From Trade War to Currency War, CNY on the move

The 7.00 “line in the sand” for USDCNY has been breached for the first time since 2008, and last week saw the first Yuan fix weaker than 7.00 since 2008. This week the daily fix will continue to focus attention and direct risk sentiment, following Friday’s affirmation of continued mounting trade tensions from President Trump who said he was not ready to strike a trade deal with China and indicated the next round of talks scheduled for September might not take place.

The risks relating to the trade war continue to rise, particularly as the cyclical slowdown in global growth, which predates the trade war, takes its grip. The escalating trade tensions have become akin to pouring kerosene on what is fast becoming a synchronised global slowdown. The uncertainty paralyses decision making for multinational companies, burdens capex intentions and forces supply chains to be unravelled in order to remove risk. Globalisation has created global networks and supply chains that are under assault as tensions ratchet higher and the resetting of the US/China relationship can no longer be dismissed as the “art of the deal”. The China hawks within the US administration are in descent, wielding national security concerns, and Trump seems determined to reset the relationship with China, rather than allowing them to buy their way out with large soybean purchases. China’s mercantilist regime has become a bipartisan issue in the US and the onus is on Trump not to squander this opportunity to level the playing field. With every week that passes our longstanding notion that trade tensions are a sideshow for a long-running economic conflict and battle for tech dominance and hegemony, and that tensions were set to accelerate, becomes ever apparent. Tariffs and the bilateral trade deficit are just scratching the surface in a far deeper rift. As we have said many times, the tariff impact on global growth will be pervasive, non-linear and lagging, yet equities have basked in a warm glow of complacency. Placing infallible confidence in the hope of a trade deal and the ability for central banks to underpin earnings and pivot the economic cycle. What could go wrong?

The latest tariff announcement has further intensified the tensions and it looks like the two sides are now rousing the troops in a protracted bind as previously drawn out battle lines are reinforced. Hu Xijin, the editor of the Global times, a state-controlled newspaper in China that is widely thought of as a “mouthpiece” for Beijing outside of the party’s official statements, has tweeted: “Washington's repeated bullying has made it meaningless to continue trade talks in short run. China is mobilizing internally to fight firmly with the US, and all official media is participating in the mobilization. China and the US are caught in a stalemate worse than last round”

The US treasury labelling China a currency manipulator last week was clearly in retaliation to the Yuan breaching 7.0 and marks a rapid deterioration in relations. It will now be significantly harder for either side to backpedal from the current position and even a superficial deal looks a long way off, if at all. This war of attrition is no longer being fought through trade and tariffs alone, we have moved to technology and now currencies. Marking the end of the beginning in trade war turned economic war, where no tool is off the table.

In terms of manipulation the irony is that Beijing have actually taken steps to prop up the value of the currency, limiting depreciation and have consistently fixed CNY stronger than the market forces would imply. The currency remains under fundamental pressure, depreciating as growth slows, monetary policy is eased, tariff measures impact and the trade war bites. And if CNY were floated the currency would be significantly higher today without PBOC intervention due to market pressures. Although we should see a weaker CNY due to market forces, none the less the direct linkage between the USD/CNY breaching 7.00 for the first time since 2008 and rekindled tensions has weaponized the currency and shots have been fired signalling China can and will use the currency to mitigate the impact of tariffs on exporters.

The Yuan will continue to be a proxy of China’s intent and the state of trade negotiations. Every day the USD/CNY reference rate (fix) is weaker and the CNY continues to depreciate. Previous strength was evident of negotiations continuing in good faith. But given Trump’s latest announcement of further tariffs just as the 2 sides resumed talks is the polar opposite of one of China’s key demands, negotiating in good faith, we have seen warning shots fired. And if the additional tariffs go ahead on September 1^st CNY will depreciate further. Back of the envelope calculations suggest a $30bn impact to be offset (10% tariff on $300bn imports = $30bn), if we assume the current level accounts for pre-existing tariffs, USDCNY will be headed upwards of 7.30. And that is without accounting for potential non-linear impacts of accumulated tariffs and the hit to growth.

In the event these tariffs were raised to 25% in a more severe escalation of tensions we could see a more marked depreciation, pushing up past 7.50, but this is not the base case.

The slow and steady depreciation is managing sentiment and therefore capital outflows. But even though the impact on sentiment has been relatively light, given the fixing has been consistently stronger than estimates and previous close, make no mistake the trend is weaker, and the yuan is slowly but steadily depreciating. Administrative measures preventing large capital outflows remain intact and the managed devaluation is preventing a panic rush for the exits from ensuing allowing the PBOC to devalue CNY without uncontrolled outflows. This is a top priority for the PBOC for whom the scars of 2015/2016 panic run deep, which will prevent any intent and rapid depreciation from occurring.

Even prior to this latest trade escalation the PBOC were managing the message, preparing the market for any such measured move, hinting there was no line in the sand at CNY 7.00 per dollar. Again, signalling that the PBOC would like more flexibility in the exchange rate, but stability will always be a key focus so as not to dent credibility. Which would deter the long-term goal of internationalising the Yuan. Another hindrance to a significant CNY depreciation is the high levels of USD denominated debt held by Chinese corporates, Chinese property developers and other corporates who have international debt priced in dollars will struggle to foot the bill upon any significant devaluation as most of their earnings are CNY.

Never the less it is likely we see a continued CNY weakness, proceeding in the same measured manner, as the PBOC persist in engendering further exchange rate flexibility thus desensitizing the market away from the 7.00 level. Depreciation is likely to be capped at 7.50 throughout 2019, unless we see another marked escalation in the US/China relationship for example 25% tariffs on all Chinese imports. Continued CNY depreciation could also lead to downside in other EM Asia currencies setting off a competitive devaluation. The continued depreciation is unlikely to sit well with President Trump and the weaker CNY tracks the more likely 10% tariffs on so far untargeted imports go ahead on September 1^st.

Meanwhile the combination of falling producer prices as China PPI contracts for first time since 2016, along with the CNY depreciation, is indicative of mounting global deflationary pressures. Add in the continued slide in oil prices, iron ore prices collapsing as the supply shock rally recalibrates given global demand is faltering and a copper chart that looks ready to break and it is clear disinflationary forces loom large. In this this environment as a synchronised global slowdown takes effect there is no reason that bond yields should be heading higher and there is a good chance Fed must cut by more than the market is currently implying. Race to the bottom anyone?