Anyone who thinks the worst is over in the Trump trade war is dangerously mistaken.

Sycophantic American oligarchs speak of a couple of quarters of domestic recession. Others point out, correctly, that Australia has been spared the biggest tariff hikes, and we don’t export much to America anyway.

But restricted sales of goods into America are not the main impact; financial markets are where most of the action will occur.

Who in their right mind would assume China would refrain from retaliating to the Trump tariffs? It is true that President Xi Jinping has said there are no winners in a tariff war.

But China judged that it was in its interests to retaliate against the eye-watering Trump tariffs by imposing high tariffs against American goods. It can also restrict imports of agricultural products from America that are important in Republican rural states. And China’s government has reportedly ordered no more purchases of Boeing aircraft.

Since the imposition of tariffs on China by Trump during his first term, which president Joe Biden retained, China has been busily diversifying its export markets. In 2018, at the start of the first trade war, US-bound exports comprised almost 20 per cent of China’s total exports. In 2023, that figure had fallen to less than 13 per cent.

Yes, the trade war will hurt China, but the Chinese authorities since the period of Chinese Communist Party rule have successfully told their people from time to time to “eat bitter” for China’s sake – to persevere through hardship without complaint.

Those American oligarchs who, in the hope of maintaining their good standing with President Trump, and other economic commentators who examine the impact of the trade war on flows of goods and services between the two countries, are looking in the wrong place.

By far the biggest impact is likely to be on confidence in financial markets and the resulting effect on interest rates.

As an immediate response the Trump’s massive tariffs on China, the Chinese monetary authorities sold large quantities of their vast holdings on US treasury bonds. By flooding the market with Us government bonds, they drove up interest rates, threatening a global recession. If US treasury bonds were as good as gold before the trade war, they no longer might be.

High interest rates, as we know, choke off investment and damage consumer confidence. It is this effect that seems to have been top of mind when Trump suddenly paused his announced tariffs on most countries other than on China and the general 10 per cent duty on all imports.

A destabilised global financial system would be catastrophic for the global economy, including Australia. Investors and consumers would lose confidence, cutting back on their spending.

How will American companies bring manufacturing back to America when the financing costs are large, and investors lack confidence in Trump’s next moves?

Even his closest cabinet colleagues and advisers do not seem to know what he will do next. Brawls have broken out between Elon Musk and Trump’s trade adviser, Peter Navarro, Musk calling Navarro a “moron” who is “dumber than a sack of bricks”.

If manufacturing were to be brought back to America, as Trump hopes, financiers would need to be confident in a return on their investments that clearly exceeds the (rising) cost of capital.

Designing and building new auto and other manufacturing plants takes years and billions of dollars. Who could predict what policies or policy reversals Trump, or a successor president, might announce in the meantime?

Back in Australia, the Reserve Bank board next meets on May 19-20. At its last meeting, the day before Trump announced his “liberation day” trade war, the board decided to keep the cash rate on hold, concerned that inflation had not been tamed.

Interestingly, markets knew the board would not cut the cash rate at that meeting, pricing in more than a 90 per cent chance of a hold. By April 9, they had ascribed a 100 per cent chance of a cut in the cash rate at the May meeting – but this is now down to 70 per cent.

On Thursday this week, the Australian Bureau of Statistics released the labour force figures for March. They show a slight uptick in the unemployment rate to 4.1 per cent. The Reserve Bank has described the current cash rate as restrictive. There is no sign of the wage-price spiral that the board fears and no good reason it to keep the cash rate at restrictive levels.

A cushion against the global financial market disruption emanating from the Trump trade war would be welcome. Let’s hope the Reserve Bank board sees it that way and cuts the cash rate at its May meeting.

Craig Emerson is managing director of Emerson Economics. He is executive chair of the APEC Study Centre at RMIT University and adjunct professor at Victoria University’s Centre of Policy Studies. He was Australia’s trade minister from 2010 to 2013