Dollar Drops as Markets Weigh Trump's Tariff Threat

The dollar traded near a one-week low on Monday as traders grappled with the potential impact of President-elect Donald Trump's proposed tariffs on imports, which could stoke inflation and disrupt global supply chains. The greenback has been strengthening in recent weeks, boosted by expectations of higher U.S. interest rates and a more expansionary fiscal policy under the incoming administration.



Trump has pledged to impose a 60% tariff on Chinese imports and a 10-20% tariff on all other imports, a move that could significantly increase the cost of goods for U.S. consumers and businesses. The Peterson Institute for International Economics (PIIE) estimates that a 60% tariff on Chinese products would lead to a 0.7 percentage point increase in U.S. inflation and a 0.2% decline in U.S. GDP.

The proposed tariffs could also have a significant impact on the dollar's exchange rate. While a higher trade deficit typically weakens a currency, the dollar has been strengthening in recent years due to factors such as the U.S.'s exceptional economic and megacap business performance, which has attracted a torrent of overseas investment. This investment has overwhelmed the U.S. trade deficit, leading to a net international investment position of $22.5 trillion by the middle of 2024, almost three quarters of America's entire annual GDP.

However, if Trump's tariffs lead to a significant increase in the trade deficit, it could potentially weaken the dollar. Deutsche Bank, for example, thinks Fed rates will not get below 4% in this cycle while European Central Bank rates will fall as low as 1.5%. This would leave an eventual gap of 250 basis points between the two policy rates compared to current market pricing for a peak of 180bp. In this scenario, the euro/dollar exchange rate could plunge below parity, more than 5% below current levels. China, the German bank reckons, will also allow the yuan to gradually weaken in that scenario.

Retaliatory tariffs from other countries could also influence the dollar's exchange rate with major currencies. If trading partners impose tariffs on U.S. goods, it could lead to a decrease in U.S. exports and an increase in imports, which could weaken the dollar. However, if investors perceive the U.S. as a safer investment due to its strong economy and political stability, they may increase their demand for the dollar, causing it to appreciate against other currencies.

In conclusion, while Trump's proposed tariffs could potentially weaken the dollar by increasing the U.S. trade deficit, the dollar's strength is also driven by other factors, such as overseas investment in U.S. assets. The ultimate impact on the dollar's exchange rate will depend on the balance between these factors. Investors should closely monitor the situation and consider the potential impacts on the dollar's exchange rate with major currencies when making investment decisions.