Thoughts on the Market: How Do Tariffs Affect Currencies?

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: How Do Tariffs Affect Currencies?
• Release Date: February 13, 2025
• Description: Short, thoughtful, and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.

Introduction

In the February 13, 2025 episode of Thoughts on the Market, James Lord, Morgan Stanley's Head of Foreign Exchange and Emerging Market Strategy, delves into the intricate relationship between tariffs and currency volatility. Addressing the contemporary economic landscape shaped by recent tariff implementations and negotiations, Lord provides a comprehensive analysis of how these trade policies influence foreign exchange (FX) markets.

Current Tariff Landscape and Immediate Impacts

Lord opens the discussion by contextualizing the recent developments surrounding President Trump's tariff proposals. As of the episode's release, the U.S. had successfully negotiated tariff agreements with Canada and Mexico, resulting in a 10% tariff on Chinese imports. Despite initial heightened volatility in currency markets during the negotiation phase, the overall net impact remained relatively subdued post-agreement.

“Currencies experienced heightened volatility during the negotiations, but the net impact at the end of the negotiations was small.” (00:40)

Similarly, tariffs announced on steel and aluminum imports have not significantly disrupted markets. However, the looming threat of reciprocal tariffs continues to inject uncertainty, keeping investors vigilant.

Distinguishing Between Types of Tariffs

A central theme of Lord’s analysis is the differentiation between two primary types of tariffs:

1. Negotiation-Oriented Tariffs: These are imposed with the intent to leverage negotiations and secure deals on other critical trade issues.
2. Strategic Economic Tariffs: These aim to achieve broader economic objectives, such as reducing the U.S. trade deficit or protecting domestic industries from foreign competition.

“The first type is proposed with the intention to negotiate to reach a deal with affected countries on key issues. The second type serves a broader purpose.” (01:45)

Lord emphasizes that the market reactions vary significantly depending on the tariff type. When tariffs are negotiation tools, any resultant currency volatility is typically transient and likely to reverse once a deal is finalized. Conversely, tariffs that are part of a broader economic strategy may lead to more sustained currency fluctuations.

Currency Implications: Case Study on U.S. Dollar and Renminbi

Focusing on the strategic economic tariffs, especially those targeting Chinese imports, Lord predicts a sustained appreciation of the U.S. dollar against the Chinese renminbi. He forecasts that the USD/CNY exchange rate could reach 7.6 in the second half of 2025, reflecting the longer-term impact of these tariffs.

“We believe that tariffs on imports from China should be considered in this context. As a result, we do see sustained dollar renminbi upside, with that currency pair likely to hit 7.6 in the second half of 2025.” (02:10)

The Importance of Tariff Timing

Timing emerges as a crucial factor influencing FX markets. Lord points to April 1 as a pivotal date when more details regarding the "America First" trade policy are expected to materialize. The anticipation of this policy revelation could strengthen the U.S. dollar in the lead-up to the date, with heightened investor activity surrounding tariff enactments.

“April 1 is very likely going to be a key date for foreign exchange markets. As more details around the America first trade policy are likely revealed.” (02:50)

Investors are advised to monitor developments closely around this period, as they could signal significant moves in currency valuations.

Evaluating the Future of FX Volatility

A salient question addressed by Lord pertains to whether the current period of FX volatility is a temporary spike or indicative of a new, structurally higher level of uncertainty. Contrary to prevalent investor assumptions, empirical evidence suggests that while FX volatility may experience episodic increases during key tariff-related events, there is no substantial trend toward permanently elevated volatility levels.

“Indicators that track the level of uncertainty around global trade policy did rise during President Trump's first term, specifically around the period of escalating tariffs on China, and while this was associated with the stronger dollar, it did not lead to rising levels of FX volatility.” (03:20)

Lord acknowledges a slight uptick in FX volatility at the onset of Trump’s second term but maintains that implied volatility remains below the peaks observed over the past decade. However, he cautions that persistent or more severe macroeconomic repercussions resulting from tariffs could alter this outlook, potentially leading to structurally higher FX volatility.

Conclusion

James Lord concludes by reinforcing the nuanced nature of tariffs' impact on currency markets. While specific tariff actions can trigger short-term volatility, the overarching effects depend on the types of tariffs employed and the broader economic strategies they support. Investors should remain vigilant around critical dates like April 1 and reassess assumptions about long-term volatility in light of evolving trade policies and their macroeconomic repercussions.

“FX volatility is likely to rise around key dates and periods of escalation, and while structurally higher levels of FX volatility could still occur, the odds of that happening would increase if tariffs resulted in more substantial macroeconomic consequences for the US Economy.” (03:35)

Key Takeaways

1. Differentiate Tariff Types: Understanding whether tariffs are negotiation tools or strategic economic measures is essential for assessing their impact on FX markets.
2. Monitor Timing: Significant dates, such as April 1, can serve as catalysts for currency movements due to policy announcements.
3. Assess Volatility Trends: Current evidence suggests that while episodic volatility may rise, a structural increase in FX volatility remains uncertain unless tariffs lead to deeper economic challenges.

Final Thoughts

Morgan Stanley's analysis offers valuable insights for investors navigating the complex interplay between tariffs and currency markets. By distinguishing tariff motives, attentively observing key policy dates, and critically evaluating volatility trends, investors can better position themselves to respond to the evolving trade landscape.

This summary is intended to provide a comprehensive overview of the podcast episode for those who have not listened to it, highlighting the critical discussions and expert insights shared by James Lord.