Dollar Firm as Trade Tensions Rise

  • Rhetoric from both sides is getting more heated, making a US-China deal seem a long way off (if at all)
  • We would downplay headlines claiming the PBOC won’t let the yuan weaken past 7 per dollar
  • Jitters about Italy helped push the euro lower yesterday and that has continued today
  • The US announced it would cut tariffs on Turkish steel by half to 25%
  • Singapore reported weak April trade data; BRL real continues to underperform

The dollar is broadly firmer against the majors as risk-off sentiment picks up ahead of the weekend. The yen and Stockie are outperforming, while Aussie and sterling are underperforming. EM currencies are broadly weaker. RUB and IDR are outperforming, while ZAR and THB are underperforming. MSCI Asia Pacific was flat, with the Nikkei rising 0.9%. MSCI EM is down 0.9% so far today, with the Shanghai Composite falling 2.5%. Euro Stoxx 600 is down 0.6% near midday, while US futures are pointing to a lower open. 10-year UST yields are down 1 bp at 2.38%, while the 3-month to 10-year spread is steady at a flat zero bp. Commodity prices are mixed, with Brent oil up 0.7%, copper down 0.3%, and gold down 0.2%.

Rhetoric from both sides is getting more heated, making a US-China deal seem a long way off (if at all). Chinese state media has gotten particularly strident. An editorial today carried by state-run Xinhua news agency noted that until the US makes concessions on key issues, it would be “meaningless” for US officials to come to Beijing to continue talks. This is feeding into risk-off sentiment ahead of the weekend.

At this point, this means there will be no high-level negotiations between the two until a potential Trump-Xi meeting at the G20 meeting in late June. This means the next round of tariffs will likely come into play, signaling further escalation and making a deal that much harder.

We would downplay headlines claiming the PBOC won’t let the yuan weaken past 7 per dollar. The story, however, suggests that yuan weakness would be acceptable due to fundamental factors but not from speculative activity. This distinction is too fine for us. Basically, our takeaway is that PBOC won’t stand in the way of a broad-based dollar rally.

We note that the correlation between CNY and MSCI EM FX is currently near -0.79. That supports our view that the PBOC has allowed greater market forces to determine the exchange rate, not less. We also note that the spread between USD/CNH and USD/CNY is growing, something that seems to happen under periods of stress. The last time we saw an extended period of divergence was after the 2015 yuan devaluation.

Speaking of EM, MSCI EM continues to sink under the weight of rising trade tensions. Today, it broke below the 1004 area. MSCI EM has given up nearly two thirds of this year’s rally and is on track to test the January low near 946.   MSCI EM FX has fared even worse and is nearing the January low near 1610.

Jitters about Italy helped push the euro lower yesterday and that has continued today. It is trading at the lowest level since May 6 and is on track to test the cycle low near $1.1110 from April 26. Please see our recent MarketView piece for our thoughts on Italy (Italian Political Outlook Hinges on European Parliamentary Elections).

During the North American session, the US reports April leading index and May University of Michigan consumer sentiment. Of note will be inflation expectations component of the Michigan survey. In the April survey, 1-year inflation was expected at 2.5% while 5- to 10-year inflation was expected at 2.3%, both cycle lows.

The Fed’s Williams and Clarida speak today, while Kaplan puts in some overtime with a speech Saturday. All Fed officials are singing off the same song sheet now. Even super-dove Kashkari said yesterday that he doesn’t favor an insurance cut or a cut in reaction to recent weakness in the data. In other words, rates are on hold for an extended period.

Yet the US rates markets don’t see it that way. US yields are near cycle lows, while the Fed Funds futures strip is leaning even more dovish than simply one cut this year and one next year. The implied yield on the January 2020 contract is 2.08%, which is starting to price in a second cut this year. Furthermore, the implied yield on the January 2021 contract is 1.81%, which is starting to price in a second cut next year.

The US announced it would cut tariffs on Turkish steel by half to 25%. These tariffs were enacted last summer as relations between the two worsened over the fate of exiled Turkish cleric Gul. The move comes despite an ongoing dispute about a Russian missile defense system and supports our view that the US is pulling in its horns elsewhere as it focuses narrowly on China. Nevertheless, we remain very negative on Turkish assets despite this move.

Singapore reported weak April trade data. NODX was expected to contract -4.6% y/y but instead came in twice as bad at -10%. The regional trade outlook remains negative until a US-China trade deal is reached. Meanwhile, the economy remains sluggish and headwinds are building. While the MAS does not have an explicit inflation target, low price pressures should allow it to remain on hold at the next semi-annual policy meeting in October.

The Brazilian real continues to underperform. It started the year strong on Bolsonaro-related optimism, but that was clearly misplaced. Markets are repricing their views on pension reforms. Add in growing downside risks to growth as well as a poor global backdrop for EM and we have perfect recipe for a weaker real. USD/BRL made a new high for this move yesterday near 4.05 and is trading at the highest level since October 1, before the election. Next target is the August high near 4.2135 and then the September 2015 high near 4.2480.