On February 12, Bank of America noted in its latest report that the first round of U.S. tariffs supported the dollar, but the second round of retaliatory effects could weaken the dollar. BofA believes that while the U.S. is less dependent on trade, it is more vulnerable to confrontation with the rest of the world, and the dollar's strong position could be reversed.
In addition, risk sentiment, monetary policy and long-term growth will also have an impact on the direction of the US dollar. For example, a sell-off in US equities could weaken the dollar, a relatively dovish Fed could weaken the dollar, and weaker long-term US economic growth could weaken the dollar.
Tariffs have helped the dollar strengthen
In the early days of Trump's administration, the dollar weakened as tariffs were not immediately imposed. However, the dollar experienced wild volatility as the U.S. began threatening 25% import tariffs on Canada and Mexico and delaying implementation by a month. Subsequently, the dollar strengthened again when the US announced a 25% tariff on steel and aluminum imports and further threatened retaliatory tariffs on all imports.
On February 1, local time, the U.S. government announced an additional 25% tariff on imports from Canada and Mexico, while imposing a 10% tariff on Canada's energy resources. The tariffs are tentatively scheduled to take effect on February 4.
Bank of America analysis pointed out that this phenomenon is basically consistent with the prediction of economic theory. U.S. exports as a percentage of its GDP are relatively low, which means that the U.S. will be relatively less directly hit in a trade conflict. Therefore, the initial reaction of the market to the news of tariffs was to push the dollar exchange rate higher.
Retaliatory tariffs could reverse the dollar's trend
While the above analysis shows the short-term strength of the US dollar in the face of tariff news, it does not fully account for possible retaliatory measures by other countries. BofA noted that the dollar's strong position could be reversed once the global trade conflict breaks out in full swing.
The impact of a full-blown escalation of trade conflicts
BofA believes that while the U.S. is a large economy, the rest of the world as a whole is of greater magnitude in the global trading system. If the U.S. imposes high tariffs on all imports, and other countries retaliate across the board, U.S. exports will face a greater share of tariff shocks.
This means that, with the exception of countries that are highly dependent on U.S. exports, such as Mexico and Canada, a greater proportion of U.S. GDP is exposed to tariff risk. As a result, the US dollar is likely to strengthen against the Mexican peso and the Canadian dollar, but against other G10 currencies in the event of a full-blown escalation of the trade conflict.
BofA further explained that theoretically, the market should anticipate the second round of retaliatory tariffs, which will lead to the continued strength of the dollar in the short term. However, the reality is often more complex:
Timing and coordination of retaliatory measures: It takes time and coordination for countries to take retaliatory measures, during which time market responses may lag.
Currency depreciation as a buffer: Some countries may choose to depreciate their currencies to cushion the economic shock of tariffs, which can further affect exchange rate dynamics.
Bank of America analysis: three major factors may lead to a long-term weakening of the dollar
BofA noted that in addition to the immediate impact of retaliatory tariffs, the following three factors could also contribute to the gradual weakening of the dollar over the long term:
1. Risk aversion fades and U.S. stocks pull back
Risk aversion is likely to support the USD in the near term amid tariff escalation. However, the strength of the US dollar is closely linked to the high valuation of the US stock market, especially in the high-tech sector. In the event of a sharp correction in US equities, market risk aversion may subside, which will weaken the support of the US dollar. So, while risk aversion may temporarily push the USD higher in the short term, any significant pullback in US equities will have a negative impact on the USD in the long term.
2. The Fed's monetary policy pivot
U.S. tariffs and retaliatory measures would have a stagflationary impact on the U.S. and global economies. Central banks weigh the impact of growth and inflation on their own merits. Given the Fed's dual mandate to maximize employment and stabilize prices, as well as the political pressures it may face, it remains uncertain whether it will adopt the most hawkish monetary policy.
In addition, the high fiscal deficit in the United States limits the scope for further fiscal stimulus, making it more dependent on monetary policy. If the Fed takes a relatively dovish stance, this will further weaken the position of the dollar. At the same time, the high fiscal deficit in the United States also means more monetary policy to support demand, which may not be conducive to the long-term strength of the dollar.
3. Long-term productivity impaired
Protectionism not only causes short-term economic fluctuations, but also negatively affects long-term economic growth. If the U.S. raises tariffs on other countries and other countries retaliate, all countries will eventually suffer, but the U.S. may suffer more because of its higher levels of protectionism. The rest of the world is likely to continue to trade with each other, or even reduce trade barriers to each other in response to U.S. tariffs.
In such a scenario, the long-term productivity of the United States would be severely affected, challenging its "exceptionalism" status and thereby eroding the long-term equilibrium value of the dollar.
In summary, while the U.S. dollar may be strong in the short term due to factors such as risk aversion, in the long term, multiple factors such as retaliatory tariffs, a pullback in U.S. equities, a shift in the Fed's monetary policy, and long-term productivity damage could lead to a gradual weakening of the U.S. dollar.
