22 Kasım 2021
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- The U.S. trade war has triggered further rebalancing of the China’s economy, and it is occurring on-the-fly. Key global risks now lie here.
- Turkey is a fine example of macroeconomic policy done wrong. It’s important that Italy doesn’t follow suit.
- The U.S. economic growth is set to accelerate in H2. The FOMC will continue to normalize its monetary policy, while Trump will impose additional trade tariffs.
The United States have finally hit China where it hurts. Not only has the officials’ rhetoric clearly indicated so, but the economic data and financial markets as well. The data point to dampening credit activity and unusually weak manufacturing, while a possible devaluation of the yuan is the top story for the market.
The People’s Bank of China stated last month that it had the means to keep volatility contained without depleting its currency reserves. What’s interesting is that the wording of those statements was a bit of a departure from the bank’s usual dry rhetoric. And so were the moves China introduced to ease its monetary policy.
In essence, the PBoC has launched its own LTRO-like strategy. The regulator is ready to offer medium- term loans as long as the banks extend credit to businesses and increase purchases of corporate bonds. This plan nearly mirrors the ECB’s 2011 program, which was launched in attempt to solve the sovereign debt crisis. In the current case, China is targeting corporate securities, but the philosophy of the approach is identical.
The PBoC won’t be buying debt, but it’s expanding its balance sheet to provide the system with additional liquidity. This is quite a shift from the policies of previous years, when the regulator’s main tactic was to cut reserve requirements, and that was more often than not done to offset the bank’s currency interventions. Today, however, the PBoC is adding fuel to the fire.
The problem is that the spillover effects will still hit the currency market, and it looks like the PBoC doesn’t mind at all. The yuan has already weakened noticeably against all currencies, and will continue dropping as more liquidity is injected into the system. In the current climate, however, that’s nothing unusual. Weakening its currency is the most obvious thing a country that’s been hit with trade tariffs can do. While dollar revenues falls, earnings in yuan remain do not.
Ironically, this is also the Achilles’ heel to the approach. Expectations of currency devaluation can get so high that they wipe out all the positive effects of the initial exchange rate depreciation. There are numerous examples of that happening in developing countries, a classic one being Argentina, where speculators are so used to dollarized economy that they continue sabotaging their own currency to this day.
China just can’t afford a similar scenario. A one-off weakening of the yuan in response to the U.S. trade conflict can be digested, but what if the Trump administration continues to impose more and more tariffs? Does that mean more and more yuan devaluations by the PBoC? This type of thinking would cause serious capital outflows and pose a threat to the entire financial system.
Of course, the new programs are somewhat beneficial for the banks and local markets. Importantly, China still maintains tight control over its capital account. But experience has shown that these measures are not fully effective. China is now so deeply integrated into the global economy that there’s now way its problems can go unnoticed. EM and commodities are the first to suffer.
In fact, industrial metals and oil have already taken a hit, and we believe the Chinese factor played the primary role. Sure, the markets should have also discounted the slower global growth, as well as the newly-surfaced risks for the world economy. However, physical demand for commodities has slowed down noticeably too, and that’s mainly due to the uncertainty in China’s economy. The country has no willingness to increase their investments and production as it’s unclear who it can trade with, and on what terms.
The currency market has also felt the weight of the trade war. The major victims here are the Korean won, the South African rand, the Chilean peso, the Thai baht, and the yuan itself. Those are instruments that are less popular among traders. The more traditional trading choices—primarily the euro—have not been directly affected by the trade-war headlines thus far.
The trade war has more of an implicit effect on the most liquid instruments, specifically through the balance sheet story and GDP expectations. In fact, we believe that growth forecasts will raise most questions over the next couple of months. One the one hand, as of the end of July, there is nothing that would suggest Trump’s aggressive policies have had any negative effect on the country’s economy. The U.S. GDP accelerated by 4.1% saar in Q2. Plus, the price component of the PMI is showing record- high growth, pointing to inflationary pressures building in the economy.
But on the other hand, the story is not as bright in the rest of the world. While the slowdown in Europe remains in line with expectations for now, China is fighting for survival. We are by no means suggesting that there’s no hope for the Chinese economy, but the challenges facing Beijing are too serious to underestimate. As mentioned earlier, the response to the U.S. trade tariffs has so far been adequate, but weakening the national currency is a dangerous tactic. And the country is short of time to find fundamentally new solutions.
This mix of factors, rather than the trade war itself, is contributing to the fundamental background. The Fed is now viewed as the most hawkish central bank, helping the dollar to continue strengthening against its major counterparts in July. Moreover, the FOMC will proceed with more rate hikes under any scenario. The current situation is clear: higher economic growth and new inflationary pressures will
prompt the regulator to deliver two more hikes this year and three in 2019.
But let’s suppose the trade war is elevated onto a whole new level, and its implications fully manifest themselves, meaning an economic slowdown and a surge in import prices. Surely, the regulator would still have to focus on price stability like the Volcker-led FOMC did in the 70-80s. Meanwhile, the other central banks would at least keep their rates unchanged and at most cut them, simultaneously trying to devalue their national currencies.
The markets are starting to realize that such a scenario is not off the table under the Trump administration. It is still highly unlikely: we estimate the chances of it happening to be less than 5 percent. But the risk is now there. With that, the dollar is closing the month around local highs, and could proceed with a slow and uneven strengthening in August. Meanwhile, EM-markets are floating in the sea of problems of their own, and are likely to finish the summer on a shaky note.
For Asia, the critical theme is the yuan weakness. Nearly every regulator is allowing their currencies to weaken in an attempt to remain competitive. Then, there’s the sad story of Turkey, where the government has undermined the country’s key institutions and damaged macroeconomic stability. At its most recent meeting, the Turkish central bank unexpectedly kept interest rates unchanged, a move that the market has linked to Erdogan’s new powers obtained after the referendum.
This story is critical for two reasons. First, Turkey is one of the key emerging markets, and upheavals in this country give the entire EM world a bad rep. Traders aren’t exactly lining up to invest in undeveloped economies anyway, and Ankara’s actions are driving the remaining money away from this asset class. And while the Lira doesn’t immediately affect other currencies, upside potential for the entire class is very limited. The Mexican peso is perhaps the only exception among more or less liquid currencies.
Second, the Turkish story is a stark reminder of what happens under an unpredictable administration. Here we would like to bring up Italy again. In the previous edition of this publication, we detailed the risks posed by the country’s politics. And when the new government gets to work in September, we may be in for all kinds of surprises. The main risk still lies in Italy’s new budget plan, but some questionable ideas have been voiced in other aspects as well. As the ECB winds down QE, creating drama in the Italian debt market is all too easy. This will be among the factors undermining the euro —and supporting the dollar—in August.
EURUSD: trend exhausted, new fundamental drivers needed.
We stay out of the market.
The corrective downtrend is slowing, the volatility is dying, and we don’t expect a significant new trend to form in August. There shouldn’t be any policy surprises as both the Fed and the ECB appear to be sticking to their previously outlined plans. There’s way more uncertainty in other areas, but that’s only tying investors down. The market positioning is neutral, which makes it difficult to come up with any trade ideas for August.
From the technical viewpoint, EURUSD is stuck in the 1.159-1.185 area, with the upper bound being way thicker, and much more difficult to break. Speculatively, short positions still look attractive as long as the euro manages to rebound above 1.18. A test of 1.159 is even likelier, and would make for a good speculative trade with a minimum target of 1.145. The farthest target is the 1.12 mark, but such a move would require reconsidering the whole mid-term outlook for the euro.
AUDUSD: China’s local issues on top of global slowdown.
We sell AUDUSD targeting 0.712, stop-loss at 0.747.
The Australian dollar is the clear loser among the G10 basket—the currency wouldn’t rebound much even during risk rallies. The past month saw AUDUSD consolidate as it’s preparing for another dive. China’s economic troubles will be the main driver for further Aussie weakness, coupled with the general growth slowdown, as well as the decline in commodities.
We also point out that nearly every AUD cross is showing clear signs of weakness. The most interesting pairs here are AUDCAD and AUDMXN. The former is a bet on the loonie being undervalued given where oil is currently trading (and to 70+ levels in Brent have now proven sustainable for the time being). Canada is largely dependent on the United States, and economic developments in the entire North America are more or less synchronous. This very same idea is behind going long the Mexican peso, as explained below.
USDMXN: among the first EMs to offer value.
We remain short USDMXN targeting 18.3/16.34, stop-loss at 19.5.
Mexico was one of the first EM-countries to catch the heat of Donald Trump’s fiery rhetoric. The talk of a border wall (paid by Mexico, naturally), the renegotiation of NAFTA and, later, new tariffs on automotive imports—have all been massive blows to the peso. The Mexican currency fell to an all-time nadir of 22 in early 2017, but it has been on the recovery path ever since.
As of today, Mr. Trump seems to hate NAFTA the least, while new trade tariffs are being designed to inflict as much damage on China as possible. That’s why investors have begun buying out the fundamental discount that had built up in Mexican assets. From the technical viewpoint, USDMXN is aiming at the 18.1-18.34 area, and then, after a corrective move towards 18.7-18.8, could head for 16.4. Going long on the Mexican peso against the dollar is the classic trade here, but there are other tempting ideas, such as going long MXN against the TRY or AUD.
XAUUSD: gold in free fall.
We remain short XAUUSD targeting 1130, moving the stop-loss to the entry point (1292).
Gold continues to lose its shine. Out of the past seven weeks, XAU closed six falling sharply, and only one single week nearly unchanged. The sell-off is mainly caused by the rally in U.S. rates, but the speed of the price decline is surprising. The troy ounce has already dropped to the first target outlined in our previous review ($1226/ounce), and there are no signs of the trend slowing down.
We would refrain from opening additional short positions at the current levels as there’s a build-up of speculative shorts. A weakening dollar could wipe it out, elevating gold prices back to the 1240-1250 area. We would, however, consider restoring the short position once those levels are reached.
We also remain short USDCAD, AUDJPY, and long USDRUB.
The S&P500 short stopped-out, the EURUSD long closed out at 1.1705 as the trend has weakened significantly.
Analytical materials and comments reflect only personal views of their authors and can’t be considered as trading advices. AMarkets is not responsible for losses as the result of analytical materials usage.