Why has the threat of a global trade war strengthened the US Dollar?

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10 August 2018

thomasdodds

The US Dollar extended its rally to over six-and-half percent against its major peers in just under four months on Friday morning, rallying sharply against pretty much every other currency in the world.

B
ut why has the threat of a US-China trade war caused investors to buy the greenback and drive the currency to around its highest level in over a year?

A stronger Dollar off the back of Trump’s protectionist policies, and threat of retaliation from China, may be seen as somewhat of a contradiction, particularly given China accounts for around 10% of the US’s overall export revenue. Investors did, however, take on the general view that Trump’s trade policies, including the threat of a blanket tariff on all Chinese imports, would likely have less of an impact on the US economy than those of its major trading partners. The US economy is largely domestically driven, while many of its trading partners are far more heavily reliant on external demand. These countries, particularly those of emerging markets, would therefore take a greater economic hit from lower demand from the US than vice versa.

Financial markets also took on the view that the imposition of Trump’s tariffs should, in theory, narrow the US’s sizable trade deficit, ceteris paribus. The added tax on imports from abroad would theoretically lower demand among Americans for the subsequently more expensive overseas goods and, in turn, lower the country’s currently hefty trade deficit. With announcements fairly light on the ground during the typically quiet August trading month, we expect developments on this front to continue to dominate currency trading in the next few weeks.

Geopolitical tensions sap risk appetite, UK GDP data out today

During currency trading this morning, the Dollar rose against both the Euro and the Pound following a drop in risk appetite. Investors fled to the greenback and Yen amid growing trade concerns and increasing tensions between the US and Russia, the former of which threatened fresh sanctions earlier in the week. We also saw a violent sell-off in the Turkish Lira, which sank by around 10% at one stage to a fresh record low amid a escalating diplomatic rift between Turkey and the US.

Attention will now turn to this afternoon’s US inflation data. Economists are eyeing a modest increase in the monthly figure to 0.2% from 0.1% and to 3% year-on-year from June 2.9%. A confirmation of this would cause investors to ramp up their expectations for another Federal Reserve interest rate hike in September.

Sterling should also be in focus today with the release of preliminary second quarter GDP data. UK GDP numbers don’t tend to have too much of an impact on the Pound unless there is a big surprise, given that it is a lagged indicator. Having said that, with GBP under a great deal of Brexit induced selling pressure at the moment, even a modest downward surprise (0.3% vs the 0.4% expected), would probably lead to another sell-off in the UK currency.