One catalyst that has drawn most of the market’s attention recently is the intensifying trade war rhetoric surrounding US tariffs, and what the retaliatory response will be from affected nations. The Trump administration has granted temporary tariff exemptions for Australia, but the AUD/USD exchange rate is not out of trouble. The Australian economy could still face quotas on its steel and aluminum exports to the USA.
Trade war talks are very difficult to read from the market perspective, and instead, we need to make assumptions of the effect of the tariffs by analyzing statements by the negotiators and the governments involved in the discussion.
The current escalation of the trade war between the USA and China, will also indirectly affect the Australian economy because China is still Australia’s largest trading partner. When China’s economy suffers there will be a negative effect on the Australian economy.
China is also planning to levy their own tariffs in equal measure in retaliation to the US tariffs. There is a great risk that this trade war will very quickly escalate to critical levels.
An optimistic scenario is that in the long-term the trade war rhetoric will dissipate and that the US will not pursue aggressive tariffs on trade. However, if the current rhetoric continues, it will undermine any market confidence and belief in the potential for participants to reach an agreement.
The AUD/USD Implications if a Deal is not reached
The Australian dollar (AUD) has been under pressure since the end of January 2018 because of the risk of a full-blown trade war between the US and China. This makes it much harder for the RBA to raise interest rates. The prospects of lower rates, coupled with the US Fed pursuing a much more aggressive tightening cycle in monetary policy, will continue to have a negative impact for the medium to long-term on the AUD/USD exchange rate.
Aussie crosses, however, are giving traders a lot of very appealing technical positions as the AUD/USD broke several key pivot points which makes the case for a bearish scenario much more realistic.
However, once all the trade war fears are priced in by the market, we could see a “buy the rumor, sell the news” type of event. In this case, the AUD/USD exchange rate, despite the bearish directional bias formed, could have a large squeeze rally.
The Historical Perspective
In order to understand how the Australian Dollar will react if a deal on trade tariffs is not reached, traders need to understand how the US Dollar could be impacted. The US Dollar is still the most traded currency in the world, so it makes sense to know when big fundamental catalysts are at work to drive the exchange rate.
If history is our guide, in general, trade wars are bad for the US economy and the USD.
The last time the US imposed steel tariffs was in 2002 under the G.W. Bush administration, and as a result, the USD entered into a prolonged bear market. In essence, all protectionist policies are not just bad for the US economy but likely will negatively impact the global economy as well.
Currently, the US dollar is performing in an unexpected way. This is because it’s gaining value despite the looming trade war risk. This behavior can be attributed solely to the USD safe-haven status, but the US dollar can’t retain its safe-haven status if tariffs are enacted and retaliation is swift.
If the US enacts these tariffs and there is coordinated retaliation, capital will start to flee the US economy and given the quick nature of trade war escalations, that would put the US dollar at high risk of significantly losing value and cause rapid inflation. In this scenario, commodity-based currencies, like the AUD, could potentially benefit the most as a result of a full-blown trade war between US and China and other major trading partners.