The storm on the horizon


At first glance, last week was another quiet five days for the currency markets. GBPUSD barely deviated from 1.40 – 1.41, EURUSD was stuck between 1.2220 and 1.2320 and USDCAD traded a tight range between 1.2750 and 1.2900. This was despite a plethora of data from both sides of the Atlantic, coupled with Trump and Chinese authorities exchanging blows over trade. In this week’s report, we consider two reasons why this state of calm may not persist…

 

Non-Farm Payrolls

Friday’s US employment report showed a disappointing 103,000 new jobs created in the March, undershooting expectations for 185,000. Unsurprisingly, the dollar came under immediate pressure against both the pound (see chart below) and the euro, losing around a cent against each, but most commentators seem to have shrugged off the disappointing headline number and instead decided to focus on an increase in average earnings and an upward revision to February’s reading.

 

Chart 1: GBPUSD – Payroll Impact (circled in red)

Source: Bloomberg

 

This is reflected in the Fed Funds Futures rate which is still pricing a 60% probability of another 25 basis point hike in June (unchanged from last week) although there appears slightly less confidence in further hikes in September and December. We’ve previously written about our skepticism for four Fed hikes this year and this further justifies our cautious stance.

 

Trade Wars

When Trump won the Presidential election back in 2016, he promised to deal with the annual $360 billion trade deficit with China. As seen elsewhere, Trump has followed through on his pledge and last week, US officials announced a list of products that could be targeted with a 25% tariff worth $50 billion. The following day, China responded with a list of US imports upon which it could impose tariffs worth $50bn (honors even).

 

Chart 2: Monthly US trade deficit with China

Source: Bloomberg

 

Despite a little wobble in equity markets, the general consensus seems to be that this war of words is simply a way of getting both parties to the negotiation table to discuss intellectual property rights and is unlikely to escalate into something more serious. Clearly Trump wants US companies to have access to the world’s second largest economy but without the cost of giving away too much IP. Meanwhile, China wants to continue growing and developing its output.

 

In a simple trade war (if such a thing can exist), China may well come off worse to begin with since the US is a net importer of China’s products. However, China has a number of other weapons in its arsenal including blocking US services, curtailing US oil shipments, a devaluation of the Yuan or dumping its massive holding of US Treasury Bills. The latter would have a dramatic tightening impact on US fiscal conditions and impede Trump’s ability to spend.

 

What impact could this have on currencies?

At this stage, the market seems content that the threats are unlikely to amount to actions and thus everything remains stable. Regular readers will know that one of our key reasons for being bullish on the dollar for 2018 was that if equity markets were to experience a significant reversal in trend, it would be beneficial for the dollar as investors around the world sought the safe haven of US Treasuries (as was the case during the financial crisis).

This theory still stands, but if China were to start selling US Treasuries as part of a trade war, the direct impact on the dollar would most likely be negative for the Greenback. Indirectly, if Trump were unable to fund his spending plans through issuing debt, the Fed may be forced to step in with monetary stimulus. As seen in recent years, QE has proven to be negative for the currency. Either way, the threat of heighted volatility is becoming increasingly apparent.

 

Author: Marc Cogliatti



 

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