Trade wars: How the top 5 currencies can react to the talks vs. tariffs showdown

The trade wars are flaring up once again and the situation is deteriorating rapidly. The US has formally announced it will increase tariffs from 10% to 25% on $200 billion worth of Chinese goods on Friday, May 10th, a development that will send shockwaves across the globe 

The world's two largest economies are clashing once again, in rapidly-changing escalation that began over the weekend with tweets from President Donald and now turned into imminent action. 

The Administration blamed the Middle Kingdom for backtracking on most commitments it had made in the trade talks, especially on law changes related to intellectual property and forced transfer of technology.

China reacted by postponing its delegation's trip to Washington, but Vice Premier Liu He and his team will fly into the American capital for fresh negotiations on Thursday. Trump touted the fresh round of talks in a tweet aimed to soothe investors' fears.

Will these talks succeed? That is the question markets are grappling with. For stocks, the response is straightforward. Shares are set to surge if the White House withdraws the new tariffs and they are set to stumble if the threat turns into reality.

And what does it mean for currencies? Here are the top currencies, ranked in order of the magnitude of the reaction:

Five Currencies to watch

1) Japanese Yen: The yen is the ultimate safe-haven currency and it has already reacted positively to the sudden escalation. The Japanese currency still has room to extend its gains if the tariffs go into effect. And after the recent rise, the yen can retreat from the highs.

2) Australian dollar: The Aussie is a risk currency, rising with the tide alongside stocks and sliding when markets sell-off. The A$ stands out among its peers in is sensitivity not only to equities but also to trade between the world's superpowers. China is Australia's No. 1 trade partner.

If China sneezes in reaction to the US tariffs and worsening mood, Australia may catch a cold, or even worse. Moreover, after the Reserve Bank of Australia held back from cutting interest rates, it may now get off the fence and slash rates, sending the Aussie lower.

3) Canadian dollar: The loonie is also a risk currency, sensitive to global growth and to demand for its essential export: oil. If both parties find a way forward, the C$ has room to rise. Otherwise, it may struggle. The Canadian dollar is not as sensitive as the Australian dollar, but the moves may be considerable. 

4) Euro: The common currency's reaction is asymmetric. On the one hand, EUR/USD was pressured by the global gloom and lost ground against the safe-haven greenback. It may extend its retreat if the US moves forward with its threats, but it is unlikely to go very far. And this logic goes the other way around: if both countries step away from the cliff-edge, the euro has room to advance, but also here, it may be limited.

Is this the result of the low volatility? Partially. The fuller answer lies with Trump. The president is seeking a trade war with the EU, especially on the cars. However, the Administration has opted to wage one trade war at a time, and will likely not initiate a clash with the EU without having the China issue resolved. Therefore, any outcome of the talks is a mixed blessing for EUR/USD.

5) British pound: Sterling is not shining amid the current trade tensions, but the pound's weakness also has to do with another set of talks: those between the government and the opposition on Brexit. As long as the negotiations continue in the background, the stage is set for the US-Sino discussions to impact the pound: positively on a resolution and adversely on new tariffs. 

However, Brexit is the overriding driver of GBP/USD. If PM Theresa May and Labour leader Jeremy Corbyn strike a deal, cable can ignore any breakdown in trade, crucial as it may be for the global economy. And if talks in London collapse, smiles in Washington will do little to alleviate pressure from the pound.