Haver Analytics
Haver Analytics
Global| May 01 2025

The Dollar Under Strain: The US Trade War and Structural Fragilities

The US dollar has rapidly become the central focal point for investors grappling with the fallout from recent US trade policy shifts. As markets absorb the economic and geopolitical implications of a more confrontational US trade stance, attention has turned squarely to the dollar—not just as a barometer of financial sentiment, but as a potential transmission channel for broader global instability. Its role at the heart of the international monetary system, coupled with the scale of the US current account deficit and reliance on capital inflows, makes any significant shift in dollar dynamics a matter of systemic importance. With yield differentials, trade balances, and competitiveness all now under scrutiny, the dollar is increasingly where macro fundamentals, policy risk, and global capital flows converge.

This shift, moreover, carries profound implications. When trade policy becomes a source of financial volatility rather than a tool for economic rebalancing, it raises the risk of destabilizing the very capital flows that sustain the US external position. As the world's primary reserve currency, the dollar is embedded in the global financial plumbing—from trade invoicing to cross-border lending and portfolio flows. Sudden policy-driven movements in the dollar can reverberate far beyond US borders, tightening financial conditions in emerging markets, disrupting asset allocation globally, and undermining confidence in the predictability of the international monetary system. In this context, US trade wars are no longer just bilateral disputes—they are global macro events, with the dollar serving as the principal shock absorber.

Historically, the dollar has moved closely with interest rate spreads, as yield-seeking capital flowed into US assets. But the April US tariff actions—the dollar has weakened markedly even as the yield spread between the US and Germany has widened – see first chart below. This decoupling underscores a critical shift: capital markets are reacting not just to monetary policy, but to rising trade and geopolitical uncertainty. In other words, the exchange rate is now being driven as much by risk sentiment as by interest rate arbitrage.

A second – more historical - dynamic, captured in the next chart, reveals an extraordinary correlation between the US real effective exchange rate and the potential GDP growth differential between the US and euro area. This raises the question: has dollar strength in recent years merely been a reflection of US growth leadership—or were capital inflows themselves helping to sustain this growth outperformance? In effect, the tail may be wagging the dog. Global investors have long allocated capital to the US, attracted by its macroeconomic resilience, technological leadership, and deep, liquid financial markets. But the danger now is that the trade war may disrupt this equilibrium. A sharp or sustained reduction in capital inflows could undermine growth, weaken the dollar, and trigger broader financial instability. Moreover, reversing this dynamic is not straightforward—barring a credible structural resurgence in European (or Asian) growth, the global investment landscape remains tilted toward the US.

Together, the first two charts offer a portrait of a dollar that has been propped up by relative growth leadership and yield advantages—but which now finds itself increasingly exposed to policy risk and a shifting investment calculus. If the dollar has been supported by flows into the US as the world’s best-performing developed market, the prospect of unilateral and escalating trade actions introduces a destabilizing new variable. This evolving pressure on the dollar intersects with a second, longer-term vulnerability: the deterioration in relative competitiveness. It is to this issue that we now turn.

The next chart examines relative unit labour costs across major economies since 2011. The US and China have seen a broadly similar trajectory, with steady increases in cost structures, while the euro area has remained flat and Japan has seen dramatic improvement. This suggests at face value, and from a cost competitiveness standpoint, the US is not uniquely disadvantaged vis-à-vis China. However, this parallel erosion of cost competitiveness is occurring at much higher nominal wage levels in the US, which blunts its ability to regain export share through tariff policy tweaks. The trade war strategy—absent a corresponding improvement in productivity or structural reforms—risks imposing costs without delivering material competitiveness gains.

This point is reinforced by the final chart below, which shows average monthly wages across countries. US labour remains dramatically more expensive than in peer or emerging economies. Even if China’s costs rise in tandem with the US, the global supply chain has ample alternatives. 'China plus one' strategies have been re accelerating, and the US remains structurally misaligned with low-cost production hubs. Tariffs aimed at reshoring supply chains are unlikely to deliver sustained gains unless accompanied by deep supply-side reforms, and risk further disincentivizing foreign direct investment if global firms perceive US trade policy as erratic or punitive.

At the macro level, these developments highlight the fragility of the US external position. The country runs a persistent current account deficit, financed by a capital account surplus. That surplus reflects foreign appetite for US assets, from Treasuries to equities to real estate. However, protectionist trade actions, if perceived as arbitrary or destabilizing, may eventually erode that confidence. The Trump administration’s April 2025 moves have already prompted questions about retaliatory measures, potential capital controls, and the role of the US dollar in a multipolar world. If investors begin to question the reliability of US policy—or the openness of US markets—capital inflows could further falter, and with them, the ability to fund the trade deficit smoothly.

  • Andy Cates joined Haver Analytics as a Senior Economist in 2020. Andy has more than 25 years of experience forecasting the global economic outlook and in assessing the implications for policy settings and financial markets. He has held various senior positions in London in a number of Investment Banks including as Head of Developed Markets Economics at Nomura and as Chief Eurozone Economist at RBS. These followed a spell of 21 years as Senior International Economist at UBS, 5 of which were spent in Singapore. Prior to his time in financial services Andy was a UK economist at HM Treasury in London holding positions in the domestic forecasting and macroeconomic modelling units.   He has a BA in Economics from the University of York and an MSc in Economics and Econometrics from the University of Southampton.

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