GBP/USD seen at Risk of America's Trade Protectionism Agenda

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The Pound-to-Dollar exchange rate may be on the rise but the risk of increased trade protectionism by the American leadership could threaten the uptrend say analysts at Morgan Stanley.

GBP/USD is currently trading at a new 18-month high, above 1.3700, as abating Brexit risks and lacklustre US inflation data jointly conspire to push up the Pound against the Dollar.

Despite the undoubted strength of the uptrend, foreign currency analysts with Morgan Stanley are warning of a potential spoiler in the form of a resurgence of trade protectionism in the US.

Recent data, showing the Chinese trade surplus swelling, especially with the US, has begotten rumours Trump may revive plans to impose tarrifs on Chinese imports.

The Chinese have retaliated with a warning that Beijing's taste for US Treasuries - of which it is the single largest buyer - might be waning.

Although the Dollar ended up falling (due to the fear of China dumping US Treasuries) the ultimate outcome of a trade war would be for the Dollar to appreciate, especially versus currencies with an already-weak trade accounts. 

And this is where Pound Sterling is at risk. The UK has a sizeable trade deficit with the rest of the world - including a deficit of just over 3BN with the US - making the currency vulnerable to any potential further deteriorations in trade figures.

If the US imported less it would not need to sell as many Dollars to buy foriegn imports, further increasing its value.

"The recent news suggesting a rising risk of protectionism, in a market environment of stretched risk asset positioning, may be the impetus for a correction in risk and a temporary break in the USD weakening trend. In this environment, liability currencies like USD and JPY should experience support. Currencies most vulnerable to a pullback are those with a high sensitivity to trade and a current account deficit. CAD comes to mind here, as does GBP," says Morgan Stanley strategist Hans Redeker.

But Morgan Stanley are keen to stress that the change in trend for these currencies would probably only be temporary.

"Ultimately, we view this as temporary, but from a tactical perspective, we see value in trading these dynamics as positioning becomes less stretched. As such, we adjusted our tactical trading positions accordingly," adds Redeker.

We also caution that President Trump will most likely not damage any trading relationships where the US has an advantage - as is the case with Britain. Therefore, whether or not growing trade protectionism applies to GBP as it does to CAD is questionable at this juncture.

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Pound-to-Yen a Safe Bet

Whilst the onset of increased protectionism would be positive for the US Dollar, Redeker argues it would be even more positive for the Japanese Yen.

In an environment of increasing trade protectionism investors would almost certainly turn defensive and liquidate their holdings of risky assets.

The Japanese yen is a favoured funding currency, which means it is popular amongst   investors as a currency to borrow in and invest in riskier assets, because Japan has such low interest rates so the interest repayments are low.

During times when investors grow fearful and defensive, however, they tend to liquidate their risky holdings and repatriate their borrowed money back into Yen, and it is this which causes the rise in the value of the Yen due to 'safe-haven' flows.

In the event of an outbreak of trade wars the yen would likely rise because of these risk flows.

Another factor is also expected to lead to a stronger Yen in the year ahead and that is due to Japanese demographics which show the population is both shrinking and getting older as the ratio of young to old falls.

This means there are less economically active people paying into pension schemes which will soon need to sell some of their many foreign asset holdings to pay for the pension liabilities they have. 

The repatriation flows from selling these assets will probably support the Yen.

"A declining number of working age individuals relative to retirees means that contributions to pension funds decline relative to payouts.

"This means that Japanese pensions will have to begin liquidating assets to meet these needs. A significant portion of Japanese pension assets are held abroad (GPIF is targeting a 40% overseas allocation, for example). Thus, declining pension fund AUM will likely push JPY higher via repatriation flows." Says Redeker.

Finally, there is one last factor which is likely to support the Yen, and that is expectations that the Bank of Japan (BOJ) might start to normalize monetary policy, which means ending QE and raising interest rates.

Higher interest rates are positive for a currency because they increase inflows from foreign investors seeking a high return for their money.

The impetus to raise rates comes from higher inflation which is likely to increase - even in Japan says Morgan Stanley- due to the global reflation story, higher global growth and rising commodity prices.

Overall, Morgan Stanley's analysis leads them to favour selling the GBP/JPY as an expression of their market views.

In addition they also see GBP positioning stretched to the upside and JPY to the downside, which means futures data shows traders are overly bullish the Pound and overly bearish the Yen, and this is likely to lead to a snap back as the market rebalances from these extremes.

They recommend selling GBP/JPY down to a target at 138.00 (current market level 152.20) with a stop at 157.50 which will liquidate the trade at that level.

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