Bannockburn Global Forex –
President Trump has announced a 25% tariff on steel imports and a 10% tariff on aluminum imports. While these are not yet official, and a fuller announcement is expected soon, the markets are already reacting to the news. So far, the effect has been to weaken the USD and weaken the equity markets. This suggests the market expects retaliation to the tariffs from US trading partners. Otherwise, theory suggests that the unilateral imposition of tariffs would be USD positive, though previous experience doesn’t indicate this is a clear cut result.
The unilateral imposition of tariffs without retaliation should, in theory, typically lead to a USD appreciation. The rationale is that higher import prices as a result of the tariff will either lead to higher inflation, and consequently higher interest rates and a higher USD, or the USD will appreciate in response before this can happen, wiping out the effect of higher import prices before there can be an interest rate response. Theory suggests there should be some impact from both channels, and a higher USD will result either way.
The effect on the trade balance is unclear, as it will depend on how much consumption of imports is reduced due to the rise in import prices is. If the reduction in volumes is greater in percentage terms than the rise in price (the import elasticity is greater than one) then import values will decline as well as import volumes, and the trade balance will improve. If the elasticity is less than one, import values will increase and the trade balance will deteriorate. However, if the exchange rate rises in response to the tariff, completely offsetting the rise in import prices, then the trade balance will likely deteriorate because while imports should now be unaffected, exports will typically weaken (depending once again on elasticity conditions).
Things are very different if there is retaliation. If foreign producers react to US tariffs by tariffs of their own, matching the US, the net effect on the trade balance should be close to zero and there should be no direct effect on the exchange rate. But generally higher tariffs will mean lower global trade and lower global output. Trade is good for growth, almost by definition. If you are prevented from buying goods from the cheapest producer, output becomes more inefficient globally. The effect of the weakening of trade and growth can, in practice, have exchange rate effects.
So far, the market has reacted to Trump’s announcement by selling the equity market and weakening the USD. As argued above, this suggests the market expects retaliation, leading to lower global trade and lower global growth. The impact on the USD comes because the USD currently tends to benefit against most majors from a risk positive environment which encourages cross border capital flows to the US which offers relatively high yields. If these flows are reduced the US current account deficit becomes more of a drag on the USD. A more negative view of global growth and global equities therefore tends to favor the safer haven, low yielding currencies from current account surplus countries like the JPY, CHF and EUR.
It could be argued that this is all an overreaction. Steel and aluminum imports are a small part of US imports and an even smaller relative to US GDP. In total, they amount to around $45bn a year, or around 1.5% of total imports, and around 0.2% of total US GDP. The Trump tariffs will have some effect on import volumes, but if there is no retaliation the impact would be too small for there to be any noticeable effect. Even if retaliation is confined to steel and aluminum, the impact would be negligible. Only if the retaliation expands to other products and sparks an escalation of tit for tat tariffs and a global trade war does it really become significant. In this case, it becomes a serious problem for global trade and global growth, and would tend to undermine the countries which are most exposed to trade with the US in particular and global trade in general.
The details of any Trump plan remain unclear, but if it does result in the tariff increases he has indicated, the most directly vulnerable country by far is Canada, which is the largest exporter of both steel and aluminum to the US. Exports of these to the US make up almost 1% of Canadian GDP, and this could have a significant impact if the tariffs were implemented in full. This suggests that the CAD is by far the most vulnerable currency to the tariff. This is true whether there is or isn’t retaliation, since Canada would also suffer from any weakness in global growth and trade, as this would also tend to undermine commodity prices in general which are key to Canada’s terms of trade. However, with retaliation the CAD could be expected to weaken significantly against the safe haven currencies, and somewhat less against the USD.
Retaliation does seem likely. The EU and Canada, the two largest exporters of steel to the US (the EU is the largest when all the individual countries’ contributions are added up) have already pledged retaliation, with retaliation likely to be targeted at politically sensitive states. So bourbon – from Senate Majority leader Mitch McConnell’s home state of Kentucky -, Harley-Davidsons, from speaker Paul Ryan’s district, and orange juice, largely from the politically sensitive swing state of Florida are favorites to be attacked. So far, the European response is that their retaliation will be proportionate, so will only target the same value of goods that the US does. If this is the case, it will be something of a storm in a teacup, and the market impact is unlikely to be much greater than that already seen. The danger lies in further US response to any European response and so on.
Of course, none of this is new. Former president George W Bush tried to introduce heavy duties on steel imports back in 2002. In the end, he backed down after several countries brought action at the WTO. The WTO have said they are keeping a close eye on developments, arguing that a trade war is in no-one’s interests, which, despite Trump’s protestations, is broadly true if you exclude 80,000 US steel workers. There will always be gains for some narrow interests from protectionism, but the net effect is that everyone loses in aggregate. Back in 2002, the USD also fell, but it is always hard to disentangle the causes.
Trump’s proposal to introduce a 25% tariff on steel and a 10% tariff on aluminum imports has initially had a negative impact on equities and the USD. This reflects a market belief that such measures would meet with retaliation and consequently lead to weaker global trade and global growth. However, the scale of the problem is probably small. Steel and aluminum imports are a tiny proportion of US imports, and on its own and without retaliation would have a negligible impact on the USD and the macro economy. Proportionate retaliation would also not mean a great deal for the world economy. Only if there is a big escalation in trade wars with further response from Trump after any retaliation from others is there likely to be any significant lasting reaction in markets. The most vulnerable currency in all scenarios looks to be the CAD because Canada is the largest exporter of steel and aluminum to the US as well as the largest US trading partner in general, and is also vulnerable to any decline in global growth and confidence because of its dependence on commodity exports and consequently on commodity prices.
Compliments of Bannockburn Global Forex – a member of the EACC in New York