A post about trade
OK, let’s just cut to the chase. We’re going to talk about trade.
You see, it’s really so simple. Free trade good, trade barriers bad. Tariffs are awful. Trade deficits are a terrible indicator of anything. Cutting waste is good – so long as it’s your side that does it. And having the reserve currency is such a blessing, there can’t possibly be any downsides.
Except… it isn’t simple. We need to also think about currency exchange rates, the downsides of owning a reserve currency, the consequences of large long-term trade deficits, and the impact of technology… Not to mention the negotiating style of Trump, who likes to open with big statements, make mid-flight adjustments, and continually raise the stakes so high that others cannot tolerate them.
All of these issues intertwine, and the current reporting of the so-called trade war invariably speaks to one or two of these at a time – even in publications that should know better (I’m thinking of a magazine that rhymes with “De Feconomist”) – with a healthy dose of TDS.
In this post, I’ll try to lay out how I understand what’s going on; predicting what happens next would be an exercise in humility, but I will try to extrapolate into energy markets. I’m not trying to support or destroy what is happening, I’m simply aiming to understand. Forgive me, there is a lot of context.
But first, as always, history.
The trade war didn’t start this year. Trade has always been a war, ever since flint tools were bartered for fresh meat. Trade and the resources for trading have been the cause of and alleged justification for most wars.
It’s interesting to note that for most of recorded history, traders and merchants have been regarded with deep suspicion. The Merchant of Venice was hardly a puff piece for Shylock. It was considered more noble to be an artisan, to generate value with the skill of one’s hands.
This started to change with the glamour of international shipping and the trade it enabled – think Drake and Raleigh. This really hit the gas – pun intended – with the American robber barons of the late 19th century who brought scale to international trade. The 20th century brought us the theories of Keynes and Friedman, Central Banks, and the rise of the so-called trading houses, willing to (create and) exploit any trade loophole.
Sidebar: “The World for Sale” by Javier Blas and Jack Farchy is an excellent chronicle of the rise and evolution of the trading houses. Notable for me was the undertone from this pair of Bloomberg journalists of grudging respect for the traders… I recently bumped into Javier and tested this theory with him. He (ironically, grudgingly) acknowledged this – and drew the line at the blatant bribery and law-breaking. Hard to argue with that.
Back to the history. In this period, we observed fall of the Dutch Guilder as the reserve currency, the rise and fall of the British Pound, and the rise of the US Dollar. Ray Dalio has written extensively on this.
We must of course mention the Clinton-era admission of China to the World Trade Organisation, granting them ‘most favoured nation’ status (under which countries receive trade terms no worse than the best offered to other countries) in perpetuity, rather than the year-to-year basis it had been previously. This provided an environment in which US companies could invest in China – although I’m not sure it worked out quite as many intended. For brevity’s sake I won’t document the issues like IP theft and absence of reciprocity, but I will note that this is a bipartisan issue – Biden retained most of the Trump 1.0 tariffs.
History class over, Economics next.
Let’s start with US deficit and debt. I’ve been calling for action on this on these pages for more than 2 years already, and much of what follows depends on how real and near you think the fear of US default is. Let’s try and agree on this first point:
If the US defaults, nothing good happens.
This would be a total breakdown of the plumbing of global finance. Turmoil, inflation, negative growth, volatility, bankruptcies – and quite probably civil or international wars. If history is any guide, expect this to last for two or three generations.
There is not consensus on how proximate this risk is because as the USD is the reserve currency, some believe continuing to print money is a viable option. As the reserve currency, it surely is tempting, and it is OK… until it’s not. Necessarily lax monetary policy through the second world war was the last nail in the coffin of the British Pound’s supremacy.
The US has more than nine trillion dollars ($9,000,000,000,000) to refinance in 2025, most of which was issued during the Biden administration (a fact, not a political point). The US current account deficit – about $2T – is therefore very sensitive to the interest payments on this debt, for which we’ll use the 10-year treasury bond yield as a proxy.
This number isn’t set by the Federal Reserve – when we talk about the Fed rate, that’s the return you get for parking your money at the Fed overnight. The 10 year is set by auction, by the market. Supply and demand dynamics apply.
Now to trade deficits. Let’s say country A trades with country B. To the extent that this is not perfectly reciprocal, all other things being equal, we would expect their currency exchange rates to move – compressing the country with the deficit, strengthening the surplus holder. Equilibrium reigns.
An example of this: Pre-2022, Germany as a result of its manufacturing sector had a large trade surplus so should have had a strong currency, but traded in Euros that were depressed by the deficits of other Eurozone members, meaning German exports were abnormally attractive abroad. The point of equilibrium was skewed.
Now, if you have the reserve currency, there is an abnormally high demand for your currency – meaning that the natural equilibrium cannot be found. It is therefore unnaturally attractive to print more money to try and bring down the value so exports can be competitive. Doing so means selling bonds, generally to people with whom you have a deficit – thus locking in a structural deficit. This continues until it doesn’t – so think back to earlier points about default and the demise of the Pound and Guilder.
So we have painted a picture of what we are trying to avoid… so what do we do about it? Let’s also observe that this is a riddle no one has ever solved – every reserve currency has, ultimately, failed.
In true Trump style, change can be most quickly affected by destabilising the status quo – and the ‘liberation day’ announcements certainly did that. I’m not a fan of the formula used to calculate the reciprocal tariffs – something more surgical and targeted could have been just as impactful without the collateral damage and easy-to-undermine narrative – but it certainly made a splash.
I think the objective here was to bring down the 10-year bond rate to reduce the cost of debt refinancing, whilst in parallel reducing spending through DOGE and moving on to stimulate the economy with tax cuts. I’ll also observe at this stage that Wall Street is not the same as “The Economy”, and Trump knows his base well.
For a while, it seemed to work – it sank beneath 4% for a few days – before a massive selloff in bonds forced the 10-year back up. The data isn’t out to show this yet, but many suspect China playing a role here – after a couple of decades of a massive trade imbalance, they are now the second largest holder of US treasuries (behind Japan). The effect has been to produce enormous quantities of ammunition and hand it over to your adversary – which they seem to be exchanging now for gold.
I don’t think this was expected, and the 90-day pause in reciprocal tariffs is an example of the willingness to course-correct. On this – and most issues around this policy – seek out some interviews with Treasury Secretary Scott Bessent. If you suffer from TDS (and if you’re unsure, you almost certainly do), hearing a different, rational, credible voice is helpful. Remember also he is a lifelong Democrat.
By the time this happened, the stake-raising had brought a lot of countries to the negotiating table. Bessent has spoken openly of “a new Bretton-Woods”, the post WW2 international currency system that established the gold standard and prevailed until Nixon walked away in 1971.
So, here’s what I think is the big picture: Trump does not want the US to default and lose reserve currency status on his watch. Some speculate that he’s trying to de-dollarise, to manage a move away from the USD as the reserve currency, but I don’t buy this… I think he is trying to find the very narrow path that ameliorates the worst effects of being the reserve currency, without losing the power that it brings.
What might this look like? As well as getting other countries to drop tariffs which, ironically, would reduce trade barriers, I think the Mar-a-Lago Accords in ~2 months time may seek something radical like to move much of the international dollar uses onto cryptocurrencies, most likely dollar-denominated stablecoins. This reduces dollar demand without handing the primacy of reserve status to another country, resulting in a softening of the dollar. The US will still try to maintain control of the crypto ecosystem – perhaps by stabilising the crypto aspects with a percentage of gold. Expect to hear more talk of central bank gold and crypto reserves.
I think the intention is to allow the dollar to depreciate, suppress (through coordination of others seeking better US trade terms) the worst aspects of Chinese trade policy, and thus level the playing field. Will it work? I have no idea. As I said earlier, it’s a narrow path fraught with challenges, and many things are unpredictable from here.
As for energy markets, gas still has strong fundamentals and is clearly an important tool for appeasement – complicated by the impact of data centre demand. Oil is a little more complex. I have a tendency to trust people with money on the line over commentators – a polite way of saying that I believe OPEC more than the IEA. Markets and gold suggest recession, but OPEC are relaxing production cuts either expecting demand to show up, others (such as Iran and Venezuela) to decline, or to declare war on US shale again.
#3 would be self-destructive, so we’re choosing between 1 & 2. I’m inclined to think it’s both – meaning that the nervousness we see in the oil price now will pass. One of the few bullish signals we can muster…
As always, this is not financial advice – but we surely do live in interesting times.