Weekly Comment, Trade War

Overview, Core themes

Concerns regarding the trade dispute between the US and China escalated with both the US and China announcing lists of goods that will be subject to tariffs. The biggest threat is that an escalation of tensions could eventually cause a decline in global economic growth. Emerging economies have suffered particularly by the tariff news, with the MSCI Emerging market index devaluing to 1085 late Tuesday.

Global equities trade softer on trade tariff woes, as the dispute triggered a sharp sell-off in trade-sensitive commodities stocks.

German Chancellor Angela Merkel's leadership is under threat over domestic migrant issues, prompting concerns the collapse of a fragile coalition could lead to a Europe-wide break up.

Risk of a global trade war remain a key issue for FX markets. We see USD upside risks as tariffs point towards higher inflation and thus higher interest rates in the US.  

Rates 

The markets’ demand for less risky assets pushed yields on the US 10 Year bond to a low of 2.85% this week, on escalation of the US / China trade war. We have seen a recovery back to 2.90% but risks remain to the downside. Market fears that the trade spat may weigh on US growth have contributed to demand for US bonds. The level to watch on the 10yr yield is a prior late May low of 2.76%, which if broken to the downside will open the door for a probe of 2.715% seen at the end of March.

The 10v2 spread rotates near cycle lows around 37bps. Further spread compression will not sit comfortably with some Fed members, as yield curve inversion tends to signal a looming recession. For the time being, front-end rates remain relatively anchored around the 2.55% level in the 2yr.

Last week the ECB surprised markets with a less hawkish than expected stance. The Bund/US 10yr yield spread widened further to 252bps on a policy divergence theme. This spread could widen further towards a recent peak of 258bps that was tested in May.

FX

In currency markets, the DXY index remains bid consolidating on a 95.00 handle. It has failed to sustain a break above here thus far. To the downside, the 93.50 level should provide key support, while the 95.00 mark remains the overhead resistance level to watch.

Disagreements within Merkel’s coalition government are contributing to Euro weakness due to the strain over immigration discussions.

Commodity currencies under pressure as the shadow of a Trade war lengthens.  

FX CFTC Positioning

According to data from the latest weekly CFTC report, short positions on the dollar increased to a net short position of USD 1.88bn to USD7.17bn. 

Interesting to note that open interest resumed its upward momentum having declined slightly. This may indicate the beginning of a new trend as rising open interest alongside rising shorting interest on the USD indicates a rising sense of dollar bearishness.

Judging from the data, we can summarise that the Fed move from last week had limited impact on bullish sentiment toward the USD leading us to believe that current policy of the FOMC is well discounted into the price. This leaves the market open for new catylsts and more sensitive to news of other factors affecting the price such as Trade Policy. 

Reflecting on last week’s ECB meeting, it came a surprise to most the depth of the Euro move to the downside. However, it was not just a weak Euro story. The market was slow to factor in the Fed meeting into the price from Tuesday. This widening of interest rate differentials was key to the weakness in the cross.

USD

The US tariffs on imports from China and the retaliatory tariffs on the part of China are likely to have a net-inflationary effect in the US.

While retreating off its intraday highs on Tues, the dollar managed to sustain a break above the 95.00 level as trade war fears generated haven demand. Escalation in the trade war between the US and China came on Tuesday and Wednesday with further tit-for-tat tariffs. The FX market reacted with “risk off” which benefitted mainly the Japanese yen.

The fact that the USD positive view has not yet asserted itself strongly on the market yet may be due to the fact that at present the debate mainly circles around the effects on the world economy. The broader picture sees far reaching consequences of the trade war between the US and China, and the potential for considerable correction in the US, if the Fed planned to curb future rate hikes, as a consequence.

GBP

The pound is still suffering. Apart from a stronger dollar, Brexit is currently weighing on the pound. British Parliament continues to argue with the government over the Brexit legislation.

Thursday sees the BoE meeting on Monetary policy, with general consensus being for no change in rates or monetary policy. The interest rate curve attaches only a 3% probability of a 25 bps hike compared to a 45% chance for the August meeting.

Technically Cable has traded lower to new lows for the year, touching 1.3148. This level completes the Jan/Apr double top downside objective of 4.43%. Risks are for a continuation of the more towards the 1.3040 Oct 2017 low. We would expect to see stabilisation and demand at that level. Studying the charts more closely, between 1.3150/70 there is a cluster of support drawn from long-term trendlines, (see chart). Intraday, we expect some noise in the area as the market consolidates before assuming the next phase. To the upside, first resistance is at 1.3318 and above that 1.3400/20. Downside support comes in a 1.3148, and below that opens the door for weakness to 1.3015/17.

The market will continue to trade defensively while prices remain below 1.3410 resistance.

 EUR

The ongoing issue in Germany still remains a key theme for Euro weakness at present providing headwinds for the EURUSD cross. There are many moving parts for EURUSD direction at present. Trade, monetary policy, political uncertainty in Europe, Brexit and to some degree EM weakness.

Looking back to the present issue in Germany, Merkel is under pressure due to immigration policy for Germany. If Merkel were to step down that would very much be market relevant, having profound impact on the Euro. If the Chancellor were to step down concerns about a rise of euro sceptical forces in Germany might quickly become an issue for the market. Such an extreme scenario seems unlikely at present.

This week ECB’s Mario Draghi speaks in Sintra, Portugal. The market will be quick to remember his famous speech delivered in Sintra last year with regards to QE tapering. Then, his optimistic view on the Euro zone economy was interpreted as a signal for an imminent end of the ultra-expansionary monetary policy resulting in a stronger Euro.

Last week, Mario Draghi was less hawkish than expected pushing rate hikes back further along the curve until Autumn 2019 and signalling and end to QE at the end of the year. However it was the theme of rate hikes, which caught market’s focus. Euro weakness has continued into this week keeping the negative bias entrenched. Last week’s upside corrections through 1.1825/50 seem a distant (300 pip) memory. Market focus now turns to the 1.1510 low from May, sparked by the political turmoil in Italy. This area should see good demand barring any more negative news from Germany, Merkel’s present dilemma.

Technical EURUSD is still under pressure from the bears. Intraday rallies will be capped initially by the 13 mda at 1.1690. Above, there is little resistance until 1.1835/50. It is not all gloomy however. For long term bulls, 1.1510/50 offers a new opportunity to get long using 1.1500 as a stop. This week, on the charts, two hammer patterns on the candles suggests an interim base is being formed.