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FX outlook: Tariffs drive USD strength, until...?
John J. Hardy
Chief Macro Strategist
Key points
- US Dollar's Dominant Role and Tariff Strategy: The Trump administration aims to maintain the US dollar's status as the world's preferred currency and plans to use tariffs and other measures as a tool to address perceived trade imbalances. The strategy involves leveraging the dollar's dominance to impose economic measures on global trading partners.
- Risks to the US dollar in weaponizing it: Some proposed measures, such as imposing fees on foreign official holdings of US treasuries, carry risks of global backlash and could lead to a search for alternatives to the US dollar. The US treasury market faces liquidity challenges due to high issuance needs, and any instability could prompt intervention from the Fed and Treasury to maintain market order.
- Market Volatility and Currency Impacts: The first quarter of the year is expected to be volatile as the Trump administration implements new measures, with tariffs a key focus. The strength of the US dollar, driven by tariffs, could exacerbate financial conditions globally, particularly affecting emerging markets.
Ahead of his second term, Trump and his team have made it clear that the status of the US dollar as the world’s preferred currency for trade- and global reserves must stand. At one point in December after the election and before assuming office, Trump threatened 100% tariffs and removal of access to US markets for any country seeking to create a new currency or support an alternative to the US dollar.
Trump wants to both weaponize the US dollar’s critical status and to slap tariffs and possibly other limitations on global trading partners to reduce the advantages they have reaped over the decades from using undervalued domestic currencies and the overvalued US dollar to build their economies. China is the chief target, but not the only one. Stephen Miran, the hedge fund manager nominated by Trump as the next Chairman of the Council of Economic Advisers, is one leading voice for how the US can structure a “fairer” playing field in which the US is compensated for the service it offers in providing the world’s reserve currency.
Miran suggests that the US could impose a fee on foreign official holdings of US treasuries to compensate the US for the use of US assets as reserves and force these same foreign official entities to hold 100-year “century” bonds and perhaps even perpetual bonds to ease US treasury issuance needs. Sure, if any country can get away with such weaponized use of its currency and assets it is only the US, given the dollar’s status as the dominant reserve and transaction currency. But these kinds of impositions on global trading partners are a risky gambit that could eventually spark an accelerated rejection of US treasuries and search for alternatives if they don’t want to play ball. And even without this risk to the stability of the US treasury market, the US Treasury itself already faces liquidity challenges as issuance needs due to ballooning deficits have grown to such an extreme size relative to the primary dealer network that is charged with keeping things orderly. If the treasury market faces any instability, we can be sure that the Fed and Treasury will collude with new facilities to smooth things over, whether capital controls, QE, yield caps, inappropriately low Fed Funds or all the above.
Chart: The US Fed’s Broad Trade-weighted US dollar measure has reached its highest level ever and has been on a nearly vertical ascent since before the US election. As the world’s global reserve currency, a strong US dollar represents a tightening of financial conditions, making life difficult for much of the world, especially emerging markets, where considerable portions of debt are denominated in US dollars. Trump’s tariffs can make the strong USD problem worse, but the challenges of keeping the US treasury funded, among other possible challenges, could help the mighty greenback find a peak in 2025. (Note that the US dollar has risen as US debt-to-GDP has soared ever higher, which ironically erodes the creditworthiness of the US government that backs the US dollar – this is the Triffin dilemma in action).
Shortly put, instability in the treasury market is unacceptable and won’t be tolerated. And there is likely a rather low ceiling on US treasury yields unless inflation is allowed to run rampant. But the latter is politically toxic, so the Trump administration, with the Fed willingly or unwillingly acting as an accessory (watch out for Trump-Powell fireworks as an inevitability of the coming year) will keep the US treasury market from dysfunction and when and if they do, the shock absorber in such a policy mix is the US dollar. How quickly we reach official intervention is possibly the key determinant for how quickly the USD finds its ultimate peak in this cycle.
Q1 outlook likely volatile as tariffs, US exceptionalism the focus.
The first quarter of the New Year will see the market trying to find its sea legs as a new Trump administration seeks to make maximum impact from day one with a raft of new measures. Tariffs are one of the easiest and most impactful policies Trump can move quickly on because they can be imposed via executive action. The heavier the tariff programme is relative to the baseline of expectations, (This is tough to quantify, but is assumed to be quite considerable.) the more USD strength risks extending. One critical USD pair to focus on will be USDCNH, where the 7.375 level held back further CNH depreciation in 2022 and 2023. The usual EURUSD focus will be on parity if the US moves heavily on tariffs against Europe. And for Japan, USDJPY would likely face a test of the cycle highs above 160.00 unless the BoJ is ready to viciously accelerate its tightening regime or throws heroic quantities of currency intervention into the mix.
Some argue that excessively broad-based tariffs like the ones Trump has often promised are a bad idea because they may only result in a currency devaluation from the nation upon which the tariff is imposed and not result in any change in the desired reshoring of productive capacity to the US. Rather, highly targeted tariffs that are more surgical, but far larger in percentage terms than any broad-based tariffs, could prevent the broader FX offset and encourage the desired restructuring of key supply chains.
Still, the risk is that nations upon which tariffs have been imposed come with their own countermeasures: for example, China has already imposed embargo-like controls on rare-earth metals exports that are key for semi-conductor production in response to Biden tariffs and imposed other export controls. China has considerable leverage in many critical US supply chains: It makes an array of components important for US defense applications and even pharmaceutical industries and has the largest EV battery production capacity in the world. Tariffs are not as easy as Trump makes them out to be. The other route to a weaker US dollar is via coordinated grand bargaining with China, Europe and Japan. In the increasingly fractious, multi-polar world, this looks unlikely.
The rest of the G-10, CNH and EM
CNH – USDCNH is the most critical exchange rate for whether FX market volatility is fully unleashed as we await the shape of the US-China relationship under Trump 2.0. A “deal-making” approach could be USD bearish and CNH positive, while an escalating trade war would be the opposite, initially at least.
EUR - the euro may test parity versus the US dollar, but there are many ways Trump’s agenda can founder, so “looking for the potential for a bottom” is the operative stance in the first half of 2025. Potential upside surprises could come on more forceful fiscal stimulus from Germany and even Eurozone-wide if euro bond issuance for strategic defence materialises.
JPY – the JPY will likely continue to serve as a mirror-image of the trajectory of long bond yields globally, particularly US treasuries, as the BoJ tightening cycle continues to drastically lag inflation. The JPY’s moment perhaps only arrives if we see a surprising negative US- and global growth dip and fiscal drag in the US that pummels US treasury yields. Either that or in the event of Fed intervention due to rising US treasury market instability as noted above.
CHF – SNB policy likely headed to zero as Switzerland tries to avoid an excessively strong franc versus the euro.
GBP – the general fear is of a stagflationary outcome as inflation looks set to remain high on the added spending, while the Labor programme may fall short on its hopes of encouraging investment and productivity growth. The carry from still high BoE rates helps to offset somewhat.
AUD, CAD and NZD. AUD potential heavily linked to whether China chooses more aggressive stimulus as well as the likely related trajectory of commodity prices. CAD could begin looking forward to the post-Trudeau future as self-harm risks from climate policy will fade under the new Conservative government that awaits just over the horizon after snap elections in March or April.
EM currencies – in general, will likely trade as the flipside of the US dollar’s strength or weakness, probably correlated closely with the Chinese renminbi (CNH). But EM is diverse – with MXN a very specific story, for example, that is linked to how Trump 2.0 gets along with Mexico’s Sheinbaum not only on tariffs, but how these are linked to other issues like the border and drug trafficking.