August 06, 2019

Breaking down barriers

The Chinese Yuan has fallen sharply in value versus the greenback since the Fed’s rate cut and subsequent announcement by President Trump that 10% tariffs on the remaining $300+ billion of imports from China would go into effect on September 1. The breaching of the psychologically important 7.00 Yuan to Dollar level1 on Monday was taken as a sign that the Chinese government may be willing to weaponize the Yuan for leverage in the trade war, despite China Central Bank comments that it is “confident in its capability of keeping the yuan’s exchange rate basically stable"2.

The U.S. Treasury wasted no time retaliating, and by Monday evening designated China as a currency manipulator for the first time since 1994, fulfilling a long-standing campaign promise of President Trump. The move entails Treasury Secretary Mnuchin consulting with the International Monetary Fund in an effort to eliminate any unfair currency advantage. President Trump, however, already had the power (under various statutes) to take a wide range of actions against China. Naming the country a currency manipulator does not increase his options, so the action is largely symbolic.

Why such a ripple effect through the markets?

The S&P 500 dropped almost 3% during the August 5 trading session as the Chinese Yuan breached the 7.00 threshold. For the week of the Fed cut up through the end of Monday’s trading session, emerging market equities fell over 8% and the S&P 500 shed almost 6% (see Figure 1). On the surface, a few percentage point currency move would typically be seen as a relatively small economic matter. In the context of the current back-and-forth salvos between the U.S. and China however, it represents a major escalation of the trade war and suggests a path toward even a partial resolution looks increasingly elusive.

 

What’s next?

With a deal looking unlikely, our baseline case calls for a continuation of the current “slow burn” scenario. Both parties remain sensitive to creating a severely adverse economic outcome (the next presidential election is just over 450 days away…), but without a deal on the horizon neither side is likely to backtrack on existing punitive measures. This suggests a continued move higher in U.S. tariffs over time, and perhaps additional measures by China to pressure U.S. companies in the region. President Trump has also reportedly been considering currency intervention to weaken the dollar, but such a path was recently decided against.3 An additional concern is that if China’s currency continues to depreciate, a competitive devaluation among emerging market countries would cause further stress on the global economy, an unwelcome development against an already slowing backdrop. Interest rates have also fallen dramatically as a by-product of the current turmoil, with the 10-year U.S. Treasury yield now below 1.75%. Expectations for additional support from central banks around the world has increased, and the market is now fully expecting the Fed to cut interest rates at the September meeting, even placing a decent probability on a 50 basis point reduction.

The escalation of trade tensions between the U.S. and China is fast moving and not fully predictable, though we have been believers that the conflict was likely to worsen before getting better. That said, it is not in China’s best interest to let its currency fall much further, so we do not see the most damaging scenarios playing out. President Trump’s recent actions were met with a strongly negative response from the National Farmers Union (China also halted imports of U.S. agriculture), and news stories will start to focus on the potential price increases and margin contraction that consumers and businesses will feel during the holiday shopping season, as companies are in the midst of placing those orders to suppliers. Although it is difficult to see the path to sustained de-escalation and eventual resolution, the path of further escalation is now in plain view. That path is, we expect (hopefully), too ugly to go down.

 

1 Expressed as Chinese Yuan per one US Dollar, or “USD:CNY”

 

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