How Would A U.S.-China Trade War Impact The USD?

The first half of 2018 was an eventful one on the geopolitical front. International issues such as the Brexit transition process, denuclearisation of the Korean Peninsula and an escalating U.S.-China trade war made headlines on a near-daily basis.

Each event brought uncertainty to markets around the world, including the forex. Perhaps none has a potentially greater global impact than the economic standoff between the U.S. and China.

How Does A Trade War Impact Currency?

A trade war is an ongoing dialogue between two nations in which each tries to undermine the economic prowess of the other. Viewed as a product of protectionism, trade wars are conducted by implementing tariffs and duties on specific imports.

The international trade war that ensued during the Great Depression era is a prime example of this event in action. In the wake of new and aggressive tariffs, world trade plummeted by 25% for the period.^[1] As a result, economies around the globe crumbled under rising debt and collapsing domestic currencies.

One phenomena associated with trade wars is currency devaluation. In order to mitigate the pressure felt on the export sector, it's common for trade war participants to devalue their domestic currencies. This helps offset the negative effects of increased tariffs on goods and services, preserving marketshare of exports abroad.

A modern example of this activity can be found in Japan. Named after Prime Minister Shinzo Abe, the fiscal policy known as "Abenomics" promotes a program of aggressive quantitative easing and negative interbank lending rates.^[2] The results have been positive for Japan's equities markets, but critics cite this practice as being rampant currency manipulation.^[3]

In the case of the U.S.-China trade war, devaluation came front-and-centre in late July 2018. In the midst of tariff announcements from both sides, the People's Bank of China set the reference rate for the yuan renminbi (CNY, RNB) to 6.7671 CNY to the United States dollar (USD). The action represented an instantaneous 0.9% drop from previous levels.^[4] Shortly after the move, U.S. President Donald Trump expressed his concerns in a 20 July 2018 Tweet:

"China, the E.U. and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates and the USD gets stronger — taking away our big competitive edge. As usual, not a level playing field..."^[5]

Shortly after the tweet was sent, the USD Index fell more than 1%.^[4] The tit-for-tat trade war posturing impacted both the CNY and USD negatively, as investors anticipated forthcoming devaluations of both currencies.

The Breakdown Of U.S.-China Relations: Opening Shots Of A Trade War

On the Presidential campaign trail of 2016, then-Republican candidate Donald Trump used strong rhetoric to define his position on U.S.-China trade. Citing a 2016 deficit for the U.S. of more than US$300 billion,^[6] Trump pledged to decrease the liability through mass renegotiations with China if elected. This campaign promise was put on the front burner in 2018 with an initial volley of tariffs against Chinese imports.

The following is a timeline of key events for 2018 that contributed to U.S.-China trade hostilities:

The budding U.S.-China trade war has a great potential to upset the relative calm of global markets. Their two-way trade is estimated to be worth more than US$640 billion annually,^[6] a titanic figure.

In the event that new tariffs involving hundreds of billions of dollars go into effect, this relationship will evolve dramatically. From agriculture to technology, industries are likely to be negatively affected as producers and corporate interests on both sides jockey for survival.

In short, a disruption of the existing U.S.-China trade relationship has the potential to redefine international economics. Consequences will be exchange rate volatilities in addition to an intensive revaluation of global currencies.

United States Dollar: Pre-Trade War Performance For 2018

In spite of constant economic sabre rattling, the first and second quarters of 2018 featured a strengthening USD. For this period, the world's reserve currency performed well against the majors:

Past Performance is not an indicator of future results.

For the first half of 2018, the USD posted gains against all major currencies except the Japanese yen (JPY).

Amid two first-half rate hikes from the United States Federal Reserve (Fed) and two more proposed by the end of the calendar year,^[8] the USD exhibited a monthly uptrend. In addition, the U.S. economy showed robust growth for the period with 4.1% GDP^[9] and 3.9% Unemployment.^[10]

The reasons behind the USD's strength for Q1 and Q2 2018 are debatable. However, a tightening of monetary policy from the Fed and robust economic performance are two undeniable drivers of value.

Trade War Fallout: Impacts On The USD

The fallout from a prolonged U.S.-China trade war on the USD will be substantial. While the risk of devaluation is very real, it is difficult to fully account for the peripheral factors involved in the global currency trade.

No matter which side of the fence one is on—bullish or bearish—the USD is certain to be impacted in the following ways:

• Periodic Volatility: As announcements for new tariffs or the enactment of existing ones becomes public, short-term volatilities will plague the USD.
• Fed Policy: The largest drivers of the USD's value are actions taken by the U.S. Fed. Increases to the federal funds rate limits inflationary pressures created by robust economic performance, promoting monetary strength. Future plans include raising the federal funds rate four times in 2018, to 2.5% by year's end.^[11]
• Possible Devaluation: While unlikely, it is possible that the USD could be devalued in the spirit of promoting economic growth. This scenario becoming a reality depends on the U.S.-China trade war producing an extended and devastating global economic impact. In the event the U.S. enters a recessionary cycle, weakening the USD is one course of action that can jumpstart a stagnant economy.

When it comes to the U.S.-China trade war, the USD is all but assured to experience spikes in periodic short-term volatilities as key events unfold. In the long-term, performance of the USD will depend on U.S.-global economic performance, actions of the U.S. Fed and the adopted monetary policies of central banks around the globe.

Summary

Projecting the impact of a trade war on the domestic currency of a participant is always tricky. Negotiations are ongoing and new strategic alliances are formed on a regular basis.

It is important to remember that although a U.S.-China trade war is daunting on many fronts, it is a fluid situation. As conversations continue, it's clear that both sides are interested in preserving their economic prowess. In the event that these economies experience a significant downturn, a cease-fire may come in short order.