What we've learned about Trump 2.0
Markets - and China - are very real constraints on the second Trump presidency
What drives the current US administration? This is the question I get asked most frequently and - like everyone else - I really can’t say I know. But I do know that there are very real constraints - in the form of global markets and China - that limit how aggressive Trump 2.0 can be on tariffs. I’ll lay out these constraints in today’s post and, separately, discuss what I see as the biggest unknown, which in my mind is the only reason markets are debating reserve currency status of the US Dollar.
The pivotal moment for this administration came on April 2 - Liberation Day - when reciprocal tariffs were announced. Up until then, as the black line in the chart below shows, China had been holding the Yuan steady against the Dollar. In the days that followed, China began to devalue, dragging down all other emerging market (EM) currencies (blue line) in the process. It is likely that EM central banks sold some of their Treasury holdings at this time, mobilizing Dollars so that they could intervene to support their currencies if market turbulence worsened. That selling of Treasuries destabilized the bond market, causing yields to rise even as the Dollar fell, an eerie parallel with the UK’s 2022 bond market crisis. This episode ended with the US announcing a 90-day suspension of reciprocal tariffs on April 10. President Trump backed down.
This episode illustrates two hard constraints on the administration. The US is uniquely vulnerable to EM central banks selling their Treasury holdings en masse, as also happened in March 2020 at the height of the COVID shock (when the Fed did massive emergency QE to get the Treasury market back under control). China has the power to trigger such selling of Treasuries by devaluing the Yuan, giving it immense power over the US. The nexus of markets and China is the single biggest constraint on this administration and is why markets think the trade war is over.
The single biggest unknown - and the only reason there’s any kind of debate over reserve currency status - is where this administration stands on geopolitics and its allies. There are many who claim President Trump is soft on Russia. After all, the US didn’t join the UK and EU in their recent wave of sanctions on Russia’s shadow fleet. If the US is soft on Russia, what’s to prevent it from suddenly making a trade deal with China, i.e. markets can’t count on China tariffs being in place for any length of time. It is this geopolitical uncertainty that in my mind has caused the completely counterintuitive fall in the Dollar (when tariffs should have pushed it higher). Markets don’t price tariffs because they don’t think they’ll be around for very long.
As a result, the single most important thing the US can do to avoid any erosion of reserve currency status is to make clear that its alliances are ironclad and that Russia is a foe. I’m convinced this would remove many of the questions markets currently have about US reserve currency status and would cause the Dollar to rise alongside tariffs (as any model says it should).
This is an important subject and it has left many of us scratching our heads. So it good to have someone like RB return to it with this thoughts regularly, because it stimulates thinking in the rest of us.
But there are certain things he asserts in this post without providing any economic explanations. Why should the prospect of the imposition of tariffs inevitably cause the depreciation of trading partner currencies against the USD, as he states? Is it because when threatened with tariffs (or if haphazardly applied) in Trump 1.0, overseas foreign producers would “price to market” (PTM), which is to say their currencies would depreciate in tandem so that the cost to US importers would remain unchanged in US$ (with the addition of tariffs) and the cost of production to the foreign producers would also remain the same in local currencies? And if that is a likely reason why did it not work in Trump 2.0 after the initial weakening of some currencies?
RB seems to conclude that this time the financial markets saw through Trump’s threat as simply cheap talk. And he is probably right, but we should caution ourselves that PTM might be back if Trump’s talk does turn out to be tough talk rather than just cheap.
But the US$’s continuing weakness — made more confounding despite the Fed’s neutral stance, in the face of inertial inflation, against dovishness in other major CBs — then raises the question of the end of American exceptionalism, Trump’s wrecking of the international trade and monetary order and the dollar’s possible demise as a global reserve currency. Here I detect a subtle shift in Robin’s position. I seem to remember that till recently he dismissed that argument. there were no structural forces at play, it was all cyclical. The dollar had no real challengers, he would say. But now he has moved from a positive to a normative argument. The US “ought” to protect its currency’s paramount reserve status by reverting to Cold War muscularity. The brief pop in the dollar after Trump’s recent macho display of militarism leads me to conclude that he is on to something.
All very interesting, but in a way also quite sad!
Insightful post, thank you for sharing. I have a few questions:
“China has the power to trigger such selling of Treasuries by devaluing the Yuan”. Could you clarify why devaluing the RMB triggers the selling of treasuries? Intuitively, i thought aggressively devaluing ones currency would make people less interested in holding it and they would move to other currencies (like USD assets). Is it just triggering more destabilization causing people to want to sell Treasury and bring money back home?
I agree, and think it is still an understatement, to say allies are worried and want to hedge against the USA. The “reciprocal” tariffs we harshly put on EU, UK, Switzerland, Norway. This demonstrated Trump admin treats them the same as China, Russia, etc. Just an transactional obstacle to overcome. Add in the treatment by Trump/Vance to Ukraine (and borderline admiration of Putin) and I would be shocked Europe is not quickly moving to hedge against the USA and bet on itself. As an American, I am sad to say, it would be irresponsible for them not to.
Finally, a major assumption in your bullish dollar view seems to be that when tariffs trigger inflation the Fed will act rationally and raise interest rates (or at the least hold them steady). But with a new Fed chair nomination next year (and Trump openly saying he wants to directly run the Fed) what do you see that maintains your confidence the Fed will remain a rational, independent institution? Looking at who is in charge of other major institutions (Patel, Gabbard, Noem, RFK Jr, etc) what makes you believe this corrosion won’t reach the Fed. I think many people are still underestimating that a lot of Trump 1.0 admin were still professional, mission driven, technocrats (Wray, Miley, Esper, Powell). It is a fact this is not the case in Trump 2.0. I am pessimistic critical institutions can be run by people like that for years without some real loss of independence.
Thanks again for your time. Your posts help me learn and gain more perspective against my own views.