Tariffs Trigger Dollar Depreciation Through Retaliation and Risk Repricing

The conventional wisdom on tariffs suggests they should strengthen a nation's currency by reducing demand for foreign goods. However, recent economic events, particularly those following "Liberation Day" in 2018, have revealed a more complex reality. This conversation with Giancarlo Corsetti unpacks how anticipated retaliation and a fundamental repricing of US risk can cause exchange rates to move in unexpected directions, leading to a depreciation of the dollar. The implications are significant for understanding long-run risk, the future of the dollar's dominance, and the intricate interplay of monetary and fiscal policy in a shifting global landscape. Investors and policymakers who grasp these non-obvious dynamics gain a critical advantage in navigating an increasingly unpredictable economic environment.

The Unforeseen Depreciation: When Tariffs Trigger Retaliation and Repricing

The standard economic textbook model posits a clear outcome for tariffs: they restrict imports, thereby increasing demand for domestic goods and services. This, in turn, should lead to an appreciation of the domestic currency. The logic is straightforward: if a country buys fewer foreign goods, the foreign currency must weaken relative to the domestic one. This was the prevailing expectation for how the US dollar would react to tariffs imposed since 2018. However, real-world events have challenged this neat theoretical framework.

The most striking example occurred after "Liberation Day," an event marked by the announcement of tariffs on an unprecedented scale. Instead of strengthening, the dollar experienced a significant depreciation, falling by 6% against the euro in a short period. This outcome baffled many, as it ran counter to established economic intuition. Giancarlo Corsetti explains that this surprise stems from a crucial factor often overlooked in simplified models: retaliation.

"The right comparison is not a tariff, what happened to the exchange rate, but a tariff retaliation, what happened to the exchange rate. And once we go there, we go halfway to understand what happened. The other half of the way is the fact that you see effects in the financial market beyond the dollar. We have an increase in the interest rate on the US Treasuries."

Corsetti's research, focusing on the 2018-2020 period, meticulously analyzed tariff announcements. The findings reveal a stark divergence: unilateral tariffs, those not met with immediate retaliation, tended to cause a dollar appreciation, aligning with textbook predictions. However, when tariffs were met with swift and widespread retaliation, the dollar depreciated. This suggests that the market reaction is not merely to the tariff itself, but to the ensuing trade conflict. The "Liberation Day" event, characterized by both massive US tariffs and a global readiness to retaliate, thus set the stage for a depreciation, not an appreciation, of the dollar.

Beyond Currency: The Repricing of US Risk

The dollar's depreciation after "Liberation Day" was not an isolated event. It was accompanied by another significant financial market development: an increase in the interest rates on US Treasuries. This dual movement--a weaker dollar and higher borrowing costs for the US--points to a deeper underlying phenomenon: a fundamental repricing of US risk by international investors.

Corsetti argues that the market reaction should be viewed not as a simple currency shock, but as a broader reassessment of the long-run risks associated with holding US assets. For years, the US has benefited from a "convenience yield" on its Treasuries, meaning investors accepted lower returns in exchange for the safety and liquidity of US debt. This, coupled with strong performance in US equities, created a dynamic where risk seemed concentrated in the stock market, while the bond market offered a safe haven.

"Now we see that the three markets together sing the same song. There is a repricing, a reassessment of long-run risk by international investors."

The events since 2018 have disrupted this equilibrium. The increased perception of risk in US Treasuries, alongside ongoing equity market performance, suggests that investors are demanding higher compensation for holding US assets across the board. This repricing implies a shift in the global financial landscape, where the US may no longer be perceived as the ultimate safe haven without an associated risk premium. This has profound implications for the future of the dollar's role as the world's primary reserve currency.

The Shifting Sands of Global Finance: From Gulf Stream to Tense Investment

The traditional narrative of the US economy has often been likened to a "Gulf Stream," where US assets flowed abroad in exchange for goods, a self-sustaining cycle facilitated by the ability to borrow cheaply. This system thrived because the US could absorb global surpluses without seeing its borrowing costs escalate significantly. However, Corsetti's analysis suggests this era may be drawing to a close.

The repricing of US risk indicates a fundamental alteration in how global capital flows. Investors are now more keenly aware of the potential for US policy actions, such as tariffs and retaliations, to impact the value of their holdings. This heightened awareness leads to increased caution and a demand for higher returns, making borrowing more expensive for the US. While US equity markets may continue to perform well, a larger portion of those gains might now be shared with non-residents, altering the wealth dynamics for US households and firms.

This shift is not merely an abstract economic concept; it has tangible consequences for monetary and fiscal policy. The potential for geopolitical tensions, capital controls, or taxation of foreign holdings creates an environment of uncertainty. This tension influences investment decisions, making global investors more hesitant despite the potential for returns. The "bonanza" in the US equity market, once a clear signal of strength, is now viewed through a lens of political risk.

"So all of a sudden, the borrowing becomes more expensive. So what you see, the system of flow of asset and goods is profoundly altered. There is a lot more to say about this, and I get the feeling that the markets and macroeconomists are adjusting to this new world, this regime change, and beginning to internalize what that means."

The implication is that the US may need to adapt its economic policies to this new reality, where the cost of borrowing could be higher and the global perception of US assets is more nuanced. The "end of dollar dominance" narrative, while perhaps premature, reflects a genuine shift in how the global financial system operates and how international investors perceive risk.

Key Action Items

• Immediate Action (Next Quarter):

  • Analyze Tariff Impact: For businesses operating internationally, conduct a granular analysis of how specific tariffs and retaliatory measures impact your supply chains and cost structures. Differentiate between unilateral tariffs and those met with retaliation.
  • Scenario Planning: Develop scenarios for currency fluctuations based on escalating trade tensions, not just immediate tariff impacts.
  • Risk Assessment of Dollar Holdings: For investors holding significant dollar-denominated assets, reassess the risk premium associated with these holdings, considering potential shifts in US policy and global investor sentiment.

• Short-Term Investment (Next 6-12 Months):

  • Diversify Currency Exposure: Explore hedging strategies or investments in non-dollar denominated assets to mitigate risks associated with potential dollar depreciation.
  • Monitor Global Retaliation Patterns: Track not just US tariff announcements but also the likely responses from trading partners, as this is a key driver of currency movements.
  • Understand Treasury Yield Dynamics: Stay informed about factors influencing US Treasury yields beyond traditional monetary policy, including geopolitical risk and investor sentiment towards US debt.

• Long-Term Investment (12-18 Months and Beyond):

  • Strategic Supply Chain Resilience: Invest in building more resilient and diversified supply chains that are less susceptible to sudden tariff impositions and retaliations. This may involve near-shoring or multi-shoring strategies.
  • Monitor "Saving Investment Union" Developments: For European businesses and investors, closely watch efforts to create a "saving investment union" in Europe, as this could alter global capital flows and reduce reliance on US markets.
  • Adapt Monetary and Fiscal Policy Frameworks: Policymakers should begin adapting their frameworks to account for a world where US borrowing costs may be structurally higher and the dollar's role as a reserve currency is subject to greater scrutiny. This involves understanding the interplay between monetary and fiscal policy in managing these new dynamics.