U.S.-China trade spat interrupts dollar's dip, for now

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The signs of a U.S. and global recovery -- and a revived appetite for risk -- have weakened the dollar about three percent during the past two weeks versus the world's other major currencies. But now a U.S.-China trade spat threatens to reverse that trend.

After the Obama administration slapped an up to 35 percent tariff on China's exported tires, China indicated it would restrict U.S. imports of chicken and auto products, and demanded trade talks to resolve the dispute, The Wall Street Journalreported Monday.

A temporary tiff over tires

Although the spat is unlikely to fundamentally alter the U.S.-China trade relationship -- the two economic giants benefit from hundreds of billions of dollars in bilateral trade annually -- it was enough to nudge the dollar slightly higher on Monday versus the euro, British pound, and yen. The dollar strengthened about one-half cent to $1.4539 versus the euro, about 1.5 cents versus the British pound to $1.6532, and about 1 yen to 91.07 against Japan's yen.

Currency trader Andrew Resnick told DailyFinance Monday there's no risk of a Sino-U.S. trade war breaking out, but the currency market "is concerned about rising sentiment in favor of tariffs and protectionism."

"We have many weak economies around the world and a recovery that's only just begun. No one is really fearing a 1930s-style protectionist period, but there is concern that governments may try to tweak trade policy in niche industries, protect tires over here, protect rice products over there, and that could hamper the recovery," Resnick said. "It would represent another irritant for a global economy that doesn't need any more." Resnick added that we was presently short with the dollar versus the euro.

During the 1930s, a severe decline in demand and corporate revenue prompted governments around the world to protect domestic industries with high tariffs. That further decreased international trade and lengthened the Great Depression. For the above reason, most economists oppose tariffs: they may prop-up or protect a domestic company, but as other nations impose them, the net result is decreased international business, hurting all countries involved.

Provided the U.S.-China trade spat is reconciled -- the G-20's meeting next week in Pittsburgh may serve as convenient forum to ease trade tensions -- Resnick said he expects the dollar to continue to weaken slightly versus the euro, pound, and yen, as institutional investors seek higher-returning assets in emerging markets and cycle out of U.S. treasuries and other dollar-denominated assets.

However, Resnick does not see a major dollar decline in the quarters ahead. "There will be some money flow back to Asia and some dollar selling versus the euro and pound, but overall the dollar should continue to hold its own against the euro and British pound because Europe is later in the economic cycle than the U.S.," Resnick said, adding that the above also assumes the U.S. economy recovers and GDP turns positive in Q3/Q4.

And as with most economic trends, there's an upside/downside to a slightly weaker dollar in the next year. The upside? It will lower the cost of U.S. exports to purchasers abroad, making those American goods and services more attractive -- something that will likely further decrease the U.S. trade deficit. The negative? U.S. interest rates will rise slightly, as the U.S. government is forced to increase short-term rates to fund its record budget deficit and national debt and attract capital that has other and, in many cases, higher-return options. On Monday, the U.S. 10-year note increased four basis points to 3.39 percent.

Dollar Analysis: It appears the U.S.-China tire tariff spat will only temporarily boost the dollar. That said, as noted, don't expect a dollar collapse in the quarters ahead. True, the U.S. is battling a record budget deficit -- a decided dollar negative -- but if the U.S. economy continues to mend, that will attract capital back to the U.S., and support the buck.
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