Trade wars, brexit and the Fed - DFX key themes
This blog post is to update everyone of the themes that DailyFX expects to focus on in the week ahead. Given the focus of previous weeks, the backdrop market conditions and the event risk ahead; the three topics below will be particularly important in our coverage.
Risk trends amid trade wars
If you somehow were in doubt that trade wars were already underway, the enactment of reciprocal $34 billion tariffs by the United States and China on each other this past week should banish that disbelief. For much of the world, the score is one whereby the US has triggered an opening import tax on the world’s second largest economy for what it perceives as intellectual property theft, and China has retaliated in kind.
From the Trump administration’s perspective, the actions are a long overdue move to balance decades of unfair trade practices. Both feel they are reacting rather than instigating which gives both sides a sense of righteousness that can sustain escalating reprisals. Yet, as discussed previously, this is not the first move in the economic engagement. The United States’ metals tariffs was the first outright move that came without the pretense of operating through WTO channels. And, in a speculative market where the future is factored into current market price; the unilateral and extraordinary threats should be considered the actual start.
The anticipation of a curb on global growth and capital flow very likely was a contributing factor to the stalled speculative reach and increased volatility over the past three months. Yet, markets have not collapsed under the fear of an economic stall with values pushing unreasonable heights. Perhaps this market simply needs to see the actual evidence of fallout before it starts moving to protect itself. This past week, the midnight cue for the tariffs notably didn’t send capital markets stumbling. In fact, the major US indices all advanced through Friday’s session. Blissful ignorance can last for ‘a little longer’, but blatant disregard for overt risks on a further reach for yield is hoping for too much.
A Brexit breakthrough…to the next obstacle
Heading into a full cabinet meeting this past Friday, headlines leveraged serious worries that UK Prime Minister Theresa May would find herself moving further into a corner on a split Brexit view from which she would no longer be able to escape a confidence vote checkmate. Yet, the reported rebel ministers that were pushing for a more stringent position on trade and market access in the divorce procedures seemingly relented.
May was free to pursue a ‘free trade area for goods’ with close customs ties (though bank access would be restricted somewhat). From the market’s perspective, this is a tangible improvement in the general situation as it removes at least one level of ambiguity in a very complicated web. The foundation of ‘risk’ – as I’m fond to reiterate – is the uncertainty of future returns. If your investment is 95% likely to yield a given return, there is little risk involved. On the other hand, if that return is only 10% (regardless of how large it may be) there is a high risk associated. The same evaluation of this amorphous event applies.
With the UK government on the same page in its return to the negotiation table, there is measurably less uncertainty. That said, this was only an agreement from one side of the discussion; and the EU has little incentive to give particularly favorable terms which would encourage other members to start their own withdrawal procedures. Furthermore, there is still a considerable range of issues for which the government and parliament are still at odds. If you are interested in the Pound, consider what is feasible for any bullish exposure with the cloud cover of uncertainty edging down from 100% to 90%.
Fed monetary policy can only disappoint from here
We don’t have a FOMC meeting scheduled for this coming week; but in some ways, what is on the docket may have greater sway over monetary policy speculation. The US central bank has maintained a policy of extreme transparency, going so far as to nourish speculation for rate hikes through their own forecasts and falling just short of pre-committing. They cannot pre-commit to a definitive path for policy because they must maintain the ability to respond to sudden changes in the economic and financial backdrop. And, making a sudden change from a vowed move will trigger the exact volatility the policy authority is committed to avoiding.
Yet, how significant is the difference between an explicit vow on future monetary policy and a very heavy allusion in an effort at ‘transparency’. The markets adapt to the availability of evidence for our course and fill in with whatever gaps there are with speculation. This level of openness by the Fed sets a dangerous level of certainty in the markets. With that said, what is the course that we could feasibly take from here? Is it probable that the rate forecast continues to rise from here – further broadening the gap between the Fed and other central banks?
That is what is likely necessary to earn the Dollar or US equities greater relative value given its current favorable standing isn’t earning further gains. More likely, the outlook for the Fed will cool whether that be due to the US closing in on its perceived neutral rate, economic conditions cooling amid trade wars or the increasing volatility of the financial markets jeopardizing onerous yields. Where the Dollar may have underperformed given the Fed’s policy drive in 2017, it still carries a premium which can deflate as their outlook fades. This puts the upcoming June US CPI reading and the Fed’s monetary policy update for Congress in a different light. All of this said, this is not the only fundamental theme at play when it comes to the Dollar. There is trade wars, reserve diversification and general risk trends. Interestingly enough, all of those carry the same skew when it comes to the potential for impact.
Any questions, just ask.
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