Who Will Win The Trade War? Dollar Vs. Yuan

Summary

• A weaker yuan puts pressure on the global economy.
• The USD is climbing higher because of trade protectionism and a stronger economy.
• The trade war has evolved into a currency war.

Editor's note: Seeking Alpha is proud to welcome Kyla Scanlon as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »

The US Dollar. The Greenback. The Buck. The Paper. The Benjamins. No matter what you call it, the value is determined by several different variables (expectations, term premiums, interest rates, fiscal balances, national savings, and demographics, to name a few). It’s also a fiat currency, meaning that it actually derives its value from the “full faith and credit in the government”.

Source: C. Economics

The DXY (an index that measures the dollar) has gone up 6% since the beginning of the year due to several macroeconomic variables. It is third in value only to Switzerland and Sweden, according to the most recent Big Mac Index (which is unprecedented). Because the USD isn’t tied to anything tangible (like gold), there are opportunities to manipulate the value of the currency. The gold standard served as baseline for the dollar’s value, and when we were taken off of that, the excessive use of the printing press became a way for us to manipulate the value of our currency. And other countries can do the same. Historically, China has been really effective at manipulating their currency through the purchase and sale of American bonds.

China has the ability to do this because they have a large influx of U.S. dollars through America’s purchase of Chinese goods. For example, say that you buy a t-shirt that's made in China from your favorite store for $15. That $15 is divided amongst the various retailers and distributors, and approximately $2 makes it back to China.

Once those dollars make it to China, the Chinese manufacturer needs renminbi to pay workers, to buy t-shirt supplies, and to pay rent etc. So, they turn those dollars into RMB at the nearest local bank. The local bank then turns those dollars over to the People’s Bank of China (similar to our Federal Reserve) for the rate of exchange.

The PBOC will then transfer that money to the State Administration for Foreign Exchange, which determines where the dollars will be allocated. Sometimes, they are invested in US equities, sometimes other foreign currencies, but most of the time in US Treasuries.

The dollar then is reinvested into America to be spent again on Chinese goods.

Source: Author

This creates the opportunity for Americans to continue to engage in trade with China. The U.S buys their goods, pays them dollars, which China reinvests in American bonds and then repeats the cycle over and over again.

Because of this relationship, we carry a trade deficit with China. A pretty large trade deficit.

Source: Wolf Street

The US owes China a lot of money. And China doesn’t really owe the US much of anything, in terms of trade. This deficit has gotten worse over time. The images above and below give you an idea of the discrepancy in trade. But this isn't a bad thing because of comparative advantages that China has in production of goods.

Source:

Economics Exchange

China can produce things cheaper and more quickly than the US can, so it makes perfect economic sense for the US to take advantage of that. As Daniel Griswold of the Cato Institute wrote,

“Trade deficits are not a sign of unfair trade practices or of a lack of American competitiveness. Trade deficits are caused by factors in the macroeconomy that are not directly related to trade”.

America’s manufacturing heyday is behind us. In today’s world, America is a net importer of capital. The dollars that Americans spend on foreign goods in theory get invested into American assets in the form of T-bills, stocks, real estate, etc., as discussed in the cycle chart. These investments should in theory boost the capital account (the US’s bank account) and thus boost the economy.

In today’s global economy, a trade deficit created by using respective comparative advantages can be a good thing. However, in response to a perceived imbalance, we’re seeing governments seek to “correct” the issue by issuing tariffs.

Griswold once said,

“Slapping higher tariffs on imports will only deprive foreigners of the dollars they would have earned by selling in the U.S. market.” The idea stems back to the simple thesis: “Free Trade Creates Wealth”.

Taxation on imports (tariffs) do not. Tariffs take away jobs, can create a rise in domestic prices, and create general discontent across the board. For example, consider some of the effects of the Bush Tariff (2002):

• 200,000 Americans lost their jobs, with “more Americans losing their jobs in 2002 to higher steel prices than the total number employed by the US steel industry itself.” (Forbes, 2016)
• Sectors underperformed
• Allies were upset
• The economy took at $30b hit

Source: Fisher Investments

As Carlos Gutierrez, Bush commerce secretary said “What we have learned over the years is that protectionism doesn’t protect. Protectionism actually harms.” Why would anyone repeat this blunder? In 2002, Bush used Section 201 of the Trade Act of 1974 to implement the tariffs. 201 allowed for an investigation of industries that could potentially need safeguarding from imports and further allowed action to create those safeguards. This time around, Trump declared under Section 232 of the Trade Act of 1974, which declares a national security threat on certain imports and uses tariffs as a means to provide added security. The statutory mechanisms for the tariffs are two very, very different things. Bush’s tariffs were not severe in context. Trump's tariffs, not so much.

China is definitely showing discontent with the tariffs that have been levied on them. They are lowering the renminbi for several reasons, one of them to potentially curb the impact of the tariffs.

China is expected to surpass the US in terms of GDP, with expectations ranging from 2020 to 2029. They export products to almost every single country in the world and have EM Asia on a hook. Take a look at the Belt and Road Initiative. They are developing “a whole China-centered trading network”, and the US is not invited. They also own a lot of US debt. This could be problematic, especially if they chose to release the debt.

China is a powerhouse with quite a few economic weapons on their hands, and their ability to manipulate their currency is one of those.

Source:Zero Hedge

The USD/CNY has fallen 8% over the past 3 months. Essentially, China is loading their weapons. They are showing the world that they are ready for a fight. And the strategy makes sense. Back in 2015/2016, China artificially devalued their currency and decimated global growth around the world.

Source:

Business Insider

The S&P 500 fell by 6.1% that August. EAFE fell 7.4%. EMs fell 8.8%. Volatility went through the roof.

Source:

CNBC

Emerging market volatility rose 75%, Developed market volatility rose 67%, and China volatility rose 50%. The VIX (S&P 500 volatility index) rose a sparkling 143%.

Source: Market Realist

So, to say that we are a globalized economy and that what China does with its currency matters is quite a bit of an understatement. The market has been showing incredible strength under Trump’s presidency, but he has developed into a variable unto himself. And what he says matters. Trump recently criticized a stronger dollar, citing that China and other countries were manipulating their currencies and taking away our “big competitive edge”.

Source: Twitter

He also criticized interest rate hikes, directly going after the Federal Reserve. Both statements deliver the same message: “The dollar is too strong.”

Source:

MSN Money

And the dollar reacted, with the DXY dropping 0.72% by the end of the day. Despite that, the dollar is still up 6% from lows of this year. And it should be because there is a continuous cycle of news that tells us how great things are:

• Fiscal stimulus in the form of tax cuts.
• Rate hikes.
• Record “low unemployment”.
• Low jobless claims.
• GDP growth.
• “Good inflation numbers”.
• 90% of US companies beating earnings by 4.5% on average.

This all combines into a big pot that should influence investor sentiment positively. But if China keeps devaluing its currency to maintain its export volume because of the tariffs enacted on it, none of those things positive messages will matter. It will create a global ripple effect and create weakness across all markets.

Source:

Deutsche Bank

According to the above Deutsche Bank analysis, if the USD/CNY moves to 8 (it is currently around 6.81, so it would be a huge move), US financial conditions will see a contraction of 0.57 points.

Source:

Deutsche Bank

That would result in an equivalent Fed easing of 55 bps. Two rate cuts. Just to neutralize the effect that the yuan devaluation had on the market. And we really just started raising rates. If China continues to devalue their currency, the US will be in trouble.

Conclusion

Starting a currency war with a global powerhouse (China being the global powerhouse) is not a good thing. If a continuation in devaluation and a Fed intervention did happen (extrapolating here), it would result in a systematic shock, pushing the dollar down even more and a flight from equities into bonds, which would subsequently push the market down. If the Fed didn’t move rates, China would continue to engage in currency devaluation, which would result in quite a few problems for our markets. Either way, it would be a realization – there are no winners in a trade or currency war.

The dollar is in a period of strength, approaching early-2017 levels. There are several consequences of a stronger dollar (including hurting exporters), but a country's currency should reflect the strength of that country's economy. If everything is going so well, the dollar should gain strength. The risk is other global currencies. If China continues to devalue its currency, or allow it to get weaker, that could pose an be an economic risk to the US. If the USD/CNY appreciated to 8, an 18% increase from current levels, the Fed would have to seriously consider the potential repercussions.

So, if you think that the yuan is going to continue to get weaker and the US economy will suffer, maybe it's time to buy some yen. The Invesco CurrencyShares Japanese Yen Trust (FXY) is trading $3 above 52-week lows and has room to expand as the Bank of Japan finally increases the yield on the 10Y government bond. The yen is the only currency to have appreciated against the dollar for the first 6 months of 2018, and as global tensions continue to rise, it will continue to act as a safe haven.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.