Observers and investors were expecting the US dollar to go up in value. This was without counting on the new US administration’s erratic policymaking and announcements on tariffs. Where is it going next and what other factors are affecting the greenback?
Tariff trauma
Since US President Donald Trump’s inauguration on 22 January, the US Dollar Index has declined by around 5%. USD weakness is broad-based, with the greenback making losses against both G10 and emerging market currencies. The likes of SEK, NOK and JPY have posted the best performance against the USD, which illustrates that the FX market is moving from a regime of USD-centric carry trades towards one which rewards undervalued currencies, such as SEK, NOK and JPY.
This price action is not what investors had expected: they had anticipated that the USD would benefit from the so called ‘Trump trade’ –a combination of deregulation in the US economy, high levels of import tariffs and higher interest rates.
Tariff rhetoric meets reality
The consensus belief was that tariffs would lead to an appreciation of the USD due to an expectation of import compression and a subsequent improvement in the US’ trade balance. This has not happened. This reflects the erratic nature of tariff announcements and the lack of certainty regarding the US’ final stance on tariffs. Trump’s announcements and subsequent rollback of tariff measures on Canada and Mexico is a prime example. As a result, EUR/USD barely moved when Trump announced potential tariffs on European goods: when it comes to tariffs, investors do not know whether to take Trump literally or seriously.
There is surprisingly little academic research of tariffs’ effects on currencies. However, the consensus is that the initial impact is an appreciation in the currency of the country imposing the tariffs due to changes in the balance of trade. The subsequent economic effects then tend to reverse this.
There is also a question of scale and size. The US imposed tariffs on China from 2018 onwards, and these tariffs transpired when PBoC was guiding CNY towards a slightly weaker equilibrium. We now have a scenario in which the US has imposed tariffs on China, Canada, and Mexico at the same time, and threatened to apply them to the EU. And far from seeing the USD appreciate, we have seen it weaken.
Since the inauguration US consumer confidence has deteriorated, reflecting heightened levels of tariff-related uncertainty. US long-end interest rates have declined, and consequently, the USD’s carry advantage over most G10 and emerging market currencies has contracted.
Valuation shift
We note that the USD was trading at multi-decade highs ahead of Trump’s inauguration. Its clear overvaluation is one of the main drivers behind the US trade deficit, and the US administration will be happy that the USD has weakened. We think that the bar to further USD weakness is not particularly high. Germany’s fiscal spending announcement is a game-changer, and it will result in higher growth dynamics in Europe’s largest economy at precisely the same time as the US will experience slower growth and a modest fiscal contraction (DOGE etc.). Put simply, a stronger EUR will do more to reduce the US trade deficit than tariffs ever will.
