US-China: trade war turns to currency war

• What happened
• What's in play
• What's next

In recent weeks, the US trade tariff tit-for-tat with China has escalated. As the countries jockey for advantage, interest rates and currency values are being leveraged in the effort with myriad collateral effects. The result is a mixed and uncertain currency marketplace.

What happened

The FOMC cut rates. As anticipated, on July 31 the Federal Open Market Committee cut rates 25 basis points. Since Chairman Powell said the cut was a "mid-cycle adjustment" and not the start of a full easing cycle, the market viewed the action as hawkish.¹ The Fed may further cut rates if trade tensions escalate and risk assets roll-over sharply.

Boris Johnson took over. "BoJo" replaced Theresa May as Britain prime minister after winning the Conservative Party leadership contest. As parliament scrutinizes his fitness to serve and Brexit proposals, Johnson could struggle as much as PM May did.

White House pushed back on Facebook's cryptocurrency. Treasury Secretary Steven Mnuchin views Libra as a national security issue, voicing concerns about potential money-laundering and saying Facebook has "a lot of work to do" to convince the government otherwise.²

Eurozone's economy slowed. The eurozone grew at an annualized rate of just 0.8% in Q2. Meanwhile, July saw inflation fall to 1.1%, well short of European Central Bank's 2% target.³

Chinese yuan broke above 7 RMB per dollar. On August 3, China's central bank allowed market forces to drive the USD/CNY rate above 7.0, the highest rate in ten years.⁴ We see this as a strong signal and an overt negotiating tactic by the Chinese in response to the latest trade pressures by the White House. 

Joao Gilberto, star of the bossa nova (a musical style that fuses jazz and samba) and singer of "The Girl from Ipanema," died at age 88 in Rio de Janeiro. A new trend in the Brazilian real was not seen.

What's in play

US-China tensions soar. On August 1 President Trump further expanded tariffs on Chinese goods. China responded by allowing the renminbi to weaken beyond the psychologically important 7 RMB per USD, leading Trump to label China a "currency manipulator." If anything, it may be said that China was at least guilty of 'passive' neglect, allowing market forces to take the USD/CNY higher.

Investors seek safety. Responding to first shots in a potential currency war volley, panicky investors sold equities and moved to safe haven assets including bonds, gold, the Japanese yen and the Swiss franc. Notably, investors did not rush to buy US dollars.

Dollar demand weakens. Usually considered a safe haven asset, demand for the dollar softened after Trump's latest tariff salvo. Many economists predicted further tariffs would trigger a reversal in the dollar's uptrend.

Conditions for a currency war line-up. Many conditions for a currency war are in place, including:

1. Sluggish global economic growth evidenced by the IMF further lowering 2019 GDP growth forecasts;⁵
2. Low interest rates in developed countries, with little room for further movement lower; and,
3. Constraints for use of fiscal stimuli. A cheaper currency could boost a country's economy. If the dollar strengthens further, President Trump could pressure the Fed for a significant rate cut and the White House could threaten to sell off US dollars. We anticipate President Trump will likely keep these steps as threats and will launch a "twitter-vention" first.

US bond yields collapse. Over $14 trillion of global negative-yielding debt is outstanding.⁶ In fact, all outstanding bonds of Germany, Denmark, the Netherlands and Switzerland currently trade with negative yields. Today, US Treasury 10-year notes yielding 1.65% still look attractive.

China's economy slows. China's GDP grew just 6.2% in Q2, year over year—the slowest pace in three decades.⁷ As the trade war with the US affects exports, China's economy will need to be fueled by domestic demand, but this won't be an even swap.

Brexit uncertainty continues; pound sterling unsettled. As markets process the possibility that PM Boris Johnson may leave the EU without a deal, July saw the UK pound sterling fall sharply against the dollar, becoming the worst performing major currency against the dollar last month.⁸

• A "no confidence" vote could lessen fears of a "no-deal" exit. UK Parliament returns early September and will hold a confidence vote to determine whether Boris Johnson is fit to be PM. If Johnson loses, which seems likely, the odds of a no-deal Brexit will lessen.
• Scotland vociferous against no-deal Brexit. Nicola Sturgeon, Scotland's First Minister: "The people of Scotland did not vote for this Tory government, they did not vote for this new prime minister, they did not vote for Brexit and they certainly did not vote for a catastrophic no-deal Brexit which Boris Johnson is now planning for."⁹ Scotland, not Ireland, may be the bigger issue for the new PM.

What's next

Central banks to remain center stage. Central banks have been a major driver of financial markets in the first half of 2019, and are expected to continue to be through the second half. Our expectation is they will take steps to actively soften effects of a global economic slowdown.

• ECB meets September 12. Odds are 80% that the European Central Bank will cut rates by an additional 10 bp (to -0.50%).¹⁰
• US Fed meets on September 18. Despite public remarks and a reasonably solid economic/labor outlook, the Fed has begun easing rates. Odds are 58% for another 25 bp rate cut (to 1.75-2.00%).¹¹
• Reserve Bank of Australia (now at 1.00%) and Reserve Bank of New Zealand (now at 1.50%) are expected to cut at least a further 25 bps before year-end.¹²
• Bank of Japan, Bank of Canada, Bank of England and Swiss National Bank all are expected to ease policy in one form or another before year-end.

September/October likely to see reversals. Historically, September and October have been big reversal months in financial markets. For example, last October the US stock market uptrend reversed, the new downtrend costing nearly $2 trillion.¹³ Our expectation is the long-term uptrend of the US dollar will reverse and head much lower during the remaining months of 2019 and into 2020.

Contact us

If you’d like to discuss your specific situation or explore the merits of active FX management, contact your SVB FX Advisor directly, or email us at fxadvisors@svb.com.