Our Head of Foreign Exchange & Emerging Markets
Strategy James Lord discusses how much tariff-driven
volatility investors can expect in currency markets this year.
----- Transcript -----
Welcome to Thoughts on the Market. I’m James Lord, Morgan
Stanley’s Head of Foreign Exchange & Emerging Markets
Strategy.
Today – the implications of tariffs for volatility on foreign
exchange markets.
It’s Thursday, February 13th, at 3pm in London.
Foreign exchange markets are following President Trump’s tariff
proposals with bated breath. A little over a week ago investors
faced significant uncertainty over proposed tariffs on Mexico,
Canada, and China. In the end, the U.S. reached a deal with
Canada and Mexico, but a 10 per cent tariff on Chinese imports
went into effect. Currencies experienced heightened volatility
during the negotiations, but the net impacts at the end of the
negotiations were small. Announced tariffs on steel and aluminum
have had a muted impact too, but the prospect of reciprocal
tariffs are keeping investors on edge.
We believe there are three key lessons investors can take away
from this recent period of tariff tension. First of all, we need
to distinguish between two different types of tariffs. The first
type is proposed with the intention to negotiate; to reach a
deal with affected countries on key issues. The second type
of tariff serves a broader purpose. Imposing them might reduce
the U.S. trade deficit or protect key domestic industries.
There may also be examples where these two distinct
approaches to tariffs meld, such as the reciprocal tariffs that
President Trump has also discussed.
The market impacts of these different tariffs vary
significantly. In cases where the ultimate
objective is to make a deal on a separate issue, any currency
volatility experienced during the tariff negotiations will very
likely reverse – if a deal is
made. However, if the tariffs are part of a
broader economic strategy, then investors should consider more
seriously whether currency impacts are going to be more
long-lasting. For instance, we believe that tariffs on imports
from China should be considered in this context. As a result, we
do see sustained dollar/renminbi upside, with that currency pair
likely to hit 7.6 in the second half of 2025.
A second key issue for investors is going to be the timing of
tariffs. April 1st is very likely going to be a key date for
Foreign Exchange markets as more details around the America First
Trade Policy are likely revealed. We could see the U.S. dollar
strengthen in the days leading up to this date, and investors are
likely to consider where subsequently there will be a more
significant push to enact tariffs.
A final question for investors to ponder is going to be whether
foreign exchange volatility would move to a structurally higher
plane, or simply rise episodically. Many investors currently
assume that FX volatility will be higher this year, thanks to the
uncertainty created by trade policy. However, so far, the
evidence doesn’t really support this conclusion. Indicators that
track the level of uncertainty around global trade policy did
rise during President Trump's first term, specifically around the
period of escalating tariffs on China. And while this was
associated with a stronger [U.S.] dollar, it did not lead to
rising levels of FX volatility.
We can see again, at the start of Trump's second term, that
rising uncertainty over trade policy has been consistent with a
stronger U.S. dollar. And while FX volatility has increased a
bit, so far the impact has been relatively muted – and implied
volatility is still well below the highs that we’ve seen in the
past ten years. FX volatility is likely to rise around key dates
and periods of escalation; and while structurally higher levels
of FX volatility could still occur, the odds of that happening
would increase if tariffs resulted in more substantial macro
economic consequences for the U.S. economy.
Thanks for listening. If you enjoy the show, leave us a review
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