Boiling point

The trade war between the United States and the rest of the world reached a boiling point in April after President Trump unveiled reciprocal tariffs that were far greater than what anyone was expecting and as he flagged a new round of sectoral tariffs. The response by other countries varied, with many, like Australia, Japan and the United Kingdom, deciding not to retaliate. But others, such as the European Union and China, have not held back in responding with some counter measures.

China’s response has been the most aggressive, likely taking the White House by surprise. As expected, though, the tit-for-tat retaliation only infuriated Trump, escalating into a full-blown trade conflict. Prior to the weekend talks between US and Chinese officials aimed at diffusing the situation, Chinese businesses were staring at a staggering 145% tax on their exports to the US, while American imports were being charged a somewhat lower 125% rate.

Stepping back from the brink

All this suggests that a truce was inevitable. Reports on who initiated the talks vary, depending on the source. But most likely, both sides were seeking an urgent de-escalation, as such punitive tariffs can only be harmful to the world’s two largest economies. Hopes were high heading into the weekend meetings in Switzerland as Trump had hinted that he was willing to lower tariffs on China to 80%.

In a huge relief for investors, the outcome was far better than expected, as both sides agreed to slash each other’s tariffs by 115%, bringing the rate on Chinese imports to 30% and the rate on US goods entering China to 10%. Not forgetting the sectoral tariffs on steel and cars, this leaves the average level of levies between the two countries still above what it was prior to the start of the trade war in February.

No end to the uncertainty

More concerning for investors and other decision makers, especially business leaders and central bank policymakers, is that the temporary reprieve does little in removing the uncertainty. Reaching an initial trade deal was probably the easy part. Agreeing on a comprehensive trade pact that resolves differences on key areas such as intellectual property rights, the illegal flow of fentanyl and US access to Chinese markets will be much more difficult.

This leaves markets exposed and vulnerable to any potential setbacks during the 90-day pause, while failure to reach a more permanent agreement risks reviving fears about a US and global recession.

Dollar perks up

The easing trade tensions have helped the US dollar recover significant lost ground. The dollar index surged towards its 50-day moving average (MA) the day after the Sino-US deal was announced, extending its rebound from April’s three-year low of 97.92 to more than 4%. However, the 50-day MA has proven to be a tough obstacle to overcome, and the greenback has since retreated somewhat, casting doubt about its outlook even if trade frictions continue to de-escalate.

Inflation risks persist

Apart from the ongoing risk that Trump could re-impose some of the suspended tariffs at any point, there is also huge uncertainty about what will happen to inflation. For now, US inflation appears to be gradually declining, putting the Fed in a strong position to resume its rate cuts at some point in the second half of the year.

However, the Trump administration has repeatedly indicated that the 10% baseline tariffs that were introduced on April 2 are here to stay. The 25% duties on specific sectors are also not likely to be abolished completely, even if there are some further exemptions in the future. Plus, tariffs on additional industries are possible.

This makes it difficult for the Fed to feel confident about inflation maintaining its current downward path as there’s bound to be some impact from the higher tariffs on US prices even in the best cast scenario. Investors currently foresee just two rate cuts this year, with a full 25-basis-point reduction not fully priced in until September.

Fed still faces a dilemma

A long pause seems more justifiable now that exorbitant tariff levels have been scaled back and no longer pose a threat to the economy. But then why is the dollar’s rebound looking shaky?

It’s likely that investors still see a significant risk of stagflation, as the uncertainty about Trump’s policies will probably hold back business and consumer spending to some extent, suppressing growth while costs go up. It’s also the case that the supply chain landscape will go through an inevitable transformation, as many businesses will be forced either way to shift some or all of their production to the US, pushing up costs.

A China deal may not be easy

Investors should not be fooled into thinking that America’s quest to decouple from China will stop when Washington and Beijing finalise their deal, which itself may not bring an end to the broader economic war.

One reason why Trump is coming down hard on China in his second term is because of the failure of the Phase I agreement signed in January 2020 during his first term. The Chinese did not live up to their commitment of buying more US goods, so the White House will be wary not to repeat the same mistake and will seek better safeguards for enforcement of the deal.

Hence, the stakes are a lot higher this time, meaning a resolution of the trade dispute may take a lot longer than anticipated. This explains why many investors are maintaining a substantial degree of caution until there is a more convincing breakthrough in the negotiations.

Reason for optimism

Nevertheless, some optimism in the short term is warranted, as all the signs suggest the Trump administration wants to avoid another stock market meltdown and is determined to get more preliminary deals across the finish line. It’s also highly likely that the existing 90-day delays on reciprocal tariffs will be extended, while the evidence from the latest announcements on the chip and pharmaceutical sectors is that the White House is toning down its stance amid outcry from industry leaders.

For the dollar, a break above the 50-day MA is vital if the recovery is to gain any traction, with the next critical barrier likely to be found around 103.35, followed by the 200-day MA. Though, the 200-day may be too bullish a target at the moment as downside risks persist.

Doubts about Dollar’s reserve currency status

Trump’s constant flip-flopping on trade and undermining of America’s democratic institutions is harming the dollar’s position as the world’s reserve currency. This may limit the dollar’s advances even if there is a further cooling in trade tensions.

But in the event that there is a re-escalation in the trade war and Fed rate cut expectations are ratcheted up, there is scope for the dollar index to slide all the way down to the 94.60 region towards 2021 lows.

Source: XM