The USD has a little more near-term upside as US trade policy is starting to show more bite than bark. For now, it appears to be benefitting from the trade war scare. This is a departure from its behaviour last year where there was a tendency by markets to associate protectionist rhetoric with a weaker USD, which would have been helpful for US exports.
However, as trade tensions moved beyond rhetoric to open conflict, markets appear to have become more focused on the relative economic impact of tit-for-tat retaliation. The next key date is 6 July, when the first tranche of US tariffs is scheduled to be implemented along with China’s reciprocal measures. The US economy, which is less exposed to trade, is expected to suffer less, at least initially, than the export-oriented economies of Asia and Europe.
Politically, Trump's tough rhetoric on trade is working well for his domestic popularity in the lead up to the November mid-term elections. We may need more market discipline to force a de-escalation of trade tensions. Given the comparative resilience of the US stock market, suggestions that US stock market volatility has the power to force Trump to ‘back down’ on trade threats means things could still get worse before getting better. If China does institute a crackdown on US companies in China with stricter enforcement of regulations and perhaps a boycott of US companies and goods, this would certainly sober up some of the complacency the US stock market has exhibited with regards to trade war risk.
The risk of tit-for-tat tariff escalation is fuelling worries over tech supply chain disruption that would hurt small, open Asian economies such as Korea and Taiwan that not only are heavily exposed to the Chinese economy, but are also dependent on global supply chains. Consequently, the differentiation between the ‘bad’ current account deficit currencies (i.e. INR, IDR and PHP) and ‘good’ current account surplus currencies (i.e. THB, KRW, TWD, MYR and SGD) is starting to blur. Reflecting equity outflows from Asia, the recent bout of Asian FX weakness has centred on ‘equity-centric’ currencies, which includes many currencies from the latter group.
'Equity-centric' Asian currencies increasingly pressured by trade anxieties
China seems prepared to accommodate a negative US-led trade shock with monetary policy (more domestic liquidity). With the CNY basket previously near its highs, the authorities could be willing to see some CNY weakening, but in a gradual manner, against the USD. However, recent USDCNY fixings send a clear signal that the authorities are not willing to tolerate a rapid build-up of RMB bearishness. We therefore do not think China will use FX as a trade retaliation tool. China has more to lose from inciting a weaker currency, and is unlikely to risk undoing the efforts of recent years to manage sentiment and outflows.
Recent USDCNY fixings suggest that China is unlikely to use FX as a trade retaliation tool
We are cautious about extrapolating USD gains, as our base case remains that an all-out trade war will be avoided. First, the surprise divergence between the strong momentum in US growth and the slowdown in the rest of the world since early 2018 has driven the USD stronger of late. However, the medium-term base case continues to be for growth re-convergence as breakneck US growth cools and Eurozone and EM growth stabilise.
Second, USD fundamentals are not great. Given the US’s large current account deficit and relatively expensive US equity valuations according to the Shiller CAPE measure, vulnerabilities persist for the USD in the medium-term. Periods of protectionism in US history have been associated with subsequent USD weakness. This is likely because what pushed the US to serious trade action in the past was a perceived loss of trade competitiveness, which was subsequently restored through sustained currency depreciation.Disclaimer applicable to recommendation
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