The Weekly: Trade War to Currency War?

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05/11/2018
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Last week saw a positive return for global equity markets, with most recovering some of the ground they lost in October. This was attributed to hopes that the US-China trade war was coming to an end and a deal was in sight. However, that optimism may be misplaced. With the US midterms here, Donald Trump does not want to tone down the rhetoric in fear of appearing weak to his voting base. If anything, we should have expected an increase in rhetoric, and this is certainly something that seems to be happening.

As the migrant caravan edges closer towards the US border Donald Trump has deployed troops with orders to use deadly force if necessary to protect the US border. The troops will be twiddling their thumbs because the migrant caravan is still hundreds of miles away and won’t arrive for several weeks.  However, the purpose of sending troops isn’t to protect the US border, but to protect Donald Trump ahead of the US midterm elections. The priority for Donald Trump is to still ensure that he appears tough on migration before voters go to the polls.

It’s not just the migrant caravan feeling the wrath of Donald Trump. The US has unleashed its toughest sanctions against Iran resulting in Iranians burning US flags on television and chanting ‘Death to America’. This all plays into the narrative of Donald Trump and drums up support from his base. After all, its America first and everyone else is secondary. The sanctions will hit the Iranians where it hurts the most; on their oil exports, but it will also impact other sectors such as banking and shipping. This was always going to happen after Trump pulled out of the 2015 deal aimed at curbing Iran’s nuclear ambitions. However, some will question why the most drastic sanctions were not imposed until the day before the midterm elections. Some would say whilst it isn’t fake news, it is certainly well-timed news!

So, when equity markets were pushing up last week, we were less optimistic of a deal between the US and China. If anything, it appears that Donald Trump is winning his trade war, from an economic standpoint anyway, so why change tack. We believe the US will be the ultimate victor in this dispute in a world where there is plenty of industrial capacity and plenty of raw materials. It is always the buyer that has ultimate power, not the seller.  America is buying, and China is selling. However, while we believe that the US will be the victor, this isn’t to say that Xi Jinping, leader of the Chinese communist party, doesn’t have a few cards he can play. 

As the US pushes up interest rates, the US dollar becomes more attractive, especially when many other parts of the world are experiencing ultra-low interest rates. However, what Donald Trump might have underestimated in his on-going trade war with China is the fact that whilst the US currency is free floating, the Chinese Renminbi isn’t. As one would expect with rising US interest rates, the US dollar has strengthened against most currencies recently. However, the extent of its strength when compared to its Chinese counterpart is at its most pivotal point in recent history. Since the introduction of tariffs on steel and aluminium at the start of the year the Chinese Renminbi is now 10% weaker.

 

In fact looking over the last decade, the Renminbi has never been weaker:

graph

 

It is an open secret that the Chinese communist party likes to keep their domestic currency weak to keep exports competitive. Xi Jinping can use this to his advantage. Currency wars are nothing new, but rather than retaliate with tit-for-tat tariffs, their best weapon is their currency. This is already offsetting a large part of the tariffs the US has introduced.

However, this does leave them the little problem of what to do with the US dollars they receive. They can of course convert the US dollars back to the yuan, but this may have the adverse effect of pushing up its value to a point where their exports become less competitive. While the yuan isn’t free-floating, converting to the yuan would certainly push it to the top of its controlled range. The other potential options are to buy US treasury bonds, or simply hold the cash.

Both options are not that enticing for China. Holding US dollars won’t achieve anything for China and sinking US dollars into treasury bonds isn’t exactly appealing either. If anything, one of the options Xi Jinping has is not only to stop buying US Treasury Bonds, but to dump some of the $1.17 trillion that they already own (1). This might pale in significance to the total debt pile of the US, but it would still have the effect of increasing the yield on US treasuries. This would throw a spanner into the works for Donald Trump at a period where he is lowering taxes and increasing spending. However, this would be a case of China cutting off its nose to spite its face. It is the largest holder of US treasuries so by trying to increase the yield on US government securities, it will be devaluing the value of the US treasuries that they continue to hold. Conversely, it will also mean that they are able to secure a favourable yield on any US treasuries they need to buy.  In effect, by dumping (selling) their existing US treasuries (below par) they will increase the yield, thus they will in effect be refinancing their debt and achieving a better return for new purchases.

It is unlikely this hasn’t been considered by Donald Trump or at least by his economic advisors, so while we expect the rhetoric to continue until at least a short time after the midterm elections, it probably all just boils down to either side not wanting to lose face. After all, both China and America are the two most powerful countries in the world and even if America is in the more advantageous position, a prolonged trade war benefits nobody. 

We are going to avoid speculating on the result of the midterm elections, but Donald Trump has it all to lose, and should he lose either the Senate or the House of Representatives, then the Democrats can severely limit what he can do in the final two years of his first term as President. Judging by his rhetoric on Iran, China and the migrant caravan, we think Mr Trump is indeed worried however, if he is to maintain his control of the two houses then we believe he should focus on economics, as opposed to scare tactics. After all, anyone that votes on immigration and Iran is already going to vote Republican. Where the midterms will be won and lost will be marginal voters which don’t sit with the Republicans or the Democrats. Sound economic data, such as record low unemployment is what the Republicans need to be advertising and championing. A knee-jerk reaction to appeal to the rust belt on scare tactics when they are already going to vote for you means the Republicans might just be shooting themselves in the foot.

 

Source: Department of Treasury Reserve Board (1)

 

Equities Rebound Brings Shocking October To A Close

Global equity markets rebounded last week, regaining some much-needed lost ground after a prolonged period of broad based weakness. October once again proved to be a bitterly disappointing month as a number of factors, including the ongoing US-China trade war and concerns that US interest rates could rise quicker than expected, left investors in a panic. Last week brought an end to the losing streak with all the major indices concluding the week in positive territory. 

Domestically, the mid-cap space was the start of the show with the FTSE250 jumping by an impressive +5.3%. The FTSE100 rose by +2.2%, a number bettered slightly by the S&P500 which benefitted from a number of strong earnings reports from the likes of Facebook and the semiconductor companies (1). European equities took the lead from their American counterparts with the German DAX30 and French CAC40 rising by +2.8% and +2.7% respectively. In Asia, both Japanese and Chinese equities surged, the former by an impressive +5.0% (Nikkei225).

With equities rallying around the globe, sovereign bond yields pushed higher. 10-year US Treasury yields pushed back beyond the 3.20% mark following an increase of 14 basis points (bps). Closer to home, the gilt equivalent yield also rose sharply (+11bps), albeit to just 1.41%. 

Sterling enjoyed a decent week rising by over +1.0% against both the Dollar (to $1.296) and the Euro (to €1.139). This was due to increase optimism regarding Brexit and signals from the Bank of England that interest rates could rise quicker than expected if the ‘divorce’ runs smoothly (2). 

In the oil markets, both Brent and WTI continued their respective slumps. US shale production has spiked sharply as oil prices pressed higher over the course of 2018 with increased Saudi output also offsetting some of the concerns regarding the impact that US sanctions on Iran will have on supply (3). Last week, Brent declined by -6.2% to $72.83 a barrel. Gold also ended the week in negative territory, dropping by -0.8% to just over $1,231 an ounce.

 

Source: T.Rowe Price 2018 (1)

Source: Reuters 2018 (2)

Source: Oilprice.com 2018 (3)

All other numbers taken from DataStream

 

Week Ahead

The UK economy will be subjected to a preliminary estimate of Q3 economic growth. GDP is currently forecast to have risen to a quarterly rate of 0.6% (1).  The dominant Services sector, despite a fall in this morning’s Services, PMI has shown more resilience than the UK manufacturing industry in the face of political uncertainty.

Overseas, many will of course focus on the US midterm elections taking place on Tuesday. Polls currently suggest the Democrats could win back the House of Representatives, but the Republican party will likely hold the Senate.  The Federal Reserve also meets this week (Thursday) for its latest decision on monetary policy – few are expecting any change to policy on this occasion but the final meet of the year in six weeks’ time could still bring one further rate rise this year.

 

Source: Forex Factory 2018 (1)