How would the U.S. dollar respond to a Trade War 2.0?

Hello, my name is Marina Valentini and I am a Global Market Strategist at J.P. Morgan Asset Management. Today's question asks "How would the US dollar respond to a trade war 2.0?" With the U.S. elections just a week away and polls indicating a tight race, investors are closely assessing potential impacts for currency markets. Trade policies remain in sharp focus, as the prospect for higher tariffs could strengthen the dollar. While both candidates have signaled a tough stance on China, Trump has proposed a potential universal 10% tariff and up to 60% tariffs on Chinese imports, pointing to a stricter approach[1].

The 2018-19 trade war offers key insights into how tariffs impact FX markets. During this period, the Trump administration raised tariffs on approximately $370 billion of Chinese goods from an average of 3% to 19%, prompting Chinese retaliation that raised tariffs on US exports from 7% to 21%. While other factors influenced currency movements, trade policy uncertainty tended to bolster the dollar, with the DXY index rising up to 10% during tariff announcement windows in 2018 and 4% in 2019. Additional forces impacting currencies included the Fed's rate hikes in 2018 and subsequent cuts in 2019, weaker growth outlooks in China and Europe and Brexit negotiations.

Meanwhile, the Chinese renminbi depreciated by up to 10% in 2018 and 5% in 2019 as trade talks ebbed and flowed. The PBOC allowed the CNY, which operates within a semi-fixed exchange rate regime, to devalue through controlled FX mechanisms. A weaker CNY partially cushioned the impact of tariffs by making Chinese exports relatively cheaper and preserving their competitiveness in the global market. However, it led the US to label China as a “currency manipulator” in 2019, generating additional FX volatility.

Global trade uncertainty also impacted other G10 and EM currencies. The EUR depreciated by up to 10% in 2018 and 4% in 2019, while other major trading partners like the MXN dropped by as much as 14% and 6%. Currencies linked to commodities and China, such as the CLP, COP, ZAR and BRL were particularly affected. 

Ultimately, the potential impact of a Trade War 2.0 on currencies depends on the scope and execution of any new tariffs. There remains significant uncertainty surrounding the approach a Trump administration would take, including whether a tariff strategy would be targeted in nature to negotiate trade terms and protect intellectual property, or used as a broad-based revenue offset for other policy items. Regardless, trade tensions will only be one piece of the puzzle driving currency markets. Other factors, particularly interest rate differentials[2], remain crucial to the USD's trajectory against major currencies like the EUR and GBP, which recovered to below their peak 2019 levels within seven months. Investors should remain mindful of risks for more impacted EM currencies, with most taking over three years to return to peak levels, and some, like the CNY, never fully recovering.