Tariffs and Forex: Are they connected? Yes! Tariffs are intimately connected with forex, because the original purpose of foreign exchange is to pay and get paid for products in a different currency. Tariffs directly affect the price that is paid for imported products, which directly affects the demand (and supply) of currencies. That’s besides the effect that tariffs have on interest rates, which also drives currency moves. So, forex traders need to keep a close eye on what’s going on with tariffs, and their impact on currencies the impact of tariffs on currencies.
Typically, when a country applies tariffs, its currency gets stronger. This is, actually, one of the reasons historically for why governments have been eager to apply tariffs. The normal state of trade up until quite recently, and still in most of the world, is for tariffs to be applied on cross-border trades. This is why:
Forex and Trade Wars: A Tariff War is Likely
Countries have a strong incentive to put tariffs on foreign goods. It increases revenue for the government, it makes their own products more competitive, and strengthens their currency. The downside is if other countries apply tariffs. It’s generally accepted among economists and the “developed world” or “global North” (pick your euphemism) that free trade among countries is better, because everyone benefits. But if one country can get away with tariffs without having its own products being tariffed, then it will be eager to find an excuse to apply the tariffs.
This is why when Trump has threatened tariffs, the targets have immediately suggested slapping tariffs of their own, and even more onerous ones. With politicians eager for any excuse to apply tariffs, there is a very clear risk of “escalation”. A 10% tariff by America, for example, can provoke a 20-30% “punitive” tariff in response. Followed by a further escalation by the US in response since the “winner” is whoever has higher tariffs. This has happened in the past, and the inevitable slowdown in global trade has generated worldwide recessions.
How Bad is It?
The limiting factor for applying tariffs is economic growth. As tariffs increase, the economy experiences a slowdown. So, if a country has a fast growing economy, it can ‘afford’ to have some degree of a tariff war. This is why, for example, China with its 5.0% annual growth rate has tariffs of its own already applied and isn’t so worried about the latest round by Trump, even if it’s an export-oriented economy.
For example, the US has a growth rate of 2.5%, while Canada has a growth rate of 1.1%. Setting aside the size difference, if a trade war slows economic growth by 1.5%, then the US will grow at a 1.0% while Canada falls into recession at -0.4%. That difference will be magnified depending on the rate of trade dependence and size between the countries. Therefore, countries with high trade deficits against the US, and with slow growing economies, are particularly vulnerable to tariffs.
Currency Strength and Tariffs: How It Affects Currencies
Since the announcement of the tariffs over the weekend, stock markets have tanked, and the dollar shot higher. However, the response was relatively muted – the CAD lost “just” 2.0% against its southern counterpart. The Mexican peso had a similar move.
And that’s potentially because traders are acting in the way that got the tariffs applied in the first place: They don’t believe that situation will last long. It seems that Ottawa was confident that Trump wouldn’t go through with his threat. But as discussed previously, in order for a threat to have meaning, it can’t be just a bluff. It seems some traders are thinking that now that Trump is shown to be serious, then a negotiated settlement can be reached quickly.
Historically, Trump did apply and then withdrew tariffs on Canada after getting concessions. The issue is that it’s not exactly clear what Trump is demanding, and why Canada in particular is unwilling to comply. That could be the difference for how long the current tariff