FX Monthly Outlook: US/China trade settles into trench warfare

Trump fired two salvos of tariffs at China – one in an attempt to bring the Chinese to the negotiating table and the second in response to a retaliatory round of tariffs launched by China.  The dollar remains strong vs. most major currencies as investors rush to US Treasuries.  Economists at Jackson Hole question the dollar’s function as a lynchpin in global trade as they seek new tools to combat a slowing global economy.

What's Happened?

The Jackson Hole meeting of central bankers left no doubt that trade uncertainty is now a permanent feature of monetary policy making. Furthermore, the US dollar’s position as the preeminent global currency was questioned.  With 50% of trade invoices and two-thirds of securities issued around the world priced in dollars, a substantially weaker US dollar could shock global trade. Dollar-based invoices would have to be renegotiated at best and cause bankruptcy in the worse cases.

Argentina saw an exodus of global investors after President Macri suffered a surprise primary defeat before the October election. Just like Brexit and the US election in 2016, the polls missed voter behavior as Macri was expected to win the primary but instead got crushed by almost 15%. The Argentine peso dropped 32% in a single day and local equity markets have collapsed 48%.  

What’s in play

Trade war slows global economy.  Trumps’ tariffs and his threats of more leads to delays in business spending in the US and other economies. Manufacturing slowed in the US and China and signaled contraction in Germany and other European countries. The dollar continued its summer strength mostly as a safe-haven currency.

Brexit still stuck in UK parliament. Endless discussions and political maneuvers by Prime Minister Boris Johnston will likely result in a new election and the extension of the October 31 deadline.  The UK pound sank below 1.20 and remains volatile.  A hard Brexit combined with political uncertainty could drive the pound below 1.15.

Bond yields upside-down. US Treasury bond yields inverted in August triggering a global sell-off. An inverted yield curve means bond investors will receive higher returns from short-term bonds and lower returns from long-term bonds. Historically, inverted yields have indicated a poor market outlook and could indicate a pending recession. Investors should expect yields offered by long-term fixed income to continue to fall.

Hong Kong protests.  Even though Hong Kong Chief Executive Carrie Lam formally withdrew the extradition legislation that set off recent protests, the Hong Kong economy has suffered. Should pro-democracy protests expand, economic slowing could extend to China, the regional economy and worldwide trading partners. The Hong Kong dollar is essentially pegged to the US dollar since 1984.

India and Pakistan tensions rise. The Indian government moved to revoke special status for Indian-controlled Kashmir. The move further stifles Kashmir’s autonomy, and raises fears of renewed armed conflict. Even though Indian-occupied Kashmir accounts for less than 1% of India’s GDP, the ongoing conflict has compelled investors to pull money out of Indian assets, weakening the Indian rupee to new lows.

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What’s next

September may underperform—again. September has been the worst performing month for the Dow Jones Industrial Average and the S&P 500 since 1950, and the worst performer for the Nasdaq since its inception in 1971. Usually, the US dollar would benefit as a safe-haven currency during periods of global financial market turmoil. However, when equities sank in May of this year, the dollar failed to rally -remaining flat relative to a basket of currencies. If history is a guide, investors should plan for a repeat of sagging equities in September with a weak performance from the dollar.

Fed and ECB will meet. The US Federal Reserve Bank and European Central Bank will meet this month and are expected to further lower interest rates, making credit cheaper and spurring economic activity. Central banks lowering rates through “Monetary Easing” is an accepted policy strategy. However, negative interest rates are an unconventional monetary policy tool. The willingness of central banks to engage in a monetary policy which allows negative interest rates to persist speaks to a perception of central banks lacking sufficient tools to manage today’s modern economies. Negative interest rates in many developed nations could become even more negative.

Spot Returns August 2019

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About the Author

Peter Compton is a senior foreign exchange advisor for Silicon Valley Bank’s global financial services group, and has been with SVB since 2007. He helps clients design and implement hedging strategies for foreign currency exposures. Compton has over 20 years experience in global financial markets.

Before joining Silicon Valley Bank, Compton spent seven years working in the European equity markets. Based in Germany, he spent four years with HSBC and three years as Head of Equity Sales for ABN-AMRO in Frankfurt. Prior to his work overseas, Compton spent seven years with Bank of America in San Francisco as an equity and fixed income derivative specialist.

Compton holds a bachelor's degree in business and management from the University of Rhode Island and a Master's of Business Administration from San Francisco State University.