Anticipation and Scenarios Into the Sunday US Deadline for China Tariff Escalation
The active week of trade ahead will be pocked by a few very high profile events which will tap into key themes. Monetary policy and Brexit updates – both with explicit growth implications – are top listings while liquidity is readily available. Yet, one of the most potent potential events ahead has a deadline that occurs over the weekend. The United States warned some months ago that it would increase the tariff list on Chinese imports if the two countries had not reached a meaningful compromise. Though the two countries seemed to agree to the concept of a Phase One deal back in mid-October before a planned escalation in the tax rate on existing tariffs, the details on this accord have thus far been notoriously absent. White House officials and President Trump himself have stated explicitly these past two weeks that they intend to follow through with the escalation if a bargain was not struck. Of course, what qualifies as acceptable to reach a stage one accord and ward off the onerous escalation is open to interpretation, so the future is ambiguously in the Administration’s hands. We have been here so many times before (see the image) that the markets have grown numb to the risks that exist should the outcome be poor. That is a particularly dangerous brand of complacency.
With this uncertainty and hopefully a little more introspective appreciation of the risk it represents in mind, it is worth considering the scenarios. Through the active trading week, it is unlikely that US or Chinese authorities pull the plug early and make clear another wave of painful tariffs is in the cards. Rhetoric to reiterate what is at risk is very likely as both sides intend to pressure the other in their long-standing ‘game of chicken’ but that is par for course. That suggests that if there is any truly definitive development in this tense trade negotiation, it would more likely turn out to be a breakthrough that disarms the threat. That could very well offer a relief rally to risk assets, but there aren’t many that are deeply discounted at this point and it would struggle to recharge the year-end liquidity fade. More productive would be a rally for the Australian Dollar. The currency has suffered a crushing depreciation over the these past years as the same connection between the Australian and Chinese economy that helped the former avoid recession during the Great Financial Crisis is now steering it into the rocks. With AUDUSD also suffering from the lowest activity reading (25-day ATR) since 2002, conditions seem ripe for a spark.
Alternatively, if we head into next weekend without a favorable resolution in hand, traders should consider thoroughly their risk tolerance with holding exposure as exchanges close through Friday. It is certainly possible that there is a last minute agreement in the hours before the stated US Trade Representative’s Office deadline, but that is a lot of assumption to put on the shoulders of politicians who have not committed to any significant de-escalation efforts since this trade war started. What’s more, the bullish case scenario is relative tepid as discussed above. Alternatively, the inability to strike an agreement, would increase the stress on global growth materially. Considering the US indices as a milestone for risk are just off record highs, there is worrying premium at risk should blind enthusiasm be crack. This revelation of pain could be made when Asian markets are online and thereby some liquidity to respond, but shallow market conditions amplify rather than absorb volatility shocks. Consider your risk tolerance.
The Genuine Concern Underlying Both the Fed and ECB Rate Decisions
There are a host of major central banks due to update their policy over the coming week. For the majority of them, no change is expected. That doesn’t come as much of a surprise given the general state of monetary policy across the globe as well as the condition in capital markets as of late. There has been a not-so-subtle escalation in global accommodation through 2019 that has included rate cuts (for some into or further into negative territory) and material purchases of assets. Growth measures of late may have also solidified the lackluster outlook, but the balance of risk assets removes some of the urgency to push support further into uncharted territory. There is a cost associated to everything, and the balance of global monetary policy is showing increasingly greater cost relative to the quickly fading benefit with each subsequent iteration. That is what traders should be truly monitoring when it comes to monetary policy events like these this week and into 2020; because should confidence founded on this support falter, the optimism that it has filled in for these past years will cause a likely-severe rebalancing of priorities.
Now, we have seen serious questions over the effectiveness in monetary raised these past few months, but the concerns have been beat back after some short pangs of concern. That said, so long as the global economy continues to flounder despite the efforts; the risk of recognition of an inevitably-bankrupt strategy and pillar of current stability will rise when the largest actors maintain or escalate their efforts. Thus approaches the Fed and ECB policy meetings. The US central banks is first and on the hawkish end of the scale. They have come off of a series of three consecutive rate cuts which leaves their benchmark at 1.75 percent but it is expected that they will hold this month with no commitment with further easing into the future. We will get a better sense of their policy course moving forward with the planned Summary of Economic Projections (SEP), but they have not been particularly aggressive with their forecasts. The stability this may insinuate is undermined by the short-term funding pressure that has pushed the Fed to flood the repo market with liquidity. This has led to a sharp increase in the central bank’s balance sheet which they are quick to remark is not a return to traditional stimulus efforts. I would agree that it is not the ‘traditional’ QE effort, but its purpose is even more troubling: to fend off serious financial stability threats rather than to simply accelerate growth. Watch references to this in Chairman Powell’s press conference along with any insight into the discussions on general strategy that the board has been engaged.
At the other end of the perceived policy spectrum, the dovish ECB is in just as profound straits as its US counterpart. With a negative deposit rate and actively engaged in quantitative easing (the traditional type), we already know that there is a serious measure of concern for this authority when it comes to growth and financial health. It is between his effort and the immediate concern of its effectiveness that we find the most tangible threat to a crack in the façade of cure-all monetary policy. There has been a well-publicized uprising in the rank of the ECB with a host of members openly questioning the effectiveness of their extreme accommodation and the dilemma it leaves them in should an actual economic downturn – or worse, financial seizure – necessitate an effective response. Will the market adopt and action these concerns?
Take the Global Traders’ Perspective of the UK Election
Passions inflame when it comes to politics – particularly if you are a citizen of the country heading to the polls. That said, when navigating the markets, it is very important to divorce one’s personal, social and even moral views of parties and candidates to consider the genuine implications to the financial system. That is easier said than done, but the mantra should be repeated. For the upcoming UK general election Thursday, there is a clearly impassioned populace. With Brexit still hanging over the future leader and party like the Sword of Damocles and economic activity sputtering, it is easy to see the financial line blur in the myriad of concerns. Is this a matter of economic recovery, the future of trade between the UK and its largest economic partner or just a binary assessment of whether the divorce will finally proceed to a conclusion?
While there are many important implications from this event, I believe the market for the Pound – and certain capital asset benchmarks – will respond first and foremost to the favor for party and proximity to a majority. The closer the UK is to a unified position towards negotiations, the more likely a path will be decided for Brexit with deadlines being kept rather than pushed back. As an aside, an outcome that sees a reversal on the Article 50 could eventually charge the Sterling much higher, but it is a very low probability and would not be interpreted as such a possibility immediately after the General Election outcome necessary as a first step. This past week, we have seen remarkably volatility behind the Cable, EURGBP and other Pound crosses owing largely to the polls signaling a clearer support for the Conservative party (again not a party preference but rather the clarity it suggests) The volatility signals just how much activity could follow this event. DailyFX will be covering the election through the day and evening with live updates, outcome articles and forecasts for Brexit next steps.