The dollar slipped Friday after the U.S. government said it will impose duties on imports of coated paper from China, raising fears of protectionism between the two economic superpowers.
While traders and investors were debating what the news would mean and whether it was the opening salvo in a trade war, its impact on foreign exchange markets was immediate.
"The impact in the market has been to see the dollar get pummeled as dollar longs have been forced to bail out on the idea of trade protectionism ultimately undermining the U.S. economy," said Brian Dolan, director of foreign exchange research at Forex.com in Bedminster, New Jersey.
"This is still a developing story and it could turn even uglier if the tariffs are only on one product category."
This is the first time the United States is applying duties to subsidized goods from non-market economies, the Commerce Department said.
"The news about the tariffs on China is definitely taking the dollar down," said David Watt, a senior currency strategist at RBC Capital Markets in Toronto.
"It doesn't seem to be the best way to handle the issue. First, the U.S. still needs at lot of investment from abroad, especially from Asia, and it's not clear what type of impact such measures will end up having on consumers and on the U.S. economy," Watt said.
A trade war, with duties imposed by both sides, would ease demand for U.S. exports by making them cost more in foreign markets and slow U.S. economic growth. It would also make imports to the United States more expensive, adding to inflation pressures.
It could also prompt China to diversify some of its foreign exchange reserves out of the U.S. dollar. China had more than a trillion dollars in foreign exchange reserves at the end of 2006, the world's largest foreign exchange holdings. Analysts estimate about 70% of that amount is denominated in dollars.
Around the same time the China headlines reached investors, the dollar was hurt also by rumors that Washington had advised citizens in Bahrain to leave. That impact faded, however, when the White House said it was unaware of any such advisory.
Michael Woolfolk, senior currency strategist at Bank of New York, said the market's reaction showed how sensitive investors were to any news that could impact a U.S. economy already teetering on the brink of recession.
"Any escalation of tensions is one step closer to war and higher oil prices," he said.
Crude prices had already climbed before the Bahrain rumor as the dispute between Iran and Britain over captured Royal Navy personnel showed no signs of a quick resolution. The U.K and Iran tensions are on top of moves by the United States and other Western countries to pressure Iran into giving up its nuclear enrichment program.
The rhetoric with Iran on both issues has investors concerned about the impact of any rescue mission or large-scale attack on oil markets and the spillover into the global economy.
The Swiss franc, a traditional safe-haven currency, benefited from Middle East concerns.
Earlier, the dollar had firmed on higher-than-expected U.S. core inflation data and a robust Midwest manufacturing survey. That backed the view the Federal Reserve would be in no rush to cut interest rates.
The dollar showed little reaction to data showing U.S. consumer sentiment fell in March to its lowest in six months amid worries about inflation and slowing gains in income.