One way to understand the financial impact of policy uncertainty is to look at the implied volatility of important bilateral currency pairs in the price of options.
This dynamic is seen in a curve known as the dollar volatility smile, which shows how the American dollar can strengthen against another currency based on economic performance.
The curve captures both the status of the U.S. dollar as the primary international reserve currency as well as the relative strength of the U.S. economy compared with its major trading partners.
Under this framework, during times of global economic disruption, investors seek the safe haven of the greenback, and capital flows into dollar-denominated assets. A robust American economy attracts global capital, bolstering demand for the dollar and causing it to appreciate.
But during times of stagnant growth, the dollar depreciates, which causes an outflow of capital in search of greater returns around the globe.
Given the onset of 25% tariffs on Canadian and Mexican imports as well as 20% on Chinese-produced goods, expect an upward curve in the price of implied volatility in options.
In the month before the announcement of higher trade taxes, the implied volatility strongly suggested that the U.S. dollar/Canadian dollar currency pair showed robust demand for protection against a rising dollar.
Investors and corporations seeking to hedge against tariffs sought out such protection through global financial markets.
Read more of RSM’s insights into the global economy and the middle market.
Now, the gently upward-sloping curve over the next month, as seen in the right side of the curve, implies what will be dollar strength versus the loonie.
This strength will be attributed to interest rate differentials as well as to the hit that will be absorbed by Canada, where 25% of its gross domestic product is dependent on trade with the U.S.
