Over the course of U.S. President Donald Trump's first term, reducing the U.S. foreign trade deficit became a priority of the Office of the U.S. Trade Representative (USTR). Headed by Robert E. Lighthizer, the USTR spearheaded a campaign of commercial pressures upon numerous international trade partners during 2018 and 2019. China and the European Union (EU) were among the largest targets. Subsequently, the prolonged escalation of tariffs regularly brought the term "trade war" front-and-center to the global financial news cycle.
How Does A Trade War Impact Currency Values?
A trade war is the exchange of tariffs and regulations between two or more nations. The primary goals of such ventures is to reduce deficits or impose other commercial reforms. Traditional financial theory addresses a trade war as the product of economic protectionism.
The actual impact that a trade war may have on assorted currency values is complex. According to Lerner's Symmetry Theorem of 1936, import/export tariffs are equally protectionist but frequently result in a neutral aggregate effect. While the participants' actions may largely cancel out, there are several concerns capable of influencing monetary policy and spiking forex volatilities.
Slowed Economic Growth
One of the largest concerns surrounding a trade war is the creation of commercial impediments. Trade barriers have historically proven to slow global commerce and, in turn, economic growth. In fact, retaliatory tariffs and protectionist policies of the early-1930s are often credited for driving the Great Depression.
From a theoretical perspective, raising taxes on imports and exports is believed to stimulate inflation. According to this idea, increased duties on goods or services can trigger a "ripple effect" and boost the pricing of related goods. The higher costs of certain goods or services are then directly passed on to the consumer, businesses that require such inputs, and investment services. Subsequently, consumption may decrease and a competitive advantage may be realised by tariff-exempt goods or services.
While rising inflation is an ongoing concern of central banks and governments, its difficult to pinpoint the exact relationship to trade levies. For instance, in early-2019 the Federal Reserve Bank of San Francisco (FRBSF) estimated that a 25% U.S. tariff on Chinese imports would raise consumer prices by 0.3% and investment prices by 1.0%. Due to the fact that the FRBSF is viewed as being a financial authority, such estimates are typically respected by analysts and economists.
Central Banking Policy
In the event that a "hot" U.S./EU trade war develops, two factors would drive valuations of the United States dollar (USD), British pound sterling (GBP) and euro (EUR): economic growth and inflation. These two factors are capable of prompting policy actions from the European Central Bank (ECB), Bank of England (BoE) and U.S. Federal Reserve (FED).
Each of these central banks have the authority to enact policies designed to establish pricing stability and promote sustainable growth of the domestic economy. If needed, the ECB, BoE and FED could take a variety of measures to accomplish these goals, most of which are based upon programs of either quantitative easing or tightening. Under such policies, the value of each domestic currency may be greatly influenced in comparison to one another or safe-havens such as gold (XAU) or the Swiss franc (CHF).
A Two-Front U.S. Trade War?
Beginning in July 2018, the U.S. intensified trade reform efforts with China through imposing a sweeping collection of tariffs. Over the subsequent 18 months, the U.S. placed tariffs on US$550 billion worth of Chinese products. In retaliation, China placed new levies on US$185 billion in U.S. imports. Until the 15 January 2020 signing of the Phase One U.S./China trade deal, the situation remained tense.
Although rebalancing the US$320 billion annual trade deficit with China was a top priority of the Trump administration, it also put commerce with the EU under the microscope.
Another of America's leading economic partners, the EU benefited from a US$162.5 billion surplus in goods trade for 2019. In a 3 October 2019 statement, President Trump lauded a judgment from the World Trade Organisation (WTO) and addressed the "unfair" U.S./EU trade relationship via Twitter:
"The U.S. won a $7.5 Billion award from the World Trade Organization against the European Union, who has for many years treated the USA very badly on Trade due to Tariffs, Trade Barriers, and more. This case going on for years, nice victory!"
Trump's tweet marked the escalation in the economic tensions between the U.S. and EU. Later in October, the USTR slapped tariffs of 10% on large civilian aircraft and 25% on European agricultural goods. The new tariffs were largely a product of an ongoing conflict regarding EU subsidies to airplane manufacturer Airbus and the WTO's decision on the matter.
In addition to the 10% and 25% tariffs, the USTR outlined several other policies under consideration:
- 100% levies on Spanish olive oil, European whiskey and cognac, French cheese and Portuguese fish fillets.
- Tariffs of up to 100% on US$2.4 billion worth of French imports. The tariffs were to be put in place as a response to France's new digital services tax against U.S. online retailers such as Amazon and Google.
At the World Economic Forum in Davos, Switzerland, Trump declared the desire for a comprehensive trade deal with the EU. During a 21 January 2020 engagement, he stated that tariffs aimed at European automobiles were likely if a deal was not reached:
"They know that I'm going to put tariffs on them if they don't make a deal that's a fair deal."
The rhetoric at Davos came on the heels of threats to enact 25% tariffs on European automobiles if Germany, France and Britain failed to accuse Iran of breaking the terms of a 2015 nuclear deal. As of press time, these duties have not gone into effect. Further, each of the three nations has publicly condemned Iran's behaviour with respect to nuclearisation.
Impact On GBP And EUR
While the import excises and tough rhetoric of late 2019 suggested that an all-out U.S./EU trade war was possible, they were not the first exchange in the standoff.
A series of U.S. tariffs on steel and aluminum imports went into effect on 31 May 2018. The scheduled duties were defined as 25% on steel and 10% on aluminum imports from Canada, Mexico and the EU. Many economists viewed the action as motivation for targeted countries to ratify new trade deals such as the U.S.-Mexico-Canada Agreement (USMCA).
In response to the levies, EU Trade Commissioner Cecilia Malmström called it "a bad day for world trade." Additionally, European Commission President Jean-Claude Juncker called the action "totally unacceptable" and vowed to bring a case before the WTO before imposing retaliatory tariffs.
Several weeks later, on 22 June 2018, the EU introduced new taxes on €2.8 billion in U.S. exports. The goods targeted included bourbon whiskey, motorcycles and orange juice.
Uncertainty Dominates The Forex During June 2018
The fresh trade strife of June 2018 had little impact on the valuations of both the GBP and the EUR. Although only about one month in scope, the period following each round of tariffs heightened uncertainty in the forex markets. As a result, foreign exchange participants took a non-committal stance to the tariff exchange.
Concerns over forthcoming inflation, lagging economic performance and central bank activity flatlined the action for the USD, GBP and EUR throughout the levy enactments. Below is a look at a few key performance metrics for the month of June 2018:
- EUR/USD: The EUR/USD entered consolidation, losing only 9 pips (-0.07%) for the month.
- GBP/USD: Traders viewed the new tariffs on British steel as being a significant issue. As a result, the GBP/USD fell by 90 pips (-0.68%) for June.
- EUR/CHF: The EUR turned in a solid performance vs the safe-haven CHF, with the pair gaining 43 pips (+0.38%).
- GBP/CHF: Once again, traders priced in the U.K. economy being placed under additional pressure. For the tariff-laden month, the GBP/CHF lost 30 pips (-0.23%).
Past performance is not indicative of future results.
The period between 31 May 2018 and 22 June 2018 brought considerable uncertainty to the GBP and EUR. However, instead of moving directionally against the USD or CHF, values held firm. The tit-for-tat tariff exchange brought little in the way of currency revaluation.
As of this writing (22 January 2020), the trade relationship between the U.S. and EU remains in flux. Both sides have threatened increased tariffs, but the current levies actually stem from 2018's exchange and the WTO decision regarding Airbus.
In the event that a full-scale U.S./EU trade war develops, the GBP, EUR and USD exchange rates will very likely feel the strain. Given the unpredictability surrounding the Brexit transition and future of global economic growth, extreme volatility would be likely across the majors. Factor in potential BoE, ECB, or FED monetary policy actions, and currencies around the globe may enter an extended period of revaluation.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…