The Impact of Tariffs on Currencies: An Overview – Forex Education – Orbex

Following the tentative agreement – or “truce” as it’s being billed in the media – between Trump and Xi, tariffs are once again the conversational topic of the Street. And given that the truce is a 90-day stay on already agreed-upon tariffs, that situation is not about to change.

So, how do tariffs in general impact Forex, and why have they seemed to have the opposite effect than expected on currency markets?

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The Background

Back in June when tariffs were originally set in motion, and analysts were pondering how this would affect the markets, quite a few implied that a trade war would weaken the Dollar and that it would become weaker against most other currencies as soon as President Trump announced measures. But the opposite happened: the Dollar got stronger.

The logic behind this analysis was that a trade war was negative for the US and China, that it would impact trade, and the demand for currency between the respective countries.

That turned out to be true, with shipments of soybeans from the US to China turning around in the middle of the Pacific when the tariffs were implemented. If fewer products are moving across the ocean, less money is going in the opposite direction to pay for them.

Dutifully, the offshore Yuan dropped in value by almost 8% over the next couple of months (meaning the USDCNY rose from around 6.50 to nearly 7.00). The Dollar, on the other hand, did no such thing and actually strengthened.

It’s Simple

The explanation is quite straightforward: the USD is still the reserve currency and is considered a safe-haven. The trade war brought financial and economic uncertainty, along with talk of a potential recession, leading people to seek the safety of treasuries – US treasuries in particular.

The other factor is size: in 2017, the US exported $129.9B to China, or just under 16% of US total exports of $1.55B, and less than 0.7% of the US economy. A 25% tariff on those goods is just $32B, an amount the US economy produces in a matter of hours.

Comparatively, almost 25% of China’s total exports go to the US, but more importantly is the type of exports. The US generally exports base commodities to China, such as agricultural products (the famous soybeans), scrap and petroleum products. With the exception of aviation parts, usually, they are things that don’t have a broader impact on the economy.

The other way around, however, China exports manufactured goods and consumer products to the US which have a much larger supply chain behind them, reaching deeper into the economy.

Going Forward

Arguably, a drop in exports is not good for any economy; but when your economy is the largest in the world, you can still have more capital inflows from people worried about the broader world impact of a trade war than a loss of income from exports. This would lead to a strengthening currency and a weaker stock market.

This is why the detente between the first and second largest economies in the world leads to USD weakness and a jump in the stock market, reversing the effects seen above. In other words, we are seeing another one of those circumstances where the market performs counterintuitively.

The rule of thumb is that all things being equal, tariffs should lead to a weaker currency for the country imposing them (the US-EU steel disagreement in 2002 as an example). But the US-China relation is not equal; US imports are nearly four times higher than exports, and US per capita GDP is almost six times that of China. The US can absorb the cost of tariffs much easier than China can.