Market and Volatility Considerations
Table of Contents
Tariffs Then Dollars or Investments
A second Trump term is likely to be even more forceful than the first when it comes to reconfiguring the international trading and financial systems. With President Trump unable to run for another term, he can focus on his legacy and achieving some of his core goals of reindustrialization, manufacturing revitalization, and improved international competitiveness.
I have reviewed a menu of policy tools that can work toward these ends. Although volatility risks are material, President Trump has shown repeated concern for the health of financial markets throughout his Administration. That concern is fundamental to his view of economic policy and the success of his presidency. I therefore expect that policy will proceed in a gradual way that attempts to minimize any unwanted market consequences of efforts to improve burden sharing for provision of reserve assets and the defense umbrella.
Further, President Trump is familiar with tariffs and they successfully raised revenue the first time around on China, whereas major changes to dollar policy would be a new foray for him and several of his trusted advisors have in the past warned of potentially risky side effects. Tariffs offer revenue in a time of large deficits, whereas currency adjustments do not.
These considerations suggest several consequences:
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There is good reason to be more cautious with changes to dollar policy than with changes to tariffs.
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Steps to strengthen undervalued currencies will likely not be taken until risks can be mitigated. The Administration will likely wait for more confidence that inflation and deficits are lower, to limit potentially harmful increases in long yields that could accompany a change to dollar policy. Waiting for turnover at the Federal Reserve increases the likelihood that the Fed will voluntarily cooperate to help accommodate changes in currency policy.
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Tariffs are a tool for negotiating leverage as much as for revenue and fairness. Tariffs will likely precede any shift to soft dollar policy that requires cooperation from trade partners for implementation, since the terms of any agreement will be more beneficial if the United States has more negotiating leverage. Last time, tariffs led to the Phase 1 agreement with China. Next time, maybe they will lead to a broader multilateral currency accord.
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Therefore, I expect policy to be dollar-positive before it becomes dollar negative. While tariffs are now decently understood—tariffs will cause some dollar appreciation, though the extent of that appreciation is debatable—the contours of currency policy are less well understood, in part because it hasn’t changed in decades. That also argues for more caution on currency changes than tariff changes.
There is another potential use of the leverage provided by tariffs: an alternative form of Mar-a-Lago Accord that sees the removal of tariffs in exchange for significant industrial investment in the United States by our trading partners, China chief among them. Such an exchange was critical in resolving trade conflicts during the Reagan Administration (and spearheaded in part by Robert Lighthizer). In comments in July, President Trump indicated he would welcome China building, among other things, auto factories in the United States.26 While such an agreement is possible, there are some reasons for caution.
First, China does not have a good record abiding by trade deals it makes with the U.S., and the memory of Phase 1 is still fresh. The U.S. ougbt to therefore demand some security—for instance, China’s Treasury portfolio in escrow—to ensure it abides by a deal like this one. Second, China is loath to make such concessions as exporting some its industrial production abroad in a way that creates jobs for non-Chinese, and would likely require lengthy negotiations or significant pressure to do so.
The U.S. is not likely to sit idly by while China drags out negotiations, so tariffs will likely be imposed to create urgency for any such talks. This is likely still a case of tariffs first, then a deal, because the deal requires some pressure to take form.
Moreover, because reducing inflation is critical to helping alleviate bond market concerns as well as allowing the Fed to pursue a deeper cutting cycle, a Trump Administration is likely to prioritize structural policies that reduce inflation via supply side liberalization. That means aggressive deregulation, and a concentrated effort to reduce energy prices.
This combination is probably bearish oil prices, but ambiguous for energy producers, and quite bullish for equities and growth. If deregulation boosts potential growth and reduces inflation—as this contributed to the noninflationary growth experienced in the first Trump Administration—that will help support both the bond and equity markets.
Finally, tariffs could be implemented in a way that offers graduated scales based on other nations’ willingness to share the burdens of reserve asset and defense umbrella provision. Countries that are happy to help share the burden and work to be inside the security zone will likely receive lighter tariffs. Assets in countries receiving higher tariffs are likely to suffer disproportionately.
Multilateral Currency Approaches
Getting trading partners to agree to a multilateral approach to strengthening undervalued currencies can help contain unwanted volatility. An agreement whereby our trading partners term out their reserve holdings into ultralong duration UST securities will:
- a) alleviate funding pressure on the Treasury and reduce the amount of duration Treasury needs to sell into the market;
- b) improve debt sustainability by reducing the amount of debt that will need to be rolled over at higher rates as the budget deteriorates over time
- c) solidify that our provision of a defense umbrella and reserve assets are intertwined. There may even be arguments for selling perpetuals rather than century bonds, in this eventuality.
In this world, both the dollar and long yields can come down together, instead of moving in opposite directions. But, as argued above, terming out the duration of Treasury held by friendly/ally countries’ central banks is hard enough; such flows will have to overwhelm selling from private sector agents, which depending on their sensitivity for foreign exchange losses, can be substantial. The reason for the uncertainty is that much of the private sector ownership of USD assets is for reserve purposes and therefore much less price sensitive.
To what extent this is more than a shortterm blip will depend on the scope of currency losses, private sector sensitivity, the size of the improvement to the longer-term U.S. budget outlook, and whether the Federal Reserve decides to coordinate with the process.
Unilateral Currency Approaches
Unilateral currency approaches bring bigger volatility risks, but increased flexibility of action. If the Fed creates dollars with which to buy foreign assets, it may seek to sterilize that money creation, and sterilization has consequences—likely, higher front yields, lower back yields, and a flatter yield curve.
If Treasury imposes a user fee on foreign reserve holders’ USTs, it will be very helpful if the Fed is willing to help contain any unwanted volatility in interest rates, subject to the Fed’s freedom to pursue its inflation mandate.
Should the Fed not help with a unilateral shift in currency policy, there is scope for greater volatility. If the U.S. takes steps to discourage foreign holders of Treasurys by imposing a user fee on remittances of interest or principal, term premia can increase as foreigners reduce their holdings. Sharp increases in Treasury yields can lead to declines in the stock market.
Therefore the Administration, in such an approach, is likely to move gradually, and start with very small increments of withholding. Small and slow movements would reduce volatility, but increase the amount of time it takes to find the right combination of interest rates and currency values for the Administration. Patience will be helpful.
Despite any attempts at gradualism, the market may move sharply anyway; the hint of such a policy change could induce significant market moves without any need for actually implementing the policy. Such volatility risks spiking long yields as global investors rebalance out of USD assets.
Without the assistance of the Fed in capping yields, or of foreign reserve holders terming out their debt, an Administration has fewer good options for intervention to stabilize yields. However, there are still some tricks:
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Activist Treasury Issuance of the type discussed in Miran and Roubini (2024). By shortening the maturity profile of its debt, Treasury can reduce supply of duration to offset the increased supply that occurs as a result of foreign sales. There are limits and costs to such a policy, as discussed in Miran and Roubini (2024). The justification for ATI in this context would be to buffer volatility due to foreign selling.
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The Exchange Stabilization Fund may be used to help reduce volatility in this instance.
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Pursue a parallel policy of deregulation, cheap energy and fiscal consolidation aimed at reducing deficits and inflation, which will boost aggregate demand and reduce supply of debt to help offset sales by foreigners. Nonfinancial steps to shore up the fundamental attractiveness of UST securities can help.
None of those provides a huge amount of short-term financial power against market volatility, while they may prevail over longer periods of time. It is clear that taking this type of unilateral approach is riskier, but it nevertheless is an option if the President decides he wants to pursue changes to the currency markets.
In All Cases
There are some common consequences across all these possible scenarios, if the Administration pursues any of them. First, a much stronger demarcation between friend, foe and neutral trading partner. Friends are inside the security and economic umbrella, but there is more burden sharing. Based on the scope of that burden sharing, friends may experience more favorable trade or currency terms.
Those outside the security umbrella will also find themselves outside friendly arrangements for international trade and easy access to the U.S. consumer. They will have more aggressive costs imposed on them via tariffs and other policies. There are obvious implications for asset prices. Second, the threat of withdrawal of the security umbrella without burden sharing will have its own, potentially volatile, consequences.
Will it spur nations around the world to invest more in defense? Will it encourage more aggressive action by bad actors against those now outside the defense umbrella? These are significant degrees of uncertainty which will permeate markets. Risk premia may rise for assets in countries that now experience greater security risks. Third, a structural increase in implied volatility in currency markets. The scope for monumental, once-every-fewdecades level of shifts in policy ought to significantly heighten expectations for volatility.
Fourth, these policies may supercharge efforts of those looking to minimize exposure to the United States. Efforts to find alternatives to the dollar and dollar assets will intensify. There remain significant structural challenges with internationalizing the renminbi or inventing any sort of “BRICS currency,” so any such efforts will likely continue to fail, but alternative reserve assets like gold or cryptocurrencies will likely benefit.