Trump tariff plan explained: What are trade wars and how do they affect currencies

Here are some answers to trade wars.

What are trade wars?

The term trade war refers to countries imposing tariffs or other trade limitations such as quotas or regulations on each other. A move by one country to punish another is then reciprocated by another country. The measures are often described as "tit for tat" -  one nation responds with an action that is more or less equal to the rule imposed by its peer. This was common around the Great Recession in the 1930s. 

Why are we talking about trade wars?

The America First agenda of US President Donald Trump was not evident in over a year after assuming office but his announcement on a 25% tariff on steel and 10% on aluminum, both critical metals, put the topic back on the agenda. The threats of retaliation by the European Union and others kept the issue at the top. The moves by Trump are a sharp break from the trend in the past decades: fewer and fewer tariffs and other barriers, and more and more Free Trade Agreements (FTAs).

Are we at a full-scale trade war?

Not yet. While the tariffs on essential metals is a severe escalation, the exemptions for Canada, Mexico, and Australia and an open door for further exceptions somewhat take out the sting out of the announcement. Moreover, the US and other countries have imposed the occasional tariffs and enacted countermeasures via the WTO in the past. So far, these were the exceptions and not the norms. However, things may escalate. 

What would trade wars do to the global economy?

Higher tariffs and barriers limit trade and thus lower potential economic growth and may even swirl the world into a global recession. The countries which have trade surpluses and are dependent on exports would suffer most. This includes China, other emerging markets in Asia, commodity exporters in Africa, and also Germany which has a high trade surplus. 

What would trade wars do to inflation?

Inflation would go up everywhere. Trade opens markets and facilitates economies of scale. If a country needs to produce goods it does not specialize in, these products will be more expensive. Examples are toys from China, clothing from Bangladesh, machinery from Japan, and even wine from Britain. 

How will trade wars affect interest rates? 

Higher inflation implies higher rates. However, the ensuing recession may convince central banks to keep rates at a low level to encourage economic activity. Lower rates result in a weaker exchange rate, making exports more attractive but angering trade partners even further. 

How do trade wars end? 

Am agreement to undo the measures may come after negotiations, defusing the situation. A more adverse outcome is that the atmosphere calms down leaving the new tariffs in place, lowering global trade but not escalating. The worst scenario is that the resulting economic deterioration and nationalistic sentiment contribute do a real war, not only a trade war. That is what happened in the 1930s, and we are very far from there. 

What do markets think about trade wars?

They do not like it. Markets prefer fewer barriers to trade. Trade wars scare stock markets and trade agreements are cheered by them. 

How do currencies react to trade wars?

In general, the countries that see their exports punished also see their currency punished. Countries that see their exports guarded against tariffs can see their currencies gain. The currency swing then balances things out: a country with a weaker exchange rate has more attractive exports. 

Which currencies were affected most by the recent round? 

The Canadian Dollar, and to a lesser extent, the Australia Dollar. Canada exports most of its steel to its neighbor, the US. The tariffs sent the Canadian Dollar down. When Canada was exempted, the loonie surged. The Aussie benefited from the exemption but to a lesser extent. The moves demonstrate how tariffs or lack thereof move the "punished" country.

Which currency may suffer next due to trade wars?

The euro. The euro-zone and Germany, in particular, are net exporters. A tariff on cars or car parts may weigh on the common currency. However, a tit for tat trade war between the US and the EU will eventually hurt the US as well. Contrary to Canada, the euro-zone economy is vast. 

How do trade wars play out with safe-haven currencies? 

Safe-haven currencies, and most prominently the Japanese Yen, gain in times of trouble, even if the trouble is at home. The Yen may benefit as things deteriorate. Yet if they go too far and Japanese exports are hurt, the Japanese currency may turn south as well. The Swiss franc, currently a second-tier safe-haven, may gain and gain on inflows.

How will the pound react to a trade war? 

The UK is still part of the EU (but not the euro-zone), and the fate of the pound depends on the outcome for the whole project, at least for now. Exemptions for Britain may complicate matters in the Brexit negotiations and may have unknown consequences. In general, weaker global trade and weaker global growth are not good for Britain, mainly out of the EU. 

What is next? 

A lot depends on Trump. The President was happy with the gains of stock indices and may prefer to tame down new moves to keep equity markets happy. A fall in stocks may give the notion that there is nothing to lose and may worsen matters.

The reactions of trade partners matter too. At the moment, the vast majority of the world, including the largest blocs, the EU, China, and Japan are deeply devoted to opening up trade and not undermining it. The remaining 11 members of the TPP agreement that Trump abandoned have signed a new deal. The EU and Japan are working on a free trade deal, and China's Belt and Road Initiative (BRI) is meant to facilitate trade.