raising the cost of entry for goods into the country, its relative purchasing power increases. In other words, you can buy more with dollars overseas if fewer dollars are flowing overseas to pay for goods. The second is that the increased cost of imported goods would likely translate into higher inflation. That, in turn, means the Fed will have to keep rates higher, supporting bond yields. Higher bond yields make the dollar a more attractive investment, keeping it stronger.
So, What Are We Missing?
First, a quick aside. Even though markets have jumped higher following Trump’s election, all the indicators that there could be a recession haven’t gone away. Jobs numbers are under performing, the yield curve recently de-inverted, the Fed started its rate cut cycle – all things that happen right before a recession. The mere fact that Trump has been elected isn’t enough to undo fundamentals, and might actually marginally increase risk of a downturn.
The rise higher in stock prices meant that valuations also increased, in some cases doubling the mean. In other words, stocks were overvalued before the election, and with the market rising, they are even more overvalued now. Over the medium to long term, those valuations can come into line if the companies see growth (say, from a growing economy) so that their earnings increase to match the stock price. But, that takes time, leaving stocks vulnerable to a correction, that could tip further into a liquidity crisis. If that were to happen, the Fed would have to crash cut rates, undoing what is supporting the dollar at the moment. However, a recession would likely affect the whole world, so the dollar might not be relatively as hurt, given its safe haven status.
Do Tariffs Raise Prices?
The last time Trump was in office, he imposed a series of Trump Tariffs, particularly affecting China. And there wasn’t a major inflation problem under his administration. While tariffs can increase inflationary pressure, many economic models suggest that consumer behavior could offset the increase in prices. In other words, there is no reason to assume that Trump Tariffs will necessarily lead to higher inflation, given current economic theory and recent history.
On the other hand, smaller disruptions are easier for the economy to absorb, and Trump has promised sweeping tariffs that are much bigger in scope than in 2017. But also, Trump has used tariffs more as a cudgel to get concessions, instead of implementing them outright. He’s also been eager to dial back the tariffs as soon as he gets concessions in other areas. Which might mean his bluster about tariffs is just that: Bluster. Once he secures other concessions from countries who he has threatened with tariffs, then the levies won’t go into place. That would avoid inflationary pressure, but also mean the dollar wouldn’t get the same boost.
For the short term, it doesn’t matter what will happen, as much as what the market expects will drive prices. But, it’s good to consider what will happen in the medium term once the market catches up with reality – assuming that the market is being overenthusiastic about dollar gains for the moment.
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