Trump, tariffs, and the dollar’s role as reserve currency

The benefits of the U.S. dollar’s reserve currency status do not come for free; the costs are paid for with a trade deficit. President Trump’s goal of transforming the U.S. trade deficit to a trade surplus similarly is not free, with the long-term cost being a weakening of the dollar’s reserve currency status.

This may well turn out to be a very expensive goal. The estimated worst-case impact of Trump’s newly announced tariffs on the S&P 500^® Index is for it to fall to 4,650, about 16% lower than the current level.¹ This assumes all the price increases from tariffs are borne by companies – not the consumer – thus reducing earnings.

President Trump imposed tariffs on imports from across the world. The largest increases were concentrated on Asian countries. These tariffs will affect the prices of imports such as household products and automobiles sourced from abroad. The cost of goods imported into the U.S. will invariably increase.

The price increases simply cannot be offset by goods production at similar cost in the U.S. The cost of insourcing would be much higher than the cost of current imports.

So, the question is: Will these costs be offset? This is highly unlikely. Some claim taxes will be reduced, or that budget deficits will fall thanks to tariff revenue. Others claim that with more production in the U.S., a larger number of domestic workers will lead to more income-tax revenues and reduce demand for transfer payments that have grown in recent years. This theory posits that the accompanying deficit reduction would pay for tax cuts, which would then dampen the effect of increased prices on workers across the economy. If this rosy scenario were to materialize, work would have already been brought back to the U.S. Furthermore, such a transition would take years to work its way through the economy.

Not guaranteed

The U.S. will invariably import fewer goods because of these tariffs. This will have an impact on our reserve currency status along with its myriad benefits as the supply of U.S. dollars abroad falls. The U.S. is a deficit country, simply because it imports more than it exports. But this goods imbalance is the mechanism that supplies dollars to the rest of the world. The consistency of these flows underpins the greenback’s status as the world’s reserve currency – a status that has greatly benefitted the U.S.

Dollars held by foreigners must go somewhere, and where they go – on a massive scale – is back into U.S. assets, particularly Treasuries. Persistent demand for Treasuries finances our debt and deficits at very low rates. The U.S., unlike the rest of the world, enjoys natural buyers of its debt – in the form of foreign entities awash with dollars – which allows the country to finance investments and consumption easily and cheaply. This enormous advantage would be lost should the reserve currency status be weakened or abandoned. This is the brutal cost of moving away from a trade deficit to a trade surplus country.

A painful transition

Where there is a shock to the system, volatility increases as firms and consumers adjust or attempt to adjust to the new paradigm. With increases in volatility, growth tends to slow. This is no different than the negative effect that volatility has on compound returns, which are just growth rates. With more volatility, it takes more time for decisions – particularly investment and timing decisions – to be made as we wait for uncertainty to resolve.

A path toward a trade surplus country would cause the cost of producing goods to increase and consumption and investment to fall because of uncertainty and accounting for the necessary cost changes. Consequently, efficiency of production would also fall relative to foreign production, know-how, and costs. The U.S. labor supply for manufacturing, its quality and know-how, are lower than what’s available abroad. Transforming the U.S. to a manufacturing hub is not costless, nor is it expedient.

The dollar should strengthen as imports are reduced. This would offset some of the tariffs. Foreign producers end up paying partially for the tax. Both foreign countries and the U.S. would incur material costs – a scenario in which there are simply no winners. The U.S. will be frustrated if the dollar strengthens too much. The Trump administration wants the dollar to weaken to bring production back to the U.S. This might be tough as imports fall, leading to a reduction in the dollar supply. With increased uncertainty, “home-bias” would be expected until a viable future state of global trade is identified. The administration needs the dollar to weaken to affect its policies, otherwise it will be hard to bring manufacturing back.

A strong dollar – or chaos?

There is a cost to a weaker dollar; again, there is no “free lunch”. The cost is the reserve currency status being undermined as foreigners do not want to hold a weak currency. This is why the U.S. has always pursued a strong dollar policy. A strong currency and ample global supply are necessary conditions for reserve currency status. President Trump’s policies threaten both. There are huge quantities of U.S. securities in the international system. The U.S. has lived well on its reserve currency status; where does all this paper go should the party end? How will the U.S. finance its deficit? In a world without a clear reserve currency, gold may very well be a good investment.

A wide range of outcomes

There are many moving parts at play. We believe that the benefits of tariffs might be more than completely offset by the loss of reserve currency status. We could see growth stalling in the months ahead, but damage mitigated by monetary and fiscal stimulus. The Federal Reserve could be forced to reduce interest rates more quickly than previously planned, thus lowering the all-important real rate.

Sustaining the 2% real rate currently in place requires real productivity growth of 2%. Will it come from artificial intelligence (AI)? We don’t think so. There is not enough growth in AI to sustain current valuations of AI companies. The market had priced in very aggressive AI growth as it saw a resilient economic moat created by the assumption that building capabilities would be too expensive for all but the largest tech hyperscalers. DeepSeek called that moat into question. We believe the hype as to what AI could do is just too great at this moment. Maybe the tariff wars will reduce the value of these tech companies, and any “irrational exuberance” will deflate (similar to the dot-com bust in 2001).

Discounting the risks

It is unclear how other countries will respond to this round of U.S. tariffs. As it stands today, it is expected that tariffs will generate around $500 billion in “tax” revenue for the U.S.² In the extreme case that this tax is fully paid for by companies, we estimate that, based on a discounted cash flow analysis, the S&P 500 would fall to 4,650, about 16% lower than the close price today (April 3, 2025).³ This isn’t too bad for a worst-case scenario.

The upshot of these tit-for-tat responses could be no international trade: We return to an expensive Robinson Crusoe world where each country vainly attempts to become self-sufficient. We must not forget that the U.S. relies on the rest of the world to finance its debt, and the rest of the world relies on prodigious U.S. consumption. Neither side of the equation benefits from a trade war.