S9 Ep7: How exchange rates responded to tariffs

Episode Summary

Executive Summary: The episode explains why tariffs do not always strengthen the U.S. dollar. Giancarlo Cossetti argues that when tariffs trigger retaliation, the dollar can depreciate, and in 2025 the bigger story was a repricing of U.S. risk: Treasury yields rose, the dollar fell, and investors reassessed long-run safety of U.S. assets. This signals a regime shift in trade, finance, and policy.

Main Topics: Textbook view of tariffs and exchange rates (Priority: 5/5): The conventional model says tariffs reduce demand for foreign goods, leading to foreign-currency depreciation and domestic-currency appreciation, with relative price adjustments producing a real appreciation at home. Why Liberation Day surprised markets (Priority: 5/5): The April 2 tariff announcement was described as an unprecedented regime shift, with tariffs up to 25% and 100% plus expected retaliation, producing a fast dollar selloff rather than dollar strength. Retaliation versus unilateral tariffs (Priority: 5/5): Cossetti stresses that the right comparison is not tariff versus no tariff, but tariff versus tariff-plus-retaliation. In 2018-2020, unilateral tariffs appreciated the dollar, while retaliation offset or reversed that effect. Financial-market repricing of U.S. risk (Priority: 5/5): The 2025 episode was not just a trade shock; it also moved Treasury yields and broadened into a reserve-currency/dollar-risk shock, indicating investors reassessed the safety of U.S. assets. Long-run risk across three markets (Priority: 4/5): He argues equity, Treasuries, and the dollar now move together as international investors reprice long-run U.S. risk, unlike earlier periods when the dollar was less responsive. Implications for capital flows and policy (Priority: 4/5): The U.S. system of borrowing, asset flows, and trade balances is changing, with possible effects on monetary policy, fiscal policy, capital allocation, and the future of dollar dominance. Persistence and uncertainty in the new regime (Priority: 3/5): Cossetti says the old system will not return unchanged, but the final equilibrium remains uncertain because political risk, capital controls, taxation, and fragmentation could reshape investment patterns.

Key Arguments: Tariffs usually appreciate the home currency in textbook models because reduced demand for foreign goods shifts relative prices and exchange rates. The 2025 dollar decline is not a contradiction of economics if tariffs are paired with retaliation; retaliation can offset the expected appreciation. The 2018-2020 U.S. experience shows unilateral tariffs appreciated the dollar, while retaliated tariffs depreciated it; the size of the depreciation depended on how global the retaliation was. The 2025 episode differed because financial markets also repriced U.S. sovereign and reserve-currency risk, not just trade flows. Treasury yields moved sharply in the opposite direction from 2018, implying that tariff shocks were transmitted through broader financial channels. International investors are reassessing long-run risk in U.S. assets, and that reassessment links equities, Treasuries, and the dollar. The U.S. role in global finance is shifting from a stable 'Gulf Stream' model of asset issuance and goods absorption to a more expensive borrowing environment. Future monetary and fiscal policy will need to adapt to greater fragmentation, security concerns, and uncertainty around capital flows.

Data Points: Tariff magnitude on Liberation Day: Up to 25% and 100% - Described as shocking across-the-board tariff announcements on April 2, 'Liberation Day'. Dollar move against the euro: About 6% depreciation - The dollar fell substantially and quickly after the Liberation Day announcement. Timeframe of first Trump tariff episodes: 2018-2020 - Used as the main historical comparison period for tariff-response analysis. Global crisis market response: Not quantified - Speaker notes that earlier crises typically led to dollar appreciation, unlike this episode. Treasury-yield response in 2025: Rose sharply - The tariff shock was associated with an increase in U.S. Treasury yields, unlike the 2018 experience. Relative comparison in 2018 US-China case: Near-zero net dollar effect - Dollar appreciation from the tariff announcement was nearly offset by depreciation from China’s retaliation.

Pivotal Quotes: "The intuition is very simple. You put a tariff, there is a change in the relative demand for goods, there is less demand for Foreign goods, so there must be a depreciation for the foreign currency, an appreciation of domestic currency to balance out." — Giancarlo Cossetti: Explaining the standard textbook logic for why tariffs are expected to strengthen the home currency. "What we saw in the last 10 years is a shift in the risk assessment that has created a change in the way the US is borrowing." — Giancarlo Cossetti: Describing the broader financial revaluation behind the 2025 dollar and Treasury-market moves. "The three markets together sing the same song. There is a repricing the reassessment of long-run risk by international investors." — Giancarlo Cossetti: Summarizing how equities, Treasuries, and the dollar now reflect a unified U.S. risk premium.

Implications: Tariffs now affect exchange rates through retaliation and risk re-pricing, not just trade balances. Markets may no longer assume the dollar rises in crises, and U.S. borrowing could become more expensive if investor confidence in safe assets weakens.