How does US trade balance impact the US dollar?

The US trade deficit increased 27.0% last year to an all-time high of $859.1 billion. 

Of course, it has long been felt that trade exerts a far diminished role in determining currencies, particularly major developed currencies such as the dollar, euro, and yen. Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks trade may still have some role to play, albeit a very specific one. The reasons for the demise of trade as a currency determinant are usually put down to a number of different things. The most obvious is the rapid growth of currency transactions that relate to the purchase and sale of assets, while trade-related flows have been stagnant in comparison.

Hence, it would seem that if any cross-border flows move currencies around, they are more likely to be those associated with transactions in assets rather than goods and services. A second issue is that the currency market has changed in many ways. For instance, if we go back twenty or thirty years, the FX market was more heavily influenced by short-term speculative traders, mostly sitting in banks, who would react, often very aggressively, to the release of new information into the market, such as the monthly trade data from the US. But these days, the influence of short-term dealers is far less for different reasons, such as regulatory and prudential pressures on banks.

As a result, the release of data, such as trade, has a far more modest bearing on short-term currency movement than it had back in the 1980s and 90s. Also, trade policy appeared much more combative at that time, particularly as it related to US/Japan relations. Partly because they did not want to endure intense competitive pressure, as was the case with Japan, central banks seemed more sensitive to the value of their currencies. This sensitivity often provoked currency intervention, and hence, even if trade was not a direct determinant of currencies, it still seemed to have an indirect role in as much as it helped dictate currency intervention. But these days, intervention is largely absent. Of course, governments might still get upset about trade, just as the US has with China in recent years, but the solution is not to be found in manipulating the currency market.

Instead, in China’s case, it was to set import targets, which, as we shall find out today, China missed by some distance. The target agreed with the previous Trump administration was that China would increase imports of certain US goods by $200 billion in total over 2020 and 2021 relative to a 2017 benchmark. But China seems to be around 40% short and, with little sign that its policymakers plan to rapidly catch up, the US administration is growing frustrated. Will it vent this frustration by expressing any thoughts on the renminbi? Probably not.

Mr. Steve Barrow said this might have been the tactic of the US administrations of 30-years ago, but seemingly not today. It would seem from this that there’s really no reason to think that the US’s ballooning trade deficit should weigh on the dollar. However, we would not write things off just yet. For a start, the US administration might not put pressure on China to strengthen its currency to "punish" it for missing trade targets, but policymakers themselves in China, who still exert some control over the currency, might still want to err towards a strong currency bias just to forestall any US pressure that might arise. And even if Chinese policymakers don’t take this view, traders in the market might still believe that it is appropriate to trade the renminbi from the long side partly for this reason. Hence, there may still be a very specific and, admittedly tenuous, grip that trade exerts over major currencies such as the dollar and the renminbi. Indeed, it is one factor that goes into the mix when we argue that the renminbi is likely to continue strengthening against the dollar despite its weaker growth and monetary policy trend. Our target is 5.50 dollars/renminbi over the coming year.