On Monday, the Trump administration announced a new round of tariffs on Chinese goods entering US markets. After targeting $34 billion worth of Chinese goods in July and another $16 in August, the Trump administration upped the ante four-fold by targeting another $200 billion of Chinese goods that goes online the 24th of September.
Through it all, US markets have largely yawned. Since its February low, the S&P 500 is up 14% as the bourse eyes an all-time high above the 3,000-point threshold. Last week, a whopping $14.5 billion flooded into US equity funds. The technology-laden Nasdaq is up 18% over the same period. While US bourses sketch out all-time highs, China’s Shanghai Composite languishes in bear territory, down 21% from its January peak. Hong Kong’s Hang Seng is deep in correction territory, down just under 16% also from a January peak. China continues to rein in the economy’s credit-fueled excesses and the country’s mountainous debt pile. Slower economic growth is the result, making the economy vulnerable to the unpredictable path of increasing trade tensions with the US.
As expected, China responded dollar for dollar in July and August while promising a further $60 billion on US goods destined for Chinese markets in its latest tit-for-tat response. With the noted exception for already tariffed steel, aluminum and Canadian softwood now adding cost to the Carolina cleanup in the wake of Hurricane Florence, US consumers will likely not feel the full thrust of the economic bite that is in store on a voluminous list of imported, off-the-shelf items much before the New Year. It is then that the current 10% tariff morphs into the more substantive 25% duty.
True, investor reaction here in the US was demonstrably one of curious relief. The Trump administration scaled back the bite of the proposed $200 billion tariff package, perhaps reflective of a continuing White House struggle between mercantilist hardliners and more internationalist voices on trade policy. The initial 10% tariff duty comes across as a compromise, cushioning the blow to consumers in the coming holiday buying season. (That most imported holiday retail fare has long been purchased and mostly delivered by October is beside the point.) The lower duty venue left ample room for investors to breathe a sigh of relief and push markets higher before the Fed raises short-term rates in September and again by the end of the year. December’s tax cuts have pushed capital investment by US corporations up $365 billion through the end of the 2nd quarter YOY. A buoyant market continues to titillate consumers’ fancy which sent August’s confidence reading to its highest level since October 2000. US trade tariffs have now targeted about $250 billion in Chinese goods entering US markets, just short of half of the $505.5 billion in goods imported by US companies through the end of 2017. And then there is the issue of another $267 billion in targetable Chinese goods that looms on the immediate horizon. The white elephant in the room? US imports almost three times the market value of goods from China than it exports in goods and services to China. US exports to China totaled $129.7 billion through the end of last year. All told, the respective US-China tariff regimes still remain small as a measure of total global trade, about 5.2% according to data by London-based Oxford Economics.
The dollar is up just over 9% from its February low through the second week in August. Since then, the dollar has lost almost 3% at the same time the 10-year note has gathered support above the 3% threshold closing with a yield of 3.06% at Friday’s market close, up 24% YTD. At some moment in the calculation, higher bond yields on the heels of two more Fed hikes in short-term rates should buoy the dollar. Instead, the dynamic has flipped on the notion that this year’s hikes are already reflected in current market pricing—explaining at least some portion of investors’ born-again risk appetite for equities. Coincidentally, the 10-year yields on US, Japanese, Canadian, Gilts and Bunds have all joined in on the sell-off festivities. Even emerging market currencies and equity positions are looking slightly more palatable to the intrepid few, despite losing $962 million in outflows last week, the sixth consecutive week of outflows for the space. If a greater appetite for risk is driving bond yields higher, higher bond yields, stronger equity demand and a weaker dollar can theoretically exist. The question is for how long. And the answer will determine if either the bond sell-off or investors' added risk appetite have legs.
Figure 1: The Chinese Renminbi, the US Dollar, the Japanese Yen and the Euro
From December 2016 through the middle of February the dollar (red dotted line) lost about 8% of its value in trade weighted terms. Global financial conditions demonstrably eased during the period as the weakness of the dollar translated into added strength for the euro (orange line) and the yen (blue line). Carry trade opportunities opened up as risk calculations fell making high-yield investments throughout the EM space more attractive. As EM banks’ appetite for risk diminishes, loan activity increases. EM banks invariably use dollars for lending against fixed asset collateral—homes, buildings, factories, equipment. When the dollar strengthens, the market value of collateral falls. In the finance world, a margin call would be triggered to rectify the imbalance. In the banking world, the loan backed by depreciated fixed assets simply becomes riskier. For non-US banks, heightened risk due to a strengthening dollar hits loan volume and, as a consequence, bottom line margins. For the economy at large, less lending by banks is a squeeze on forward growth.
The yen (FXY) (blue line), the euro (FXE) (orange line) and the renminbi (CNY) (green line) all strengthened against the dollar (UUP) (red dotted line) with the yen leading the upside charge. Since September of 2017, the market moves of renminbi and the euro appear closely correlated both to the upside and the downside through April 2018. As the dollar began to strengthen, all three currencies staged a retreat in close approximation. The renminbi, of course, is a managed currency that comes complete with a narrow trading range set daily by the People’s Bank of China (PBOC) against a basket of 13 of the country’s biggest trading partners, including the dollar. Forward guidance has trained investors in the developed world to anticipate central bank monetary moves in advance. The PBOC offers up no such guidance. This allows the renminbi to move in a much wider range against the dollar than would otherwise be the case if pegged directly to the dollar as it was prior to August 2015. Greater allowable movement against the dollar keeps Chinese corporate debt denominated in dollars on a more reasonable servicing plane. It keeps Chinese export goods priced to the low side in world markets vis-à-vis developed country currencies within its pegged basket of currencies. It dampens mainland capital flight to safe harbor assets particularly in the US—saving the PBOC billions in forex reserves defending the renminbi in world currency markets. And it also wreaks havoc on EM Asian currencies umbilically tied to the Chinese market, like Indonesia and Malaysia.
In 1965 it was then French finance minister and later President Valery Giscard d’Estaing, that brought into the popular vernacular the notion of the “exorbitant privilege” the US enjoys in the dollar’s role in the international monetary system. Then as now, the continuing source of the dollar’s strength in world currency markets is the dollar’s role in global finance. Global reserves held by central banks have maintained a 63% or more balance in US dollars through the end of 2017. Almost nine out of ten currency transactions each day are conducted with the US dollar. Almost all commodities traded in global markets are denominated in US dollars (cocoa is one exception). While China accounts for about 13% of global trade in goods, those transactions overwhelmingly are conducted in US dollars, not renminbi. The Swift cross-border payment service, based in Belgium is one of the world’s biggest processors of international payments transactions. The US exercises no formal control over its governance. Still, the Trump administration posted a November deadline for Swift to unwind all transactions with Iranian banks for the international payments of goods and services under the threat of US sanctions after the US pulled out of the 2015 Iranian Nuclear deal this past May.
There is no other country in the world that has the capability of enforcing such a decree other than the US. While the euro is the world’s second currency at just over 20% of daily payment transaction worldwide, the euro woefully trails the dollar in just about every other important global financial statistic. The renminbi at less than 2% of daily transactions, barely registers on the scale. Curiously, the Trump administration’s animus for multilateralism provides the best environment imaginable for Europe to challenge the dominance of the US dollar in the global financial system. And there’s the catch: Such a feat would require a major structural makeover of EU institutions that support the euro as a reserve currency. A pan-EU deposit insurance, a pan-European regulatory system both come to mind. The address of macroeconomic imbalances that form the basis of an almost permanent current account surplus in Germany, the Netherlands, Ireland and Italy remains a sticky international issue. And most certainly the launch of single safe asset, the Eurobond, remains far in the future.
Figure 2: The Chinese Renminbi, the Japanese Yen, the US Dollar and the Euro, 2018 YTD
Chinese market declines either on the Shanghai Composite or the Hang Seng are more modest than was the case in the August 2015-16 timeframe. That said, the memory colors the thought processes of central bankers, governments and investors alike. So far, there is little report of fleeing capital into safe harbor investment vehicles abroad. Instead, the downturn appears more connected with a slowing economy which has loosened monetary policy by the PBOC, including tax cuts and infrastructure spending in an effort to reverse the slowing economy and a sliding renminbi (green line). Increasing trade tensions with the US since May (downward green trend line) add further complexity to the equation. Offsetting fiscal measures included Rmb6.5 billion in tax cuts on R&D and plans to issue special bonds to finance infrastructure investment, providing evidence of officials’ worry that the country’s trade war with the US will exacerbate a domestic slowdown. In the 2nd quarter GDP grew at its slowest rate since 2016. Another Rmb502 billion was injected into the Chinese financial system in July which followed the Trump administration’s announced targeting of $200 billion in Chinese goods destined for US markets. The PBOC used its medium-term lending facility, designating the funds for three to 12-month loans. The PBOC injected another Rmb149 million into the banking system through loans to commercial banks in the last week in August, attempting to encourage stronger credit flows to companies and local governments.
This all comes at a time when the Fed is actively tightening monetary policy as a reinvigorated US dollar (red dotted line) bounced off bottom in the closing days of March (upward red trend line). Next week’s 25-b/p bump in the federal funds rate will be the third such increase this year, with another 25-b/p hike penciled in for December. Coupled with the new level of $50 billion/month of treasuries and mortgage backed securities offloaded from the Fed’s balance sheet starting next month, US monetary policy should be expected to firm up the dollar’s 3% slide since August (downward red trend line). At the same time, the renminbi trends to the downside (as does the euro, orange line). Both the renminbi and the euro can be expected to weaken further moving forward.
China continues to de-risk its supply chains, mainly by minimizing the country’s dependence on the US at critical chokepoints to its further economic development. The $129 billion in US imports through the end of last year largely pales in importance to the $250 billion value added to the economy by US companies manufacturing on Chinese soil. There will be no retribution taken on this front. The chokepoints are well-known: semiconductors, semiconductor fabricating equipment and aerospace. US dominance in semiconductors clearly struck home loud and clear to Chinese planners with the US banning of telecom giant ZTE from US technology imports for seven years. The reversal of the ban without wringing any concessions in trade or other areas of dispute between the two countries remains a mystery. Most of these industrial chokepoints have escaped the tariff regime to date with few notable exceptions. Interestingly, liquid natural gas imports from the US which drew an unexpected 10% tariff last week is a notable exception. LNG is a critical industrial component to the country’s ongoing battle to rein in the numbing environmental damage from its heretofore unbridled industrial cavalry charge of the past two decades. In the agricultural space, sorghum and soybeans could easily be added to the list. Both sorghum and soybeans now have steep tariff duties attached which has essentially nixed US-Chinese trade in these commodities for the foreseeable future.
In essence, the renminbi has become a proxy for the Chinese economy and by association, the EM space—not to mention the ongoing risk appetite of investors here and abroad. Investors universally believe the PBOC will maintain a floor on further devaluation of the renminbi. Chinese Premier Li Keqiang in a speech to the World Economic Forum in Tianjin, China said his country would not devalue the renminbi but keep its currency at an adaptive and equilibrium level. Presumably, this takes a repeat of August 2015 off the table. That said, Beijing can likely be relied on to allow its currency to slowly weaken through benign neglect, rather than opting for the more abrupt and destabilizing overnight devaluation.
It goes without saying: If trade tensions increase and the renminbi floor abruptly collapses, the flight of international capital flows to safe harbor assets will be as swift as it is financially destabilizing for all concerned. The EM space will certainly suffer the residual fallout. And the current risk appetite of investors throughout the developed world will be sucked dry in the mayhem.
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