The Dollar's Trajectory: Navigating Market Volatility Amidst Trade Uncertainty
The US dollar (DX=F, DX-Y.NYB) traded near recent lows on Tuesday as investors parsed President Trump's latest tariff-related statements. On Monday, the dollar index experienced its most significant drop since November 2023, reversing from near two-year highs after Trump refrained from imposing broad-based tariffs on his first day in office.
Analysts were surprised by this move, as an emergency order would have allowed immediate tariff increases, unlike the lengthier investigation process that is currently underway. Instead, Trump issued a memorandum directing federal agencies to assess US trade policy, potentially paving the way for blanket tariffs on various trading partners. Later on Monday, the president indicated that levies on Mexico and Canada could materialize as early as February 1st, initially driving the dollar off its lows. However, the currency subsequently regained half of its losses before eroding those gains.
"The dollar's extraordinary sensitivity to the tariff outlook is evident," said Kyle Chapman, FX analyst at Ballinger Group. "The new administration signals that Trump's fast-paced trade policy may be less aggressive than the market anticipated." Chapman believes the absence of immediate blanket tariffs "suggests that the dollar may have peaked, although caution is warranted."
Mohamed El-Erian, Allianz's chief economic adviser, emphasized that the dollar's volatility reflects a new market paradigm. "This is not a short-lived event," he said. "Risks exist on both sides, and these uncertainties will persist."
Morgan Stanley strategists Michael Zezas and Michael Gapen noted that Trump's vacillating rhetoric "highlights the need for vigilance, as US policy direction could evolve rapidly." They maintain that any policy adjustments are unlikely to be realized until the latter half of the year.
The greenback's recent performance has been primarily influenced by two factors: Trump's election and Republican control of Congress, alongside the reassessment of potential Fed easing in light of robust economic data. After reaching a September low, the US Dollar Index, which measures the dollar's value against a basket of six foreign currencies, has rallied almost 10%. Since the election, it has increased by approximately 5%.
Despite recent declines, Bank of America advises cautious optimism regarding the pricing of tariff risk into the dollar. "Even if tariffs are delayed, they remain a cornerstone policy for the new administration," said Adarsh Sinha, lead FX and rates strategist at BofA. "Uncertainty around the timing of tariff increases persists."
A stronger dollar could, however, pose challenges for stocks. "Dispersion in earnings per share (EPS) revisions is likely to increase during earnings season due to a stronger dollar," Morgan Stanley's Mike Wilson wrote in a recent note. Companies with substantial overseas operations, such as consumer goods and household products, will face challenges from slower earnings growth resulting from unfavorable foreign exchange conversions.
El-Erian cautioned that a strong dollar could also diminish domestic competitiveness and adversely impact emerging markets that borrow in dollars but earn in local currencies. "Stability in the dollar's valuation is desirable," he said. "However, this requires concerted action from other countries. If Europe and China continue to underperform, the upward pressure on the dollar will intensify."
"Ultimately, the trajectory of the dollar will be influenced by the reality of President Trump's inheritance and the potential complications arising from policies like tariffs," added El-Erian.