The dollar isn’t acting as a safe haven in stressed markets as it usually does. On the contrary, it is absorbing a good deal of the stress. That’s still a small black cloud rather than a thunderstorm, but it suggests that markets are pricing trade-war risk into the US dollar as well as the Chinese yuan.

The implication is that the consequences of a full-blown trade war could be nasty for world capital markets.

Equity prices in the New York session today tracked the plot reversals in the trade-negotiation reality show, falling overnight when President Trump told a Florida rally that China had backtracked on earlier promises, and recovering most of their losses after Trump announced that he had received a letter from President Xi Jinping and declared that a deal still was possible.

The S&P 500 had fallen as much as 2% during Thursday trading but closed down only 0.30%.

That was to be expected. I continue to believe that the US and China will strike a deal. Although President Trump claims that tariffs have benefitted the US economy, the advice he is hearing from the business leaders he consults is that 25% tariffs on the full range of Chinese imports might push the US economy into recession and cost him the 2020 election.

China has declared repeatedly that it can live with the tariffs, but it would prefer to live without them. The rest is theatrics.

Something unexpected did happen today, but on the foreign exchange market rather than on the stock exchanges. The dollar dropped sharply against the euro and yen at 8:30 am EST for no apparent reason.

The dollar-euro exchange rate usually moves in lockstep with rate differentials (interest-rate swaps as well as government bonds), but Thursday morning it fell out of bed. The chart below shows the euro exchange rate at 1-minute intervals against the value predicted by interest rates.

Before the dollar’s small but significant drop on Thursday morning, Morgan Stanley currency strategists observed in a May 9 note to clients that something wasn’t right:

“When the US imposed additional duties on imports from China last year (effective on September 24), the initial market reaction worked via FX, seeing the USD rallying across the board. For instance, EURUSD fell from its late August 2018 high of around 1.17 back into the 1.12 handle.

“Nonetheless, 10-year US Treasury yields marched higher, only reaching the 3.26% high in early October. A similar story applied for the US equity market which topped out in early October, even though it was experiencing sector rotation from July onwards, characterized then by our equity strategists as ‘the rolling bear market.’

“Now as US-China trade tensions seem to be escalating again, it is the bond and the equity market doing the adjustment work while the safe haven bid for the USD has remained muted.”

If the dollar’s twinges of vulnerability turn into something worse in the context of a full-blown trade war, the result could be a sharp tightening of liquidity in capital markets, crowding-out of weaker borrowers and a decline in the price of risk assets.