What Will Tariffs Do to the U.S. Dollar?

Summary

Thoughts on the Market: What Will Tariffs Do to the U.S. Dollar?

Hosted by Morgan Stanley | Released on March 4, 2025

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Introduction and Context

In the March 4, 2025 episode of Thoughts on the Market, Morgan Stanley's Ariana Salvatore and Andrew Watros delve into the dynamics surrounding the U.S. dollar amidst the early days of the new Trump administration. The episode centers on the impact of recently implemented tariffs and evolving fiscal policies on the dollar's dominance in global markets.

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USD Dominance in Global Markets

Ariana Salvatore opens the discussion by highlighting the significance of the U.S. dollar in global finance, noting the recent imposition of substantial tariffs: “Last night at midnight, 25% tariffs on Mexico and Canada went into effect, in addition to 10% on China” (00:09). Andrew Watros underscores the dollar's entrenched position, stating, “The US dollar is used in about $7 trillion worth of Daily FX transactions. And the dollar's share of all currency transactions has been pretty stable over the last few decades” (00:43). He further emphasizes the dollar's dominance in trade finance: “Something like 80% of all trade finance is invoiced in dollars.”

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Comparison with 2017: Factors Influencing USD

The conversation shifts to a historical perspective, comparing the current scenario with the first year of the Trump administration in 2017, when the dollar experienced a decline. Andrew explains, “In 2017 gets a lot of client attention because the Fed was hiking, there was a lot of uncertainty about what would happen in NAFTA and the US Passed a fiscally expansionary budget bill that year” (01:07). He identifies three primary reasons for the dollar's downturn despite these factors:

1. NAFTA Uncertainties: “US Tariffs didn't actually go up” despite headlines suggesting potential NAFTA departures.
2. Global Growth Strength: “Global growth turned out to be really strong in 2017... aided by fiscal policy and growth in China and Europe.”
3. European Political Risks: “Political risks in Europe that didn't end up materializing,” alleviating investor concerns over a potential Eurozone breakup.

Andrew concludes that these factors collectively contributed to a weaker dollar in 2017, which later reversed in 2018 as conditions changed (02:07).

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Current Fiscal and Trade Policies Under Trump Administration

Ariana contrasts the current policies with those of 2017, highlighting nuanced differences. She remarks, “Tariffs and tax policy were a big focus in 2017-2019... but in a slightly different way” (03:06). Key distinctions include:

• Broader Tariff Scope: Unlike the past focus primarily on China, the current administration has levied 25% tariffs on Mexico and Canada, starting at a higher rate than the previous 25% on Chinese goods.
• Sequencing of Policies: Previously, tax cuts preceded trade tensions. Currently, the administration is “really the inverse” with trade policy being a priority even before passing the budget resolution for tax cut extensions.

Ariana further explains the fiscal landscape, noting the passage of a budget resolution in the House aimed at extending the Tax Cuts and Jobs Act (TCJA). However, she cautions that “there are some key sticking points in the discussion,” including disagreements over the SALT cap and potential clawbacks from the Inflation Reduction Act, which could delay consensus until the end of 2025 (04:47).

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Impact on the U.S. Dollar and Market Expectations

Andrew Watros draws parallels between the current fiscal developments and those of 2017, suggesting that the dollar might experience a similar decline before potential recovery. He states, “We think that compared to 2017, there's a lot more US dollar positive risk premium around trade policy” necessitating a higher threshold for the dollar to appreciate from trade-related news alone (02:16). Additionally, he points out that European fiscal expansions and anticipated Federal Reserve rate cuts pose headwinds for the dollar.

Dissecting the impact of fiscal policy stages, Andrew reflects on past patterns: “One lesson from 2016 to 2018 is that there were really two stages of when fiscal developments boosted the dollar” (05:53). The initial rally followed the election and TCJA passage, but the current scenario suggests a delayed boost contingent on tax cut extensions, leaving room for the dollar to weaken in the interim.

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Equities vs USD Dynamics

Ariana shifts focus to the interplay between fiscal policies and the equity market, particularly how tax changes might influence specific sectors such as industrials, healthcare, and telecom. She inquires about the relationship between equity performance and dollar movements, to which Andrew responds by revisiting historical trends:

“In 2016-2018 the US dollar did not trade in line with yield differentials. Instead... equities were a much better barometer” (07:58). He notes that, similar to 2017, current equity movements outside the U.S. are catching up with or outperforming U.S. stocks, suggesting that the dollar may decline as it did when international equities rallied (08:57).

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Potential Triggers for USD Appreciation

Addressing what could reverse the dollar’s downward momentum, Andrew cites lessons from 2018: “If trade tensions evolve in a direction where our economists significantly downwardly revised their global growth forecasts, then the US Dollar could start to look more attractive as a safe haven” (09:10). Additionally, he mentions that significant increases in long-term treasury yields, although not currently expected, could also bolster the dollar’s appeal.

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Conclusion

As the episode wraps up, Ariana and Andrew illuminate a nuanced forecast for the U.S. dollar amidst expansive tariff implementations and ongoing fiscal policy negotiations. While historical comparisons to 2017 suggest potential decline in the dollar's value due to broader trade policies and delayed fiscal benefits, external factors like European fiscal shifts and unexpected treasury yield movements could alter this trajectory. Investors are advised to monitor these evolving dynamics closely as the administration navigates through its economic agenda.

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Notable Quotes

• Andrew Watros (00:43): “The US dollar is used in about $7 trillion worth of Daily FX transactions. And the dollar's share of all currency transactions has been pretty stable over the last few decades.”

• Andrew Watros (01:14): “[There are] three reasons why the US Dollar went down despite all those factors... NAFTA tariffs not increasing, strong global growth, and unresolved political risks in Europe.”

• Andrew Watros (02:16): “We think that compared to 2017, there's a lot more US dollar positive risk premium around trade policy.”

• Andrew Watros (05:53): “One lesson from 2016 to 2018 is that there were really two stages of when fiscal developments boosted the dollar.”

• Andrew Watros (07:58): “In the initial years of President Trump's first term, equities were a much better barometer than interest rates for where the US dollar would go after President Trump was elected.”

• Andrew Watros (09:10): “If trade tensions evolve in a direction where our economists significantly downwardly revised their global growth forecasts, then the US Dollar could start to look more attractive as a safe haven.”

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Timestamp Reference

• MM:SS

Note: All timestamps reference the provided transcript for accurate quote placement.

Transcript

[Ariana Salvatore]

Welcome to Thoughts on the Market. I'm Ariana Salvatore, Morgan Stanley's U.S. public policy strategist.

[Andrew Watros]

And I'm Andrew Watros, G10FX strategist here at Morgan Stanley.

[Ariana Salvatore]

Today we'll focus on the US Dollar and how it might fare in global markets during the first year of the new Trump administration. It's Tuesday, March 4th, at 10:00am in New York. So, Andrew, a few weeks ago, James Lord came on to talk about the foreign exchange volatility. Since then, tariffs and trade policy have been in the news. Last night at midnight, 25% tariffs on Mexico and Canada went into effect, in addition to 10% on China. So let's set the scene for today's conversation. Is the dollar still dominant in global currency markets?

[Andrew Watros]

Yes, it is. The US dollar is used in about $7 trillion worth of Daily FX transactions. And the dollar's share of all currency transactions has been pretty stable over the last few decades. And something like 80% of all trade finance is invoiced in dollars. And that share has been pretty stable, too. A big part of that dollar dominance is because of the depth and safety of the treasury security market.

[Ariana Salvatore]

That makes sense. And the dollar fell in 2017, the first year of the Trump administration. Why did that happen?

[Andrew Watros]

Yeah, so 2017 gets a lot of client attention because the Fed was hiking, there was a lot of uncertainty about what would happen in nafta and and the US Passed a fiscally expansionary budget bill that year. So people have asked us why the US Dollar went down despite all those factors, and I think there are three reasons. One is that even though the possibility that the US could leave NAFTA was all over the headlines that year, US Tariffs didn't actually go up. Another factor is that global growth turned out to be really strong in 2017, and that was helped in part by fiscal policy and in China and Europe. And finally, there were some political risks in Europe that didn't end up materializing. So investors took a sigh of relief about the possibility that I think had been priced in a bit, that the Eurozone might break up. And then a lot of those factors went into reverse in 2018 and the US dollar went up.

[Ariana Salvatore]

So applying that framework with those factors to today, is it possible that we see a repeat of 2017 in terms of the US dollar decline?

[Andrew Watros]

Yeah, I think it's likely that the US dollar continues to go lower for some of the same reasons as we saw in 2017. So I think that compared to 2017, there's a lot more US dollar positive risk premium around trade policy. So the bar is higher for the US Dollar to go up just from trade headlines alone. And just like in 2017, European policy developments could be a tailwind to the euro. We've been highlighting the potential for German fiscal expansion as European defense policy comes into focus. And unlike in 2017 when the Fed was raising rates, now the Fed is probably going to cut more this year. So that's a headwind to the dollar that didn't exist back in 2017. So on trade, Arianna, what developments do you expect? Do you think that Trump's new policies will make 2025 different in any way from 2017?

[Ariana Salvatore]

So, taking a step back and looking at this from a very high level, a few things are different. In spite of the fact that we're actually talking about a lot of similar policies. Tariffs and tax policy were a big focus in 2017-2019, and to be sure, this time around they are too, but in a slightly different way. So, for example, on tax cuts, we're not talking about bringing rates lower on the individual and corporate side, we're talking about extending current policy. And on tariffs and trade policy this round I would characterize as much broader. Right. So Trump has scoped in a broader range of trading partners into the discussion, like Mexico and Canada, and is talking about a starting point that level wise is much higher than what we saw in the whole 2018-2019 trade friction period. The highest rate back then we ever saw was 25%. And that was on the final batch of Chinese goods that list four. Whereas this time we're talking about 25% as a starting point for Mexico and Canada. I think sequencing is also a really important distinction. In 2017, we saw the tax cuts through the Tax Cuts and Jobs act come first, followed by trade tensions in 2018-2019. This time around, it's really the inverse. Republicans just passed their budget resolution in the House that lays the groundwork for the tax cut extensions. But in the meantime, Trump has been talking about tariff implementation since before he was even elected. And we've already had a number of really key trade related catalysts in the just six weeks or so that he's been in office.

[Andrew Watros]

So you mentioned expectations for fiscal policy. What are recent developments there and what do you think will happen with US Fiscal?

[Ariana Salvatore]

I mentioned the budget resolution in the House that was passed last week, and you can really think of that as the starting point for the reconciliation process to kick off and consequently the extension of the Tax Cuts and Jobs Act. To be clear, we think that House Republicans will be able to align behind extending most of the expiring tax cuts and jobs act, but that's still on the books until the end of 2025. So we see many months needed to kind of build this consensus among cohorts of the Republican caucus and Congress. And we already know there are some key sticking points in the discussion. What happens with the SALT cap, what sort of clawbacks occur with the Inflation Reduction Act. All of these are disagreements that right now are going to need time to work their way through Congress. So not a lot of alignment just yet. We think it's going to take most of the year to get there. But ultimately we do see an extension of most of the tcj, which is, like I said, current law until the end of 2025. But Andrew, from what I understand, when it comes to fiscal policy, there are really two stages in terms of the market impact that we saw in the last administration. Can you walk us through those?

[Andrew Watros]

Yeah. So One lesson from 2016 to 2018 is that there were really two stages of when fiscal developments boosted the dollar. The first was right after the US election in 2016 and the second was much later after the Tax Cuts and Jobs act passed right after the 2016 election. Within a couple of weeks the dollar index rallied from 98 up to 103 and 10 year treasury yields rose as well. Then things sort of moved sideways in between these two stages. 10 year treasury yield just moved sideways. 50 fiscal wasn't as supportive to the US dollar and as we know, the dollar went down and then we had the second stage more than a year later. So the TCJ was passed in December 2017 and then the dollar rallied after that along with the rise in treasury yield. So we think that now what we've seen is actually very similar to what happened in 2017 where the dollar and yields moved a lot after the 2024 election. But now the budget reconciliation process probably won't be a tailwind to the dollar until after a tax cuts extension passes Congress. And as you mentioned, that's not going to be for many, many months. So in the interim, we think there's a lot of room for the dollar.

[Ariana Salvatore]

To go down and just to level set our expectations there, to your point, it is probably going to be later this year. House Republicans have to align on a number of key sticking points. So we have passage somewhere around the third or fourth quarter of 2025. But when we think about the fiscal picture, aside from the deficit and the macro impacts, a really key component is going to be what these tax changes mean for the equity market. The extension of certain tax policies will matter more for certain sectors versus others. For example, we know that extending some of the corporate provisions aside from the lower rate will have an impact across domestically oriented industries like industrials, healthcare and telecom. But Andrew, to bring it back to this discussion, I want to think a little bit more about how we can loop in our expectations for the equity market and map that to certain dollar outcomes. How do you think that this as a barometer has changed, if at all, from Trump's first term?

[Andrew Watros]

Currency strategists like me love talking about yield differentials, but from 2016 to 2018 the US dollar did not trade in line with yield differentials. Instead, in the initial years of President Trump's first term, equities were a much better barometer than interest rates for where the US dollar would go after President Trump was elected. In 2016, US stocks really outperformed stocks in the rest of the world and the US dollar went up. Then in 2017, stocks outside the US caught up to the move in US stocks and the US dollar fell. Then in 2018, all that went into reverse and US stocks started outperforming again and the US dollar went up. So what we've been seeing in stocks today really echoes 2017, not 2018. Stocks outside the US have caught up to the post election rise in and so just like it did in 2017, we think that the US dollar will decline to catch up to that move in relative stock indices.

[Ariana Salvatore]

Finally, Andrew, we already discussed the US dollar negative drivers from 2017, but what happened to these drivers the following year in 2018? And is that any indication for what might happen in 2026?

[Andrew Watros]

So 2018, as you mentioned, does offer a blueprint for how the US dollar could go up. So for example, if trade tensions evolve in a direction where our economists significantly downwardly revised their global growth forecasts, then the US Dollar could start to look more attractive as a safe haven. And in 2018 there was a big rise in long end treasury yields. That's not what we're calling for, but if that were to happen, then the US Dollar could catch a bid.

[Ariana Salvatore]

Andrew, thanks for taking the time to talk.

[Andrew Watros]

Great speaking with you Arianna, and thanks for listening.

[Ariana Salvatore]

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