Trade war escalation wreaks havoc in markets: What it all means for FX

Key takeaways:

• The recent escalation in the US-China trade clash has increased the risk of a complete fallout in the negotiations considerably
• This change in the macro backdrop has led us to review our FX forecasts and make a number of changes
• Although we keep a USD downside bias, we have lowered our forecasts for high-beta FX, we have revised higher our target for USDCNY, and we have turned cautious on emerging market currencies
• We have also lowered our forecast trajectory for EURCHF while keeping targets for EURUSD, GBPUSD and USDJPY unchanged.

Donald Trump’s announcement via Twitter that the US “will start, on September 1, putting a small additional tariff of 10% on the remaining USD 300 bn of goods and products coming from China into [the US]” has roiled financial markets. It immediately led to a retaliatory response by the Chinese authorities to halt all purchases of US agricultural products. All this triggered a sharp rally in USDCNY – which rose above the psychological level of 7.00 – and saw the US administration designate China a “currency manipulator”. Risk assets have collapsed: global equities have fallen by more than 5%, core yields have dropped heavily (the US 10-year yield nosedived to its lowest since mid-2016 of around 1.65%), Brent crude has declined by 8%, and investors have sought refuge in gold, the yen, and the Swiss franc.

...during the talks the U.S. will start, on September 1st, putting a small additional Tariff of 10% on the remaining 300 Billion Dollars of goods and products coming from China into our Country. This does not include the 250 Billion Dollars already Tariffed at 25%...

— Donald J. Trump (@realDonaldTrump) August 1, 2019

This most recent escalation in the US-China trade clash has increased the risk of a complete fallout in the negotiations considerably. While still not our base case, the probability of a “deal breakdown” has increased from 25% previously to 40% currently, in our view. This has two immediate implications for currencies: first, it suggests that one needs to account for an increased risk premium in foreign exchange rates, reflecting a higher probability of a more severe trade disruption and even damper business (and household) sentiment. Second, it argues for more aggressive Federal Reserve (Fed) rate cuts (we now expect three additional 25-bps cuts, with the possibility of more in case of further deterioration), which should influence the path of the dollar.

These developments have led us to review our FX forecasts and make a number of changes to reflect and balance these two factors. So far, we had maintained a view of moderate USD weakness, differentiated across G10 currencies and with EM FX the main beneficiary. Although we keep this USD downside bias, we have lowered our forecasts for high-beta FX, we have revised higher our target for USDCNY, and we have turned cautious on emerging market currencies. Most of our forecast revisions refer to Q3 and Q4 19, largely because we think that most of the pricing of the higher risk premium will take place in the next few months. We still expect a smoothing out of the trade relationships as we turn the corner to 2020 (although, admittedly, this has now become a very close call… something like a coin toss). Below we detail the changes to our forecasts. However, we should emphasise that the US-China trade saga has seen a plethora of developments; hence the degree of uncertainty as to the path of exchange rates is higher than normal.

USDCNY: Raising our forecast trajectory to 7.10 (Q3 19), 7.05 (Q4 19), 7.00 (Q1 20), and 6.90 (Q2 20), from respectively 6.90, 6.85, 6.80 and 6.78.

So far, we considered that the hurdle to a major CNY devaluation was high, due to the authorities’ explicit preference for exchange rate stability. While we still lean in favour of this view, we acknowledge that China's fixing of USDCNY central parity rates over the last few days demonstrates that the country has made a step towards weaponising its currency. However, a full-blown currency war that would take the RMB significantly and sustainably lower is not our central scenario, even though it remains a risk worth watching. This is largely reflected in our updated FX target trajectory, which has been adjusted partly to account for the higher risk premium associated with the trade disruptions. Additionally, we now see that China is embracing the prospect of extremely difficult trade negotiations with the US in the medium term, which contradicts our initial scenario of a more restrained diplomatic tussle leading to an eventual compromise.

All this has effectively invalidated the old currency anchor. That said, China’s reluctance to liberalise its capital account fully implies that any devaluation episode needs to be followed by the “establishment” of a new currency floor. We therefore believe that the key anchor for the currency will be more mechanical in nature and will depend on the depreciation required to offset the new tariffs by the US and keep Chinese market share stable. We estimate that this required depreciation is around 4-5% relative to the pre-tariff announcement levels. This would bring USDCNY in the range of 7.10-7.20. We chose the lower end of this range as our forecast of the “new floor” because 1) we still think the People’s Bank of China will maintain an important element of FX stability in its decisions (as long as trade discussions continue), and 2) we have pencilled in more aggressive Fed rate cuts. In short, most of the pain is likely to be felt this year, while a potential trade relationship stabilisation should allow for a modest CNY appreciation next year. All these forecasts of course carry a great deal of uncertainty, as they depend heavily on political developments and the decisions of the US administration. Predicting the latter has proven to be quite an elusive task so far.

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