Image © White House
- ING sees risk of lower stocks, USD amid new U.S. trade offensive.
- But Commerzbank looks for safe-haven appeal to offer USD support.
- Soc Gen and Goldman eye CNY correlations, and support for USD.
The Pound-to-Dollar rate is facing a plethora of downside risks coming from at home and overseas, as President Donald Trump embarks on a second major offensive in the so-called trade war with China and the UK government is said to be under pressure to terminate the cross-party Brexit talks.
America's Dollar fell last week, with the ICE Dollar Index declining 0.25% from 97.54 to 97.29, after President Trump said in a Sunday Twitter post that tariffs on $200 bn of annual imports from China would rise from 10% to 25% Friday due to Chinese backpedaling on commitments made in earlier negotiations.
I say openly to President Xi & all of my many friends in China that China will be hurt very badly if you don’t make a deal because companies will be forced to leave China for other countries. Too expensive to buy in China. You had a great deal, almost completed, & you backed out!— Donald J. Trump (@realDonaldTrump) May 13, 2019
This response, and the reasons behind it, is important not only because the greenback is a significant part of the Pound-to-Dollar rate equation but also due to the fact there could be another tariff announcement on the way as soon as Monday evening.
And last week's response by the Dollar is controversial because it differed to that seen between March and July of 2018 when the original range of tariffs were placed on Chinese goods, and the Dollar strengthened broadly through those months.
....The process has begun to place additional Tariffs at 25% on the remaining 325 Billion Dollars. The U.S. only sells China approximately 100 Billion Dollars of goods & products, a very big imbalance. With the over 100 Billion Dollars in Tariffs that we take in, we will buy.....— Donald J. Trump (@realDonaldTrump) May 10, 2019
"The dollar could still be vulnerable from a decline in US equities. Here US earnings look vulnerable to some downward revisions later this year and an all-out trade war certainly wouldn’t help. Given a market reasonably long dollar already on the US macro out-performance story, we’re a little worried that short-term position adjustment could weigh on US assets this week," says Chris Turner, head of FX strategy at ING Group.
Above: ICE Dollar Index shown at daily intervals.
Trump said last week that he's set the ball rolling on a process that could ultimately result in another $325 bn of China's annual exports to the U.S. being subjected to a blanket tariff of 25%, although a formal notification of this is yet to be made by the U.S. Trade Representative.
China has said it will retaliate and financial markets are now bracing to see exactly what shape that response will take, because it could be significant to the outlook. Economists already expect U.S. growth to slow in 2019, but anything that accelerates that slowdown would have implications for currency markets.
China is DREAMING that Sleepy Joe Biden, or any of the others, gets elected in 2020. They LOVE ripping off America!— Donald J. Trump (@realDonaldTrump) May 12, 2019
"It is hardly surprising that the Fed expectations are already falling again," says Ulrich Leuchtmann, head of FX strategy at Commerzbank. "In view of that it should be more surprising that the dollar is standing up so well rather than easing notably. In that sense we have to come to the conclusion: the dollar is a safe haven after all. Not because it is appreciating but because it is not easing despite falling Fed expectations."
The White House imposed tariffs on imports of Chinese goods last year, prompting a retaliatory response from China and ultimately leading to a cease fire and negotiations that began in December but are still ongoing today. It cited "unfair trading practices" and alleged state-facilitated theft of intellectual property.
Analysts appear to have differing ideas about what this new front in the trade war will have on the Dollar, which was expected by many to decline in 2019 as the growth boost provided by last year's tax cuts manifests as a high bar for the economy to clear this time around and brings the market's focus to bear on the Federal Reserve.
Commerzbank suggests the greenback's safe-haven status is propping it up, as the downward move has been too small for it to accurately reflect the much poorer outlook for U.S. interest rates. Financial markets had already been betting on a Fed rate cut coming as soon as year-end, but investors have increased those wagers ever since Trump began firing tariffs at China again.
However, the team at ING and a portion of the market is concerned that the tariff threat posed to the global economy could deflate the U.S. stock market and prompt capital outflows in the process, which would undermine the Dollar and support other currencies. The S&P 500 was up 12.98% for 2019 on Monday, which would be a barnstorming performance for any one year as a whole, much more so for a meagre five-month period.
Others have their eyes on a different set of factors altogether.
Above: Euro-to-Dollar rate at daily intervals alongside USD/CNH rate (orange).
"The market reaction is one-dimensional. The CSI 300 has reversed half of Friday's bounce, and is down over 6% since the end of April. Month to date, 10year Note yields are 6bp lower and the yen is up 1½% against the dollar so far in May, while the Chinese yuan, Korean won and Swedish krona have all lost over 1 ½%," says Kit Juckes, chief FX strategist at Societe Generale. "With the market in this mood, there's no point looking for gains from NOK, AUD, SEK, NZD or CAD."
Juckes says the Chinese Yuan is a globally important currency and suggests that he expects other currencies' correlations with it will hold. Those correlations exist for economic reasons and barring the odd temporary breakdown, might be slow to change.
The USD/CNH rate that reflects the U.S.-China exchange rate has a negative correlation with the EUR/USD rate, although this broke down last week when both moved in exactly the same direction for the duration.
"On Thursday EUR/USD jumped higher amidst significant weakness in risk assets. We suspect the move reflected an unwinding of EUR-funded carry trades in higher-yielding EM currencies," says Monday's morning currency briefing from Goldman Sachs. "We do not think the Euro will generally trade with a negative correlation to risky assets (like the Yen)."
Goldman Sachs says that Euro area economic growth prospects "depend importantly on Chinese activity", which means they're looking for the negative USD/CNH and EUR/USD correlation to reassert itself sooner or later.
The bank forecasts a EUR/USD rate of 1.10 in three-months and has advocated that clients sell the single currency on rallies. The Euro was quoted at 1.1252 against the Dollar Monday.
"The threat of trade conflict spreading to Europe and to auto exports must weigh on the euro. CFTC data show no signs of shorts being cut back and that is a cushion to the downside but -4bp Bund yields are an anchor," adds Soc Gen's Juckes, in a note to clients.
Above: Pound-to-Dollar rate shown at daily intervals.
A renewed negative EUR/USD and USD/CNY correlation would offer a strong contender as an answer to the question of what this new offensive in the trade war could mean for the Dollar in broad terms, and for the risks hanging over the Pound-to-Dollar rate.
Most Dollar indices, including the ICE Dollar Index and the Bloomberg Dollar Index, have flows between the Euro and Dollar comprising a substantial part of them. The Bloomberg Dollar Index assigns a 30% weighting to the currency pair and the ICE index, a stonking 57% weighting.
Meanwhile, EUR/USD trading accounts for 23% of all daily turnover in the FX market, Bank for International Settlements data shows. Combined, these factors explain why if the EUR/USD rate is in decline, it is difficult and rare to also see the Dollar index in the red as well.
This is significant for the Pound-to-Dollar rate because if the Chinese and Euro currencies are seen heading south hand-in-hand over the coming months, as a result of the trade war, then it would take a significant and unique tailwind to lift the Pound-to-Dollar rate as that plays out because of the close economic connection between the Euro area and United Kingdom.
An agreement between the UK's main political parties, and subsequently with the European Union, that sustainably neutralises the risk of a so-called no deal Brexit from happening would be sure to provide such a significant and unique tailwind. But Pound Sterling Live explained Monday why this prospect could be growing ever more distant by the day, which could leave the Pound-to-Dollar rate biased to the downside in both the short and medium-term.
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