Investor expectations of a new round of tariffs have caused the U.S. dollar to mildly appreciate in recent months.
Now, with steep tariffs on goods from Canada, Mexico and China set to begin Tuesday, one should expect the greenback to go even higher against major trading currencies.
Such a move will make American-made products more expensive overseas, hurting exporters, and will ignite calls for protectionist measures.
Then, if the trade spat is sustained, this will not only create issues for the Trump economic policy framework—tariffs make the dollar stronger, which widens the current account deficit—but also lead to a full-blown trade war.
Such a trade war would lead to beggar-thy-neighbor currency depreciations, retaliatory tariffs and the construction of non-trade barriers that inhibit trade, trade financing and trade insurance.
The primary cause of the American dollar’s appreciation over the past year has been growth and interest rate differentials.
The Mexican peso has taken the biggest beating over that time, with the euro and the Canadian dollar holding close to the value of a trade-weighted basket of currencies against the greenback.
The yuan, which the Chinese government manages closely, has depreciated against the greenback.
Read more of RSM’s insights on the economy and the middle market.
Following a 10% tax increase on Chinese imports, set to begin Tuesday, we expect close to a one-to-one pace of yuan depreciation linked to an increase in trade taxes. Put another way, a 10% increase in tariffs will most likely result in close to a 10% depreciation of the yuan.
The euro, which has yet to be formally targeted with an import tax on its goods, has been depreciating against the dollar primarily because of growth and interest rate differentials.
Should trade taxes be implemented on the European Union, one should expect a move below parity against the dollar in the near term.
On Sunday, the euro was trading at 1.023 against the greenback. If it is targeted with sustained trade taxes, it will most likely overshoot parity as investors price in retaliation by Brussels.
