Escalation in trade war tactics

In the past couple weeks, we’ve seen the tenuous truce between the US and China deteriorate and the trade war saga ratchet up to a more dangerous level.  To recap, virtually every import from China will now have a tariff levied on it, come Sep 1. With less room to navigate due to its lower import base from the US, China has retaliated by taking aim at agricultural imports, suspending purchases of all such US items, hitting one of Trump’s key voting contingent.

Chart 1—US-China Trade Tariffs

Last Monday, markets were particularly rattled (the Dow plunging by 2.9%) by China’s move to allow the yuan to drop to its lowest level in over a decade. Previously, Beijing has intervened to prevent the currency from falling below the psychological 7.0 barrier but last week, the renminbi depreciated beyond this symbolic level with People’s Bank of China (PBoC) commenting that the slump was driven by “trade protectionism measures and the imposition of tariff increases on China”.

Chart 2—USDCNY Historical Movement

The signal is clear and significant – by linking the devaluation in the yuan to the trade wars, China is showing its unwillingness to back down in this fight, effectively deploying its currency as a weaponized tool. Washington in turn branded the country as a “currency manipulator” fulfilling one of Trump’s original campaign promises and inflaming the war further.

It is fair to say that a swift end to this trade war, an outcome which was already looking improbable, is highly unlikely to occur now and global markets are expected to see more turbulence going forward.

 

The beginning of a currency war?

These aggressive moves have sparked concerns of a currency war between the world’s two largest economies. One of Trump’s long-held grievances is the weakness of the yuan which he has complained gives Chinese goods an unfair advantage.  This recent fall in the renminbi benefits China by reducing the cost of its exports, which can potentially offset the impact of the tariff increase. However, in recent years, China has repeatedly stated its intention to stabilise the yuan to encourage its use as a reserve and payment currency. Additionally, the last time that China stepped in to devalue the renminbi, the consequences were massive capital flight and market turmoil. Therefore, it’s not so clear-cut whether the PBoC will use further and persistent devaluation as a policy tool. However, the downside risk to the yuan is obvious, with many analysts projecting deterioration in the currency over the remainder of the year, albeit at a controlled pace in order to avoid capital flight.

Use of currency- related tactics in this ongoing battle is not one-sided, though. In a series of tweets on Thursday, Trump has again called for the Fed to lower rates and weaken the dollar. Trump has repeatedly pressed Fed Chairman, Powell, to lower rates to stimulate the US economy. In July, the Federal Reserve made the decision to cut rates for the first time since the financial crisis and the market is expecting a similar rate cut at the next meeting in September.

However, this easing in monetary policy did little to weaken the dollar’s prospects. In fact, while the trade war battle rages, the US dollar has been supported given that this battle is occurring amidst a backdrop of global economic weakness and uncertainty. The intensifying trade rhetoric exacerbates the gloomy global outlook, and, in this setting, we see investors displaying typical flight to quality behaviors. In the past week, traditional safe harbor assets- gold and yen- have rallied and ownership of US treasuries increased to record highs with the yield on 10Y notes falling to its lowest level since 2016. As such, a fundamental tension exists between both US’ objectives i.e. winning the trade war, as well as the “currency war”.

While direct intervention by Washington to drive the dollar cannot be ruled out, thus far Trump has stated that accommodative monetary policy should be sufficient to send the dollar lower. That remains to be seen since other Central Banks globally have also becoming increasingly dovish in wake of the trade war developments and its potential drag on global growth. While recent economic data out of the US projects lower growth in Q2 (2.1%) relative to Q1 (3.1%), this still compares favourably to the negative Q2 growth in the UK and expectations of lower growth across Europe. 

Thus, the relative strength of the US, in the context of an extension in the uncertainty regarding the resolution of the trade war, could actually prove to be dollar positive, ironically counter to Trump’s intentions.