How Do Tariffs Affect Currencies?

Our Head of Foreign Exchange & Emerging Markets Strategy James Lord discusses how much tariff-driven volatility investors can expect in currency markets this year.
----- Transcript -----
Welcome to Thoughts on the Market. I’m James Lord, Morgan Stanley’s Head of Foreign Exchange & Emerging Markets Strategy. Today – the implications of tariffs for volatility on foreign exchange markets. It’s Thursday, February 13th, at 3pm in London. Foreign exchange markets are following President Trump’s tariff proposals with bated breath. A little over a week ago investors faced significant uncertainty over proposed tariffs on Mexico, Canada, and China. In the end, the U.S. reached a deal with Canada and Mexico, but a 10 per cent tariff on Chinese imports went into effect. Currencies experienced heightened volatility during the negotiations, but the net impacts at the end of the negotiations were small. Announced tariffs on steel and aluminum have had a muted impact too, but the prospect of reciprocal tariffs are keeping investors on edge. We believe there are three key lessons investors can take away from this recent period of tariff tension. First of all, we need to distinguish between two different types of tariffs. The first type is proposed with the intention to negotiate; to reach a deal with affected countries on key issues. The second type of tariff serves a broader purpose. Imposing them might reduce the U.S. trade deficit or protect key domestic industries.There may also be examples where these two distinct approaches to tariffs meld, such as the reciprocal tariffs that President Trump has also discussed. The market impacts of these different tariffs vary significantly. In cases where the ultimate objective is to make a deal on a separate issue, any currency volatility experienced during the tariff negotiations will very likely reverse – if a deal is made. However, if the tariffs are part of a broader economic strategy, then investors should consider more seriously whether currency impacts are going to be more long-lasting. For instance, we believe that tariffs on imports from China should be considered in this context. As a result, we do see sustained dollar/renminbi upside, with that currency pair likely to hit 7.6 in the second half of 2025. A second key issue for investors is going to be the timing of tariffs. April 1st is very likely going to be a key date for Foreign Exchange markets as more details around the America First Trade Policy are likely revealed. We could see the U.S. dollar strengthen in the days leading up to this date, and investors are likely to consider where subsequently there will be a more significant push to enact tariffs. A final question for investors to ponder is going to be whether foreign exchange volatility would move to a structurally higher plane, or simply rise episodically. Many investors currently assume that FX volatility will be higher this year, thanks to the uncertainty created by trade policy. However, so far, the evidence doesn’t really support this conclusion. Indicators that track the level of uncertainty around global trade policy did rise during President Trump's first term, specifically around the period of escalating tariffs on China. And while this was associated with a stronger [U.S.] dollar, it did not lead to rising levels of FX volatility. We can see again, at the start of Trump's second term, that rising uncertainty over trade policy has been consistent with a stronger U.S. dollar. And while FX volatility has increased a bit, so far the impact has been relatively muted – and implied volatility is still well below the highs that we’ve seen in the past ten years. FX volatility is likely to rise around key dates and periods of escalation; and while structurally higher levels of FX volatility could still occur, the odds of that happening would increase if tariffs resulted in more substantial macro economic consequences for the U.S. economy.Thanks for...