Trade war escalation threatens USDCNY cap

Markets are jaw-droppingly stable, given significant escalation at the weekend of measures against China’s Huawei, in addition to signs that China’s leadership is digging in for a longer confrontation with the US rather than giving in to the latter’s pressure. Consider the FT column “Xi Jinping is preparing China for a long trade war”  that outlines the case, describing an increasingly belligerent tone in media. (A scan of headlines and some of the commentary at China’s official news service,  Xinhua, offers some flavour.) 

But easily the biggest story over the weekend was Google’s move to cut off access to Huawei devices for updates to Android and Google services. This comes on top of the implications for chip-makers who must now suspend supply of chips to Huawei after the US administration placed the Chinese company on its “Entity List”.

Still, markets are remarkably stable, with the US equity futures somehow higher overnight, even if EM equities have lurched into an ugly slide over the last couple of weeks, somewhat at odds with the underlying currencies, which as a group have only suffered a sedate slide over that time frame. But let’s not be fooled – that latter relative calm is likely buttressed by the assumption that China will continue to cap USDCNY at 7.00 – if that policy is abandoned, significant volatility is likely to propagate across currency and all asset markets. Arguably, China will need to loosen monetary policy aggressively to counter the risks to growth from the trade showdown and this can only add to the pressure on the currency to weaken.

A big shock in Australia at the weekend as the election saw the incumbent Liberal National coalition defying all of the polls and eking out a victory. The Aussie celebrated with a gap higher to open the  week, as the Labour opposition’s more stern climate change policies were seen as a likely headwind for economic growth. Given the backdrop of the US-China showdown and the inertia of the clear shift in the Reserve Bank of Australia’s guidance, however, the AUD rally could prove very short-lived, though a cross like AUDNZD may have now found a low here.

Trading  interest

Looking to fade AUDJPY bounce as long as we remain below 77.50.
USD longs via AUDUSD short (stop above 0.7000) and EURUSD short (the latter in short-dated options near-the-money – implied volatility so low…) 

Chart: EURUSD

EURUSD is marching back toward the cycle lows, driven entirely by broad USD strength. Europe  faces an interesting political test over the next six months on the upcoming European Parliament elections this week and the leadership change at all levels by November 1 (European Central Bank included). Europe has plenty to lose from a US-China trade war on the impact to its highly export-leveraged economy. With German Bunds (10-year sovereign debt) marching to a new low for the cycle at negative 10 basis points, only 10 bps from the record low back in 2016. Little to attract investment flows into Europe in this environment! Let’s see if a new low can finally catalyze a more notable trend – it may only be possible to achieve anything significant to the downside in EURUSD beyond 1.1000 if the USDCNY has been loosened to the  upside of its current trading range below 7.00.