Bank of America says some tariff risk premium is likely to remain in US dollar
The US dollar has been on a roller-coaster ride in recent years. After reaching multi-decade highs in late September 2022, the currency weakened substantially through the end of the year and into early 2023. This depreciation was driven by a number of factors, including easing inflation, declining US Treasury yields, and a reduction in safe-haven demand. However, the greenback has found its footing again in recent months, and some analysts believe that it could be poised for further gains.
One of the factors that could support the dollar in the coming months is the ongoing risk of tariffs. While the Trump administration’s trade war with China has cooled, the potential for renewed trade tensions remains. Bank of America analysts argue that this risk is likely to keep a "tariff risk premium" embedded in the dollar. This premium reflects the fact that investors are willing to pay a higher price for dollars as a hedge against the possibility of disruptive trade policies, which could negatively impact global trade and economic growth. When trade tensions escalate, investors tend to flock to safe-haven assets like the US dollar, driving up its value.
The tariff risk premium is not the only factor supporting the dollar. Other potential drivers include the relative strength of the US economy, the divergence in monetary policy between the US Federal Reserve and other central banks, and safe-haven demand related to geopolitical risks and global economic uncertainties. In terms of economic fundamentals, the US economy has shown resilience, with strong labor market data and steady consumer spending, offering continued support for the dollar. The divergence in monetary policy – where the Fed keeps interest rates at a relatively higher level than other central banks – also contributes to the dollar’s appeal, as it attracts yield-seeking investment flows.
However, there are also factors that could weigh on the dollar. One is the ongoing debate over the US debt ceiling. If Congress fails to raise the debt ceiling, the US government could default on its debt, which would have catastrophic consequences for the global economy and negatively impacting the dollar. A default would severely damage the credibility of the US government and undermine confidence in the US dollar as a global reserve currency. Investors would likely flee from US assets, including the dollar, leading to a sharp decline in its value.
Another potential headwind for the dollar is the possibility that the Fed could start to cut interest rates later this year. If the Fed does cut rates, it would reduce the attractiveness of US dollar-denominated assets, making them less attractive compared to assets in other currencies with higher yields. This narrowing of the interest rate differential could potentially lead to outflows from the dollar and put downward pressure on its exchange rate. Furthermore, a less hawkish stance from the Fed could signal concerns about the health of the US economy, potentially weakening the dollar.
On balance, Bank of America believes that the tariff risk premium is likely to remain in the US dollar for the foreseeable future. This, combined with other supporting factors, suggests that the dollar is likely to remain relatively strong in the near term. However, the risks to the outlook are tilted to the downside. The debt ceiling debate and the possibility of Fed rate cuts could both weigh on the dollar in the coming months. Additionally, any easing of global trade tensions or signs of a slowdown in the US economy could diminish the tariff risk premium and negatively impact the dollar’s strength. Thus, the trajectory of the US dollar remains uncertain and contingent on the interplay of these complex and often evolving factors.
The foreign exchange market is constantly in flux, responding to a wide range of economic, political, and geopolitical developments. The US dollar, as the world’s dominant reserve currency, is particularly susceptible to these shifts. Understanding the multitude of forces impacting the dollar’s value, including the potential for a lingering tariff risk premium, is crucial for investors, businesses, and policymakers alike. Accurate forecasts and prudent risk management strategies are vital in navigating the uncertainties and potential volatility of the currency markets. Whether the dollar continues its recent ascent or succumbs to downside pressures, its movements will have far-reaching implications for global trade, investment flows, and economic growth.
