Source : THE AGE NEWS
The huge plunge in the US sharemarket in response to Donald Trump’s universal and reciprocal tariffs on most of the world’s economies last week grabbed most of the attention. There were shifts in other markets, however, that paint an equally or even more threatening picture of the outlook for the US and the world.
Confronted with Trump’s unexpectedly high and broad new tariffs and taken aback by the unsophisticated and illogical way they had been calculated (which speaks volumes about the capabilities and credibility of the administration), the gut response of sharemarket investors was a sell-down of their risk exposures that wiped more than $US5.4 trillion ($8.8 trillion) off the value of the US market, with similar waves of selling offshore.
Trump’s tariffs are not having the effects he was after.Credit: AP
The selling has continued in Australasian and Asian markets on Monday and futures markets activity is signalling that it will restart in the US when its markets reopen.
That the outlook for US and global growth has darkened significantly as a result of the tariffs can be seen, not just in sharemarkets, but in big slumps in the prices of gold and copper, both of which had been on a tear earlier in the year.
Conventionally, when risks in the global economy and financial system rise, investors flee to the perceived haven of the US bond market, with bond prices rising and their yields (which move in the opposite direction to prices) falling.
That’s happened in the past few days. The yield on 10-year Treasury bonds has fallen from 4.21 per cent at the start of last week, on the eve of “Liberation Day”, to 4 per cent. The yields on two-year Treasury notes fell from 3.88 per cent to 3.66 per cent. Bond futures pricing suggests yields will continue to slide.
In past “risk off” environments, the rush into the bond market has also seen the US dollar strengthen as part of the flight to safety in the world’s deepest financial market. It wasn’t just American investors seeking a safe place to park their funds.
Last week, however, the dollar weakened against the currencies of the three economies with the next best pools of liquidity. While the currencies of those economies most exposed to the tariffs and a global economic slowdown were belted (like the Australian dollar, which has fallen below 60 US cents), the US dollar weakened against the euro, Japanese yen and Swiss franc.
That’s not what is supposed to happen, nor what the Trump administration expected to happen.
The theory and history say that, when tariffs are imposed, the currency of the country imposing them strengthens and to some extent blunts the impacts of the tariffs on its own consumers and companies, who (despite what Trump claims) are the ones who actually pay the tariffs in the form of increased prices.
Wall Street melted down on Friday and more pain is ahead.Credit: Bloomberg
A 2019 International Monetary Fund study of 151 countries between 1963 and 2014 showed that tariff increases did result in real exchange rate appreciation. (It also showed, despite what the Trump administration believes, that the tariffs had only a modest effect on trade balances).
There’s a simple explanation for why the US dollar should be rising. Tariffs raise the prices and therefore reduce the demand for imports, which means there’s less need for US companies to exchange dollars for imported goods, fewer dollars in circulation and, with less supply, higher “prices” for the currency.
The fact that hasn’t happened could be due to a number of factors.
An obvious one would be that investors and traders believe the US is shooting itself in the foot and that the damage to its economy will be greater than that on the economies they are shifting their exposures to.
The tariffs will lower US growth, employment and investment and lift the inflation rate, risking stagflation, or higher inflation with lower growth.
That was what the Federal Reserve Board chair, Jerome Powell, was alluding to last week when he said tariffs were likely to generate at least a temporary rise in inflation, but it was also possible that it could be more persistent.
The Fed had a bruising experience with what it thought was going to be the “transitory” spike in inflation caused by the pandemic’s impact on global supply chains. Four years after US inflation started to surge, it remains elevated and above the Fed’s target even as the US economy has slowed and before Trump’s tariffs and their negative impacts on inflation and growth hit home.
In the past, the dollar has strengthened even during US recessions, so the immediate reaction to Trump’s tariffs and the big bets against the dollar mounting in futures markets suggest there is something different this time.
The US dollar is not doing what Trump wants it to do. Credit: Bloomberg
The tariffs, the assault on the global free trade order that the US built and encouraged (and profited from) and the trade war Trump has initiated, against not just perceived foes but America’s closest trading partners, geopolitical allies and the poorest economies in the world, might be undermining the dollar’s status as the world’s reserve currency.
There might be a developing structural element to the dollar’s unusual response, driven by a backlash against Trump’s actions, which underscore the vulnerability of other economies, have heightened mistrust of America and have raised question marks over the longer-term potential of its economy.
It doesn’t help that, even as the punitive and irrational tariffs regime is being implemented, the Republicans in the Senate have introduced Trump’s “big, beautiful bill” of tax breaks and spending cuts, a bill the nonpartisan Committee for a Responsible Federal Budget says would add $US5.8 trillion to US primary deficits between 2026 and 2034 and which it says would be “historically unprecedented in its fiscal irresponsibility”.
The bill would not only extend the $US4.5 trillion of tax cuts for the wealthy from Trump’s first term, which are scheduled to expire later this year, but had more than $US1.5 trillion for the abolition of tax cuts on tips and other pledges Trump made during the election campaign.
The tariffs will lower US growth, employment and investment and lift the inflation rate, risking stagflation, or higher inflation with lower growth.
When added to the impact of the tariffs on the economy, the massive increase in America’s already daunting debt and deficit burden is occurring at the most delicate moment in the country’s post-war history.
The dominance of the US dollar in global trade and finance has meant that, regardless of domestic economic conditions or policies, the US has been able to attract foreign investment to its markets and economy.
Foreign governments have seen it as a safe and stable place to park their savings, investors have seen it as a source of higher and less volatile returns and companies have acquired US dollars in exchange for the goods they have sold into the world’s largest consumer market.
Now the world doesn’t see America as safe or stable, and the tariffs mean US corporate profits will fall, as will the need for investment capital, and the market for foreign goods will shrink.
The US has, since 1944, enjoyed what the former French finance minister, Valéry Giscard d’Estaing, once termed an “exorbitant privilege”. It costs almost nothing to print a dollar, but other countries have to supply $US1 of goods or services to acquire one.
That has underpinned a period of more than 80 years when the rest of the world has effectively subsidised the US economy and its citizens’ standards of living. Regardless of its economic fundamentals, it has been able to borrow more cheaply, buy goods more cheaply, leverage the dollar into geopolitical dominance and never have to fear a balance of payments crisis because the dollar status has effectively given it unlimited foreign exchange reserves.
America’s economic strength and stability revolve around the dollar’s status and privileges. Could Trump, his tariffs, the plan for massive increases in US deficits and debt undermine the dollar’s dominance and create an economic and financial crisis in the US in the process? We may be about to find out.
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