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)Retrieved 6 August 2018 https://www.washingtonpost.com/news/wonk/wp/2018/07/09/sorry-china-this-isnt-the-largest-trade-war-in-economic-history/ 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)Retrieved 8 August 2018 https://www.cfr.org/backgrounder/abenomics-and-japanese-economy The results have been positive for Japan’s equities markets, but critics cite this practice as being rampant currency manipulation.3)Retrieved 8 August 2018 https://www.japantimes.co.jp/news/2017/02/01/business/trump-lambastes-japan-china-currency-devaluation/#.W21zMs5KhhE

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)Retrieved 8 August 2018 https://www.cnbc.com/2018/07/20/trade-war-could-be-morphing-into-currency-war-if-china-is-plays-hardba.html 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)Retrieved 8 August 2018 https://twitter.com/realDonaldTrump/status/1020287981020729344?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1020287981020729344%7Ctwgr%5E373939313b636f6e74726f6c&ref_url=https%3A%2F%2Fwww.cnbc.com%2F2018%2F07%2F20%2Ftrade-war-could-be-morphing-into-currency-war-if-china-is-plays-hardba.html

Shortly after the tweet was sent, the USD Index fell more than 1%.6)Retrieved 8 August 2018 https://www.cnbc.com/2018/07/20/trade-war-could-be-morphing-into-currency-war-if-china-is-plays-hardba.html The tit-for-tat trade war posturing impacted both the CNY and USD negatively, as investors anticipated forthcoming devaluations of both currencies.

Open Forex Practice Account With FXCM

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,7)Retrieved 7 August 2018 https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china 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:

Date Event
3 March U.S. tariffs are enacted against all steel and aluminum imports.
22 March U.S. proposes extensive tariffs in response to China’s “unfair trade practices.”
23 March China reveals plans for tariffs on US$3 billion of U.S. imports.
2 April China threatens to levy duties on fresh fruits, nuts, wine and pork.
3 April U.S. announces tariffs on US$50 billion worth of technology imports.
4 April China announces plans for 25% duties on 106 U.S. imports, including soybeans, chemicals and aircraft. China also files a complaint against the U.S. at the World Trade Organisation (WTO).
5 April U.S. President Trump issues statement calling China’s tariffs “unfair retaliation.” An additional US$100 billion in tariffs are proposed.
17 April China enacts tariffs on sorghum imports worth US$1 billion.
3 May Trade talks in Beijing break down.
20 May An agreement is reached; the U.S. pledges to postpone tariffs and China offers to significantly increase the purchase of U.S. goods.
29 May U.S. announces plans to enact tariffs on US$50 billion of Chinese imports.
19 June U.S. President Trump suggests tariffs on US$200 billion in Chinese exports, with another US$200 billion possibly to follow.
6 July U.S. Tariffs on US$34 billion of Chinese imports go into effect.8)Retrieved 8 August 2018 https://www.bloomberg.com/news/articles/2018-07-06/the-trade-war-is-on-timeline-of-how-we-got-here-and-what-s-next

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,9)Retrieved 7 August 2018 https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china 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:

Pair Open (1/1/18) Close (31/7/18) Change (Pips)
EUR/USD 1.2004 1.1690 -314
GBP/USD 1.3503 1.3120 383
USD/JPY 112.65 111.86 -79
AUD/USD .7801 .7425 -376
USD/CAD 1.2579 1.3005 +426
USD/CHF .9743 .9902 +159
NZD/USD .7089 .6319 -770

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,10)Retrieved 7 August 2018 https://www.cnbc.com/2018/06/16/the-fed-said-its-hiking-rates-four-times-in-2018-market-not-convinced.html the USD exhibited a monthly uptrend. In addition, the U.S. economy showed robust growth for the period with 4.1% GDP11)Retrieved 9 August 2018 https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm and 3.9% Unemployment.12)Retrieved 9 August 2018 https://www.bls.gov/news.release/pdf/empsit.pdf

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.13)Retrieved 9 August 2018 https://www.kiplinger.com/article/business/T019-C000-S010-interest-rate-forecast.html
  • 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.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites contained on this website are provided as general market commentary and do not constitute investment advice. The market commentary has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and it is therefore not subject to any prohibition on dealing ahead of dissemination. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

References   [ + ]

1. Retrieved 6 August 2018 https://www.washingtonpost.com/news/wonk/wp/2018/07/09/sorry-china-this-isnt-the-largest-trade-war-in-economic-history/
2. Retrieved 8 August 2018 https://www.cfr.org/backgrounder/abenomics-and-japanese-economy
3. Retrieved 8 August 2018 https://www.japantimes.co.jp/news/2017/02/01/business/trump-lambastes-japan-china-currency-devaluation/#.W21zMs5KhhE
4, 6. Retrieved 8 August 2018 https://www.cnbc.com/2018/07/20/trade-war-could-be-morphing-into-currency-war-if-china-is-plays-hardba.html
5. Retrieved 8 August 2018 https://twitter.com/realDonaldTrump/status/1020287981020729344?ref_src=twsrc%5Etfw%7Ctwcamp%5Etweetembed%7Ctwterm%5E1020287981020729344%7Ctwgr%5E373939313b636f6e74726f6c&ref_url=https%3A%2F%2Fwww.cnbc.com%2F2018%2F07%2F20%2Ftrade-war-could-be-morphing-into-currency-war-if-china-is-plays-hardba.html
7, 9. Retrieved 7 August 2018 https://ustr.gov/countries-regions/china-mongolia-taiwan/peoples-republic-china
8. Retrieved 8 August 2018 https://www.bloomberg.com/news/articles/2018-07-06/the-trade-war-is-on-timeline-of-how-we-got-here-and-what-s-next
10. Retrieved 7 August 2018 https://www.cnbc.com/2018/06/16/the-fed-said-its-hiking-rates-four-times-in-2018-market-not-convinced.html
11. Retrieved 9 August 2018 https://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm
12. Retrieved 9 August 2018 https://www.bls.gov/news.release/pdf/empsit.pdf
13. Retrieved 9 August 2018 https://www.kiplinger.com/article/business/T019-C000-S010-interest-rate-forecast.html