A Trade-Off War Is Brewing

Originally posted at Briefing.com

The new administration has made no bones about its dislike for past trade agreements, namely the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP). President Trump signed an executive order withdrawing the US from the TPP and he has vowed to renegotiate NAFTA.

Talk of border taxes, immigration restrictions, and the president's own view that "...our dollar is too strong" have created a lot of hubbub that a global trade war is brewing.

It's a bothersome consideration that has slowed the stock market's rally effort in recent weeks, but to be fair, it hasn't derailed that rally effort.

The S&P 500 is still only a whisker away from its all-time high; 9 out of 11 S&P 500 sectors are sporting a gain in 2017; and the Russell 2000, which surged 14% between November 8 and December 30, has tacked on another 1.3% to begin the year.

Might there be an actual trade war? It is not out of the realm of possibility, but like many other things with the new administration, it remains an open question.

The answer will avail itself in due time. In the meantime, we'd like to direct readers' attention to the trade-off war that is brewing and which could make a trade war either more, or less, possible.

An Invite

Generally speaking, everyone wants the US economy to thrive. That would be good for the global economy on a variety of levels, one of the most prominent of which is that it would create more jobs.

Stronger growth, however, won't occur in a vacuum. There will be trade-offs with that growth. Stronger growth will invite higher inflation.

Higher inflation will invite higher interest rates.

Higher interest rates will invite a strengthening in the dollar.

And that's where we'll stop because the dollar is where the center of the trade universe seems to lie these days.

Going Head-to-Head

A strong dollar places US exporters at a competitive disadvantage as foreign competitors, aided by a cheaper currency, have the ability to undercut them on price. Additionally, a stronger dollar creates an earnings headwind for US multinationals -- a point of order that has been heard throughout the fourth quarter earnings reporting period.

These are points that have been oft-repeated in this column and the popular press, so there is no new ground being broken with those observations.

The new ground that has been broken recently with respect to a stronger dollar is that President Trump thinks it is too strong and that it is hurting the ability of US companies to compete.

That view runs in stark contrast to the traditional line out of Washington through the years that a strong dollar is in the interest of the United States. Then again, everyone has quickly learned that President Trump isn't interested so much in toeing the Washington line.

Still, the president's view of the dollar, and his administration's recent contention that Germany has unfairly benefited from a "grossly undervalued euro," and that China and Japan have also reaped the trade benefits of their weaker currencies, has stirred some angst that future trade negotiations will create more problems than solutions for the global economy if they result in protectionist posturing.

While the president's tough talk registers favorably with his supporters at home, it is important to remember that the leaders he will be dealing with have their own supporters and their own desire to maintain their leadership position.

In other words, they, too, have a vested interest in not looking weak and/or kowtowing to US trade demands. There needs to be trade-offs for both parties to save face, yet if it's a stand-off that happens, the end result won't be a favorable one.

Complications and a Paradox

The complicating factor in this mix is monetary policy.

Central banks in the eurozone, and Japan, in particular, continue to embrace a very accommodative monetary policy. The Federal Reserve, meanwhile, has started to tighten its monetary policy and has signaled that it sees scope to raise the fed funds rate three times in 2017.

These disparate approaches to monetary policy have sparked interest-rate differential trades that have provided an added boost to the dollar. The dollar, therefore, has benefited at the expense of the euro and the yen on account of better views about economic growth prospects for the US and higher interest rates here.

Arguably, a pickup in economic growth in the eurozone and Japan would lead to higher interest rates there that, in turn, would take some wind out of the dollar's sails (which has been seen of late). That stronger growth won't happen, though, if the US adopts a protectionist trade stance.

On another level, the Federal Reserve's outlook for the US economy and its own interest rate projections are dollar supportive in their own right, as would be a fiscal stimulus plan and border tax, as discussed by the Trump Administration.

The paradox, then, is that President Trump contends the dollar is too strong at a time when his administration is advancing policy ideas that should help strengthen the dollar, not weaken it.

In the time it takes to get those policies implemented, assuming they are approved by Congress, the Federal Reserve could very well have increased the fed funds rate again and perhaps more than once.

Time will tell there, too, yet the point is that would support the dollar further, particularly if other central banks have stayed on their easy course. That could create some unwanted rancor from the White House directed at the Federal Reserve.

What It All Means

There is no question that President Trump's domestic priorities continue to underpin the stock market. Foreign policy and trade issues, however, are simmering in the background.

A trade war isn't in the global economy's best interest, never mind in the best interest of the United States.

If the stronger economic growth manifests itself here like the stock market has been hoping, then it will lead to some important trade-offs that will help shape the policy narrative on trade.

That narrative doesn't have to contain an unhappy ending, yet it most likely will if the dollar's strength is held out as an excuse to embrace a protectionist bargaining model that leads to a series of trade battles, if not a full-fledged trade war.

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Chief Market Analyst
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