The global trade picture continued to evolve this week and to put it mildly – it's complicated.

Canada and Mexico were exempted from the trade tariffs that the Trump Administration announced last week, and then the president invited other countries to negotiate for similar exemptions. As we discussed last week, struggles regarding intellectual property rights are going to be the primary focus in the weeks ahead. To some extent we saw this with the administration's rejection of Broadcom's acquisition of Qualcomm.

More complications arose when January's trade balance numbers were released and came in with a bigger deficit than expected. Most of that was due to the trade deficit with China, which is at its highest level since September 2015.

How will the U.S. dollar react over the next few weeks? It's a fair question to ask. Economic theory would support that trade deficits weaken the dollar, as consumers sell more dollars to obtain the currencies needed to buy imports. But a glance at the dollar since 1973 shows that there has been very little correlation between the trade-weighted dollar index and the trade balance.

DXY_and_Trade_Balance

The reason for this is simple – international trade, as big as we think it is, in reality is only a small part of the overall foreign exchange volume. One recent statistic said that the volume of foreign exchange that supports international trade equals about one week of volume for the foreign exchange market as a whole, over one year. That's because the vast majority of foreign exchange transactions are related to financial transactions or direct investment, not to international trade.

But clearly the value of the dollar affects trade balances, as the price of the currency moves the price of imports and exports. President Trump often speaks about the trade deficit between the U.S. and Mexico, but much of it can be attributed to the fact that when NAFTA was signed, the Mexican peso was trading at 4 pesos per $1. Today $1 is worth 18 pesos.

The bigger factor determining the U.S. dollar exchange rate is interest rate differentials. You can see that in this chart showing the trade-weighted dollar against the 10-year Treasury yield.

DXY_and_10_Yr

The bottom line is that interest rates are the major factor, over time, of the value of the U.S. dollar, which in turn is a major determinant of the U.S Trade balance. We will be watching this closely over the next several months.

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