Tariffs and exchange rates: Anticipating what's coming

In many cases, a successful speculation requires foreseeing a coming market disruption and correctly anticipating how prices will change as a consequence. As an example, the speculator who correctly anticipates a severe drought or flood in advance of it occurring would reasonably expect substantially reduced crop yields and hence higher prices in the future. The question is whether a similar opportunity exists in connection with the likelihood of Trump imposing substantial tariffs on imports from some of our most important trading partners. Will these higher tariffs presage a predictable change in the value of the US Dollar?

Let’s suppose Trump actually imposes new large tariffs on China, Mexico, and Canada – our three most important trading partners – as of February 1, as promised. At this point, all of us should appreciate that new tariffs will make imports more expensive for US purchasers. Less attention, however, has been given to the effect of these tariffs on the value of the dollar (or conversely, the value of foreign currencies). Theory tells us that, all else being equal, higher prices for foreign goods and services will reduce the demand for those currencies. Thus, we might reasonably expect the currencies of our trading partners to weaken with respect to the US dollar.

Two important caveats are worth noting: First, in currency markets, like virtually all other financial markets, supply and demand considerations incorporate expectations. Thus, to the extent that the markets have anticipated these coming higher tariffs, the exchange rate adjustment may have already occurred. Secondly, the market may also be incorporating retaliatory actions on the part of our foreign counterparts, and those retaliatory actions would likely have offsetting influences on exchange rates. Exactly which way exchange rates will move in the future remains ambiguous. It is even possible that the market has correctly anticipated the new equilibrium exchange rates, such that no material further adjustments would occur after the imposition of these new tariffs.

We also need to realize that to the extent that tariffs may foster further weakening of the values of the affected foreign currencies, this factor is only one piece of the puzzle. Supply and demand for any currency depends not only on the cash needs associated with imports and exports, but also on the requirements associated with financial transactions – e.g., currency needs relating to investments and security purchases and sales. These effects could be contrary to the impacts that tariffs have on currency exchange rates, or they could be reinforcing. Moreover, the situation could differ from currency to currency. The notion that the dollar will strengthen in response to any new tariffs is a bit too pat. In particular, I expect the standing of the US in the eyes of the world will also play a major role in how currency exchange rates move, and that chapter has yet to be written.

To get a sense of what has been happening, I’ve looked at exchange rates for our three largest trading partners: Mexico, Canada, and China, in order of importance. Daily data can be quite volatile, so I’ve chosen to look at the monthly averages for these three exchange rates. As of December 2024, the three exchange rates were MP20.2878/USD, CAN1.4247/USD, and CNY(Yuan)7.2808/USD, reflecting changes over the prior 12 months of 17.9 percent, 6.2 percent, and 2.0 percent, respectively.

Those exchange rates show the number of foreign currency units per dollar, which means rising exchange rates presented above reflect a strengthening US dollar (i.e., more currency units per dollar), and hence a weakening of the non-dollar currency relative to the dollar. The interesting result (to me), however, is how different the changes have been for the respective currencies. That is, the hit to the Mexican Peso has been much more severe than the others, while the hit to China has been minimal.

I find the comparative performance most surprising. China has been threatened with larger tariffs than either of the others, and yet the exchange rate between Chinese Yuan and US dollars appears to have largely ignored that threat. How should these differences be interpreted? Perhaps the market sees China as better positioned to circumvent the tariff by using other countries as intermediaries before their goods get to the US, while Mexico and Canada may not have the same ability to do that. Alternatively, China may have a greater capacity to make compensating price adjustments on their exports by forcing wage cuts on Chinese workers, and again, Mexico and Canada may not have comparable authority.

These explanations may be reasonable conjectures relating to exchange rate histories; but they tell us little about what may happen to future exchange rates – particularly in the short run; and, unfortunately, that’s the relevant time frame for most speculators. Perhaps the bigger lesson from these disparate histories may be that other factors besides tariffs have a larger effect on exchange rates than do tariffs. As stated earlier, theory tells us that higher prices for foreign goods and services will reduce the demand for those currencies, all else being equal; but that qualification may be a very tall order.