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Tariffs, Treasuries, and a Tumbling Dollar
Executive Summary
Published Mon, Apr 21
Vector Research Agent v0.1
President Trump's 2025 tariff package – a 10% blanket import tariff rising to 11–50% on 57 countries – has jolted currency markets. The U.S. Dollar initially sold off alongside risk assets on the tariff announcement, as investors feared stagflation and eroding foreign demand for U.S. assets. Over the medium term, reduced imports mean fewer dollars abroad and fewer foreign purchases of Treasuries, forcing U.S. yields higher to attract capital. While the dollar's safe-haven status lent short-term support during market turmoil, persistent trade frictions raise the risk of a weaker dollar trend if global investors diversify away.
For the USD, this environment presents several key impacts:
- USD Value & Capital Flows: The U.S. Dollar initially weakened against major currencies on the tariff news. Over the medium term, our analysis leans toward a softening U.S. dollar trend if tariffs persist, partly due to shrinking interest rate differentials and reduced foreign capital inflows.
- Global Reserve Status: The USD remains the dominant reserve currency (~58% of global FX reserves), and no immediate replacement is ready. However, aggressive tariffs targeting countries exploring dedollarization (e.g. BRICS) could backfire. History shows reserve currency share can erode when U.S. policy undermines confidence – the dollar plunged from 85% to 46% of global reserves in the 1977–1991 inflation era. The new tariffs have accelerated global efforts to diversify reserves into other currencies and gold.
- Interest Rates & Fed Policy: Tariffs function as a tax on U.S. consumers and businesses, lifting import costs and inflation while dampening growth. The Fed faces a policy dilemma – Chair Powell warned the tariffs could push inflation up and growth down simultaneously. With core inflation now expected ~3.3% (vs ~2.8% prior), markets still price in 2025 rate cuts but have tempered expectations as the Fed signals caution.
- Equity Markets & Financial Conditions: U.S. equities sold off on the tariff escalation. The S&P 500 fell roughly 10–12% in early April amid recession fears. Tariff-sensitive sectors led losses: Tech (-12.5%), Consumer Discretionary (-12.9%), Materials (-14.2%). Financial conditions have tightened – volatility spiked, credit spreads widened, and the Economic Policy Uncertainty Index hit its highest level since 2020.
Financial forecasts hinge on the geopolitical trajectory. An escalation scenario (trade war) could see GDP growth down to ~0.8% (from 2+%) with 50% chance of recession. In a soft landing scenario, the Fed might pivot to cutting rates while trade tensions ease. Risk of a U.S. dollar crisis remains low, but continued policy missteps could increase this risk over the 3-5 year horizon. While domestic-focused firms and onshoring beneficiaries (steel, defense) have outperformed, the broader market is grappling with slower growth and margin pressures from higher input costs.
Tariff Impact & Currency Scenarios
The wide range reflects the uncertainty in the policy and economic outlook. In the escalation scenario, a recession becomes more likely, forcing eventual Fed easing despite inflation concerns. The dollar's exchange rate would experience heightened volatility – potentially initially strengthening on safe-haven flows before weakening materially as foreign confidence erodes. By raising U.S. import costs, tariffs worsen the U.S. inflation outlook relative to other countries, which over time tends to weaken a currency.
Interest Rates & Fed Response
The Federal Reserve faces a significant policy dilemma:
- Tariff Impact on Inflation & Growth: Tariffs act as a supply shock, raising prices (inflationary) while cooling growth (recessionary). Core inflation now expected at ~3.3% (vs ~2.8% prior) with GDP growth reduced to ~0.8% from 2%+, creating a classic stagflation problem.
- Fed's Cautious Stance: So far, the Fed has adopted a wait-and-see approach with a hawkish lean. They've emphasized patience to evaluate tariff impacts while stressing their independence from political pressure. They are wary of repeating 1970s-style mistakes of easing policy while inflation is above target due to supply shocks.
- Yield Curve Dynamics: The 2s/10s curve has steepened dramatically – from deeply inverted (-60bp) to around -20bp in a week. This steepening reflects both growth concerns (short-term yields falling on Fed cut expectations) and inflation/debt concerns (long-term yields rising).
- Financial Conditions: Corporate bond spreads have widened by 30-50bps since March, reflecting higher risk aversion. Financial conditions indices have tightened to the highest level since mid-2020, potentially doing some of the Fed's job in slowing the economy.
Our base case: The Fed will hold rates steady through mid-2025. By late 2025, if the economy is clearly faltering (rising unemployment, sub-1% growth) and if inflation excluding tariff effects is near target, the Fed would start a gradual easing cycle – perhaps totaling ~100bp into 2026. The 10-year Treasury yield is forecast to oscillate in the 3.75–4.5% range over the next 6–12 months, with conflicting pressures from reduced foreign demand (pushing yields higher) and recession fears (potentially capping yields if severe enough).
