The US-China trade landscape has shifted dramatically by February 2025, with Trump’s 10% tariff on $300 billion in Chinese imports (effective February 4) sparking retaliatory tariffs on $20 billion in US LNG and agricultural goods. Rooted in a five-year decoupling trend, this escalation threatens a trade war, unsettling markets and inflation expectations. At Lighthouse Macro, we dissect these tensions through macroeconomics, investment strategy, and technicals. The past few years we have had the Fed grappling with trade-induced inflation, setting the stage for a complex 2025.
Figure 1: Federal Funds Rate vs Core PCE Price Index (2020-2025). The chart illustrates the relationship between monetary policy responses and inflation dynamics during a period of significant trade tension
The relationship between the Federal Funds Rate and Core PCE inflation reflects the challenging balance between managing inflation and maintaining economic stability. Since 2022, the Fed's aggressive rate hikes were partly necessitated by supply chain disruptions and trade-related price pressures, though their impact on bilateral trade flows has been less straightforward than anticipated. The persistence of elevated Core PCE levels, despite monetary tightening, suggests structural factors in the US-China trade relationship continue to influence domestic price dynamics in ways that traditional monetary tools struggle to address.
Commodity markets have emerged as a crucial battleground in this economic relationship. Figure 2 reveals a striking divergence between domestic and import prices since 2020, reflecting the complex interplay of tariff policies, supply chain restructuring, and strategic competition between the world's two largest economies.
Figure 2: Commodity Price Indices (2020=100). The divergence between domestic and import prices reflects the complex impacts of trade policy and supply chain restructuring.
The higher volatility in domestic producer prices compared to import prices suggests that U.S. businesses have been absorbing significant cost pressures, potentially affecting their competitive position and investment decisions. This price divergence also highlights the incomplete success of policies aimed at reducing U.S. dependence on Chinese imports. While some sectors have achieved meaningful supply chain diversification, the persistent price differentials indicate that finding cost-effective alternatives remains challenging for many industries, underscoring the deep integration of Chinese manufacturing in global supply networks.
Currency market dynamics, shown in Figure 3, provide crucial insights into the evolving trade relationship. The interplay between the US Dollar Index and the USD/CNY exchange rate reflects both policy choices and market forces.
Figure 3: US Dollar Index vs USD/CNY Exchange Rate. Currency market dynamics have played a crucial role in moderating and amplifying trade policy effects.
China's management of the yuan has shown increasing sophistication, balancing domestic economic needs against external pressures. Periods of yuan weakness have partially offset the impact of tariffs on Chinese exports, while also raising concerns about currency manipulation among U.S. policymakers. The dollar's broader strength during this period has had complex implications for trade flows. While a stronger dollar typically disadvantages U.S. exporters, it has also provided some relief to U.S. consumers facing higher prices for imported goods. This currency dynamic has been particularly relevant given the inflationary pressures evident in the Core PCE data.
The impact on U.S. manufacturing employment has been more nuanced than many policy advocates initially predicted. While some reshoring has occurred, the aggregate employment effects have been modest.
Figure 4 US Manufacturing Employment has been declining for 2 years.
This suggests that the reconfiguration of supply chains has focused more on diversification to other countries rather than large-scale return of manufacturing to the United States. Sectors with the highest exposure to Chinese competition have seen the most significant adjustments, though often through automation rather than job creation.
Looking ahead, several key trends warrant attention. First, the persistence of price differentials suggests that the costs of economic decoupling remain significant and could continue to influence inflation dynamics. Second, the currency markets' response to trade tensions indicates that financial markets will play an increasingly important role in determining the effectiveness of trade policies. Third, the modest employment effects of current policies suggest that future initiatives may need to focus more on building domestic industrial capacity rather than simply restricting trade.
For policymakers and business leaders, these indicators highlight the need for nuanced approaches that recognize both the strategic imperatives and economic realities of US-China trade relations. The data suggests that future policy success will likely depend on targeted interventions in strategic sectors rather than broad-based decoupling efforts. The monetary policy response, as reflected in the Federal Funds Rate, will continue to play a crucial role in managing the domestic economic impacts of this evolving relationship. However, the persistence of structural price pressures suggests that monetary policy alone cannot address the fundamental challenges in the bilateral economic relationship.
As we move forward, the key challenge will be balancing strategic objectives with economic efficiency. The data presented here suggests that while some decoupling is occurring, it is happening gradually and at significant cost. Success in managing this transition will require careful coordination of monetary policy, industrial policy, and trade policy, while remaining mindful of the complex interconnections revealed by these economic indicators.
Investment Strategy
These tensions offer risks and opportunities. Agriculture faces headwinds from China’s tariffs—consider shorting exporters like ADM or pivoting to domestic staples (e.g., PG).
Manufacturing firms with Chinese reliance (e.g., industrials) may falter; favor those sourcing from Mexico or Vietnam. A strong dollar (Figure 3) suggests hedging yuan exposure or leaning into dollar assets like TLT. Diversify away from trade-sensitive sectors and track policy shifts for timely adjustments.
Success hinges on coordinating monetary, industrial, and trade policies amid gradual, costly decoupling. Investors should hedge trade risks, favor resilient sectors like staples, and track XLI for signals. Mid-2025 negotiations or escalation could shift the calculus—stay nimble as structural pressures persist
That’s all for now. Thank you for reading! We’ll keep the light on….