With the US set to roll out new tariffs on China this Friday, hitting $34BN in Chinese imports with a 25% tax, any hopes that Trump’s trade war with China is “reversible” and mostly rhetorical, are quietly fading away. On Sunday, Morgan Stanley underscored just this point, saying that “the US and its key economic partners now view trade differently: One party’s in-kind response is the other’s escalation” and added that “This is what a vicious cycle looks like.”
MS also said that with Congress unlikely to step in due to a rise in popular support for Trump’s strategy, “a near-term ‘circuit breaker’ to trade escalation is more likely to come from the scoreboard – namely, more challenged and volatile markets.“
In other words, a market crash may be need to break the regime of tit-for-tat, and looking at the sharp market drop to start the second half of the year, the market may be starting to get the message.
What about other markets, especially those in China, where the Shanghai Composite is now down 22% for the year while the Renminbi (-3.3%) just suffered its worst month since FX markets were established in China back in 1994?
According to Deutsche Bank’s Alan Ruskin – who echoes JPMorgan on the topic, here too it’s set to get worse before it gets better.
As Ruskin wrote in a note last week, anyone who has read the latest White House Office of trade and manufacturing policy report on China’s ‘economic aggression’ will understand that “the US – China relations are not going back to a ‘business as usual’ model any time soon.“
And, if he is correct, for the markets here are a few important elements to consider:
- whereas tariffs levered against US’s traditional allies has spotty/weak support at best within Republican and Democrat parties, there is widespread bipartisan support to address China trade issues, not least as it relates to perceived intellectual property transgressions. This means the IP issue is now ‘live’ and will transcend the Trump Administration.
- technology transfer has the potential to impact all trade and particularly FDI. There will likely be a strong interventionist approach on the US side to trade and FDI that has the potential to transfer advanced technologies that is not desirable from a national security standpoint and where protections are not enforceable/ enforced.
- the uncertainties generated by this shift, have the potential to cool China’s role in global supply chains at least as they relate to US corporations, and encourage alternatives where IP is perceived as better protected and where the US is seen having a less ‘competitive’ strategic relationship.
Of course, if a “peaceful” resolution of trade issues does not lead to ‘business as usual’ as assumed above, then the negative response observed from China assets, and the CNY, makes sense, according to DB.
This pivots to another topical question: will China, whose currency just had its worst month in history, seek to devalue even more aggressively? As Ruskin explains, until now China has appeared to take a view that the last thing it needs is to interject CNY weakness into the equation and complicate negotiations with the US. However, the recent price action itself suggests this resolve to keep USD/CNY stable is weakening.
And while this may be a response to the US’s tougher trade stance, it is probably better ascribed to the increased market pressures for CNY weakness.
Making matters worse for China is that Beijing now has no choice but to ease conditions as a result of a slump in the economy, not so much retaliation for US-specific trade overtures. However, to Trump it won’t matter what caused it.
Indeed, the relationship whereby USD/CNY has followed reserve requirements (as per the chart above) is likely to hold as a broader directive on CNY trends, especially with chatter of more RRR reductions to come.
And although RRR cuts should in theory not negatively impact the currency as much as rate cuts, RRR changes have historically impacted the currency more in China because:
- RRR is used as a more active liquidity tool than most parts of the world;
- it does provide a strong directive on the policy bias; and
- the broader policy bias logically gets directly reflected in the official currency bias.
Finally, as the Yuan continues to sink, here is a trade idea from Ruskin who recently noted that USDCNY vol looked under priced, adding that “the 6m straddle breakeven straddles are indicated at 6.46 to 6.75.”
The market is taking a view that China will make sure that USD/CNY is not going to intercede in ongoing negotiations with the US that will straddle the Congressional mid-term elections. However, for a currency pair that has moved from 6.38 to 6.65 since mid-June, vol still looks extraordinary low.
In short, the market still does not appear to have taken on board the likely persistence in shifting US – China relations; nor, the more troubling prospect that divergent US and China policy will engender its own volatility, resulting in a positive feedback loop that only accelerates this divergence. And for those who are leery of shorting US stocks, or the SHCOMP on fears of government intervention, the best bet may be to go long Yuan volatility which according to DB, is assured to rise as the trade was and policy divergence accelerates.
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