The re-escalation in US-China tensions have casted a cloud over the markets and raised fears of a faster decoupling of the two economies.
One of the more interesting aspects of this most recent round of tensions has been China’s restrained response, at least as of this writing. This measured response from China contrasts sharply with China’s strategy at the beginning of the trade war as it used measures including tariff hikes and tech bans.
The key question is why the Chinese have been so calm. One possibility is that China may be waiting for the right time to retaliate. It would seem that China has incentives to wait until just months before the US election to reengage in the trade war.
Alternatively, the behind the scenes bilateral relationship might actually be benign and the saber rattling just political theater. Strong rhetoric is good politics, but actual escalation of the trade war and the resulting economic shock is politically harmful, especially in an election year. Both sides indicate that they want the Phase 1 deal to work so it is possible that this is all just politics.
Regarding the Phase 1 deal, questions still remain around China’s ability to meet its obligations. Even before COVID-19, it appeared to be a significant challenge for China to hit its purchase targets, but markets assumed Trump would let it slide to avoid escalation ahead of the elections. Clearly with the pandemic driving a deep recession, it is almost impossible for China to hit its quota. This is due to both a drop in Chinese demand and disruptions to the US supply chain.
While China will miss on the overall target, expect certain categories to do better than others. The drop in energy prices makes hitting the energy target difficult. However, there is a strong incentive for China to make a push on agricultural goods. Agricultural goods are commodities so their prices tend to converge across regions. Because of this, China should be able to shift to US goods without much of a premium. Critically, by buying agricultural goods from states that support Trump, and increasing those state’s reliance on China, it will give China a stronger hand in the next trade or tech escalation.
For now, the most likely scenario is for continued noise around the US-China relationship with escalation coming after the election. But 2019 has shown economic logic to be a poor predictor of US-China relations. This leaves the possibility that the US could review the Phase 1 deal or China could retaliate before the elections.
Eurozone PMI prints point to a slowdown in economic contraction in May but still indicated a contraction nevertheless. The euro received a boost after Merkel/Macron caught the markets off guard with their EU500 billion proposal despite the lack of confirmation that the French/German plan will be implemented. On the other hand, US-China tensions continue to increase and weigh on the markets. Overall, the picture remains unchanged. As long as Europe lacks a unified fiscal response, its rebound should be less strong relative to the US’s rebound and this will pressure the euro although hopes for a European Recovery Fund breakthrough could provide some support.
The bias on cable remains bearish. Bank of England officials continue to take a very dovish tone. BoE Governor Bailey has not ruled out negative rates and acknowledged that the bank is examining just what its lower bound for rates might be. Moreover, Bailey admitted that his position on going negative has changed since entering the pandemic, but noted that negative rates have received “pretty mixed reviews” elsewhere. As with other countries, COVID-19 issue are pressuring the domestic economy as the poor retail sales numbers show. But unlike other countries, the UK also has Brexit issues with both sides still far apart. The deadline to ask for an extension is at the end of June. With the UK maintaining it won’t ask for an extension, hard Brexit risks are becoming increasingly material.
USDJPY has been broadly range bound since the middle of May. Recent flow data shows that Japanese investors net sold foreign bonds again. Excluding Golden Week, Japanese investors have net sold foreign bond holdings every week since the first week of March. This reduces a factor that has been supporting USDJPY. The BoJ’s emergency meeting came and went with no surprises. As expected, the BoJ set up a lending facility for SMEs with no impact on the currency. Market sentiment-wise, US-China tensions continue to ratchet up. So far China’s response has been measured, but once the National People’s Congress this weekend is over, the risk is for China’s pushback to be more forceful and support safe haven demand.
The CAD’s relatively measured weekly move masks decent intra-week volatility. Risk on and rising oil prices helped the CAD initially strengthen but selling interests (CAD outlook remains weak) and US-China tensions eventually brought CAD weakness. Monetary policy-wise, BoC Governor Lane expressed the view that 0.25% is the BoC’s lower bound and that further cuts were not advisable. Instead, the onus remains on fiscal policy for further support. USDCAD has been in a 1.38/1.42 range in the interbank market and nothing indicates this won’t continue.
US-China tensions continue to hang over the markets and, if anything, have gotten worse. There are two points of view on US-China tensions. A weak global economy and a weakened US economy suggest that the US would be hesitant to escalate tensions. However, growing anti-China sentiment among both Republican and Democrats as well as proximity to the US election flags the risk for escalation. Domestically, China’s response has been measured, but this could change once we get past this weekend’s National People’s Congress. If rhetoric turns action, expect it to be USD bullish and CNY bearish.
The broad story remains the same with the Aussie remaining beholden to equities with local data prints resigned to a secondary tier. Equities appear to be stretched although there is a lack of conviction in either direction. Given this, US-China tensions have taken a step up. Tensions over Hong Kong have added to rhetoric over the origins of the coronavirus among other things. So far, China’s response has been relatively muted, but this could change after this weekend’s National People’s Congress which is negative for risky assets. Moreover, Australia and China have their own tensions.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.10%
Expectations for a 0.25% rate cut to 0.50%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US GDP Q1
Expectations for -4.8% decline
US Initial Jobless Claims
Expectations for 2 million claims
US Durable Goods
Expectations for a -20.0% decline
US Consumer Sentiment Survey
Expectations for a 74.0 print
Canadian March GDP MoM
Expectations for a -9.0% decline
EZ Economic Confidence
Expectations for a 70.7 print
German Business Climate, Expectations and Current Assessment Survey
Expectations for a 78.4, 75.0 and 80.0 print, respectively
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