Hanging in the Balance for FX Traders… Brexit, Trump’s Tariff Threats, and the EU’s unprecedented Plea

From the RagingFX Trading Desk…

Dominating headlines for this week include Brexit, China, and Germany. Here’s is our take for the weeks ahead…

On the Brexit front we anticipate an extension to the March 29, 2019 hard deadline for at least another year. The EU will be holding their elections in May, which will hamper a second referendum attempt. Keeping the status quo, at this juncture, we believe is what is best for both sides, which will most likely secure Theresa May’s role as PM for the near future.

This past weekend Germany caved after witnessing Theresa May’s historic Parliamentary loss of support for the current Brexit proposal. Merkel’s supposed successor, Karrenbauer, issued an unprecedented, emotional plea from the CDU asking the UK to reconsider reentry. The $120b investments and more than twice that in trade exchange value between both countries are weighing heavily on the minds of German leaders.

If you agree that Germany holds the purse strings for the EU, this gesture has significant ramifications politically. If cooler heads prevail, both sides will seek remedies behind closed doors that should buy more time for negotiations.

What does all this mean for FX traders?

Going forward, we see a global recession triggered by the tariff war between the US and China. This morning the latest IMF global predictions concur. China’s debt levels will continue to rise as the government continues to release more funds into the economy. The resulting inflation will depreciate the Renminbi against the US Dollar. In addition, the slowing Chinese economy will dampen commodity demand, which in turn, will hurt emerging markets, all of which will eventually lead to urgent bail outs of their respective dollar denominated liabilities. Those governments saddled with Chinese loans may have little recourse, since the IMF will not recognize Beijing’s competing alternative, the Asian Infrastructure Investment Bank.

In this economically declining scenario, the USD will remain strong at least for a few more quarters due to the current economic momentum. On the mid to long term, we would not be surprised to see the Euro reach parity with the USD as the EU seeks to rebalance its tariff-stricken industries.

© 2018 Tom Kadala

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A FOREX Perspective on the US-China Tariff War

When the White House launched its first round of global tariffs to protect the steel and aluminum industries, they realized quickly that they had missed their intended target, China. After issuing a list of exemptions, they unleashed a second round of tariffs for $50b, this time aiming straight at China’s economy. The response from China came as expected in the form of a tit for tat. Trump then doubled down with a $100b tariff threat at China, where a similar response is expected soon.

What is happening behind the scenes?

Let’s start with a closer look at the import and export numbers between both countries. In 2017 China imported $130b of American goods, while the US imported over $506b in Chinese goods. The trade deficit of $376b no doubt can be viewed as a cause for concern. However, more revealing is the $130b figure because it represents the maximum the Chinese can retaliate against US imposed tariffs. Already with $150b on the line, the Chinese will have a net of $20b more in US tariffs to match. In essence the tariff war chess game between the US and China has reached a maximum ante even before negotiations have begun.

Two questions remain… What else can the Chinese do to match the US tariff burden? …and how exposed is the US economy if the Chinese tariffs are imposed?

Some have suggested that China could stop buying US debt. Such a move is unlikely because the dollar is expected to strengthen for two key reasons. First, US interest rates are on the rise in response to historically low US unemployments levels and, more so, from a broadened US economic recovery. Secondly, and perhaps least talked about is the repatriation of corporate funds overseas. Portions of a 3.5 trillion dollar corporate earnings kitty are being readied to return to US shores beginning in Q2, As this unprecedented flow of funds are transferred into US bank vaults, the impact from the increased demand for USD currency will be felt globally.

For now, China has no reason to sell its dollar denominated investments. The potential combination between increasing interest rates and currency appreciation is a formidable investment with low risk. As for US companies that will be impacted by Chinese tariffs, the net effect from having to pay a higher price for Chinese goods will be partially offset by their stronger USD earnings.

In light of this scenario, we expect the next wave of Chinese tariff retaliations may come in the form of a weakening of the Renminbi, hence, reviving the appeal for Chinese exports, while also maintaining the status quo with weakened non-USD currencies. A stronger US dollar against a weaker Renminbi could potentially be devastating for net exporting countries such as Germany. We expect the economic set backs could temporarily drive the euro below parity with the USD, while their economies adjust accordingly.

With the US corporate tax at a very competitive 21% rate, one could expect net exporters such as Germany to migrate their manufacturing bases and corresponding supply chains to the US. This trend has already begun and is expected to accelerate, especially if the US-Chinese tariff war continues unchecked.

© 2018 Tom Kadala

Powell’s Debut Rattles FOREX Currency Markets

Powell’s first news conference was definitely a switch from the scripted presentations given by his predecessor, Janet Yellen. Despite the difference in style, the message was clear: interest rates are on the rise, unemployment is at historic lows, and what remains to be seen are wage increases followed by an increase in productivity, otherwise, we can expect another recessionary pull back.

What does that mean for Forex traders?

Today we saw the dollar weaken against most currencies. At first it may seem counterintuitive for a currency with a rate increase to fall favor with traders, however, this anomaly is actually a repeat performance from previous USD rate rises. There are numerous academic arguments to support the pull back, however, our favorite is what we have heard from top traders at Goldman Sachs, “it’s just what happens.”.

From a more academic perspective, the 10-year T-Bills at 2.9% are teetering upon a psychological level of 3% where traders and investors believe the US stock markets may stall the longest bull market on record or even reverse it. Their argument is largely supported by the increasing default exposure from emerging countries such as Turkey, which have funded their long term projects with US Dollar denominated short term debt. As rates increase, their dollar denominated interest payments increase accordingly and become harder to pay back. The same is true with US credit card holders. In addition, as US consumer debt levels continue to surge, default levels may reach new levels at home, which could potentially stall the consumer retail engine that represents 70% of the US GDP.

With this unsettling USD backdrop, the GBP (British Sterling) is gaining unexpected strength against both the Euro and the USD. Recent developments between the two Brexit negotiators, Davis and Barnier, arrived yesterday with the usual British pomp and circumstance but in reality only delivered an extension of one year to the status quo. Some progress may have been made on some fronts, but the number of unresolved issues hasn’t changed significantly. Only the final Brexit date was moved to 2020. All of these shenanigans may be negotiating tactics of sorts, but at the end of the day, the feeling one can get from the very strained discussions between Westminster and Brussels is that eventually a referendum will be reintroduced in favor of the ‘Remains’.

Brussels’ negotiating tactics involve a high level of tolerance with little meaningful progress. They are letting this inevitable scenario play itself out. Unfortunately for Britain, when their leaders finally do choose to rejoin the EU (in whatever capacity), they will have gained less for their economy than what they had in place prior to triggering Brexit.

© 2018 Tom Kadala