Morning Brief – Tuesday 25th

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How many sets of eyes and ears do you really need in order to react quickly to the set of discussions taking place in Osaka, Japan this Friday? A minimum for 10 pairs, assuming each leader has a conversation with at least one other person and doesn’t have a solitary wander around murmuring international secrets?! In fact, you’ll probably need to grow a few more pairs what with the delegations backing up each leader in what is shaping up to be one of the most crucial summits perhaps this decade, even millennium.

 

Leaders and their delegations will meet later this week with huge topics set to be discussed. From the Sino-US sideline discussion on the trade war and tariffs to Italy’s defiance of the European Commission, hundreds if not thousands of reporters, analysts and interest groups will be focusing on the event.

 

The US Dollar weakened further overnight to the benefit of Gold prices. Unfortunately for global growth and the health of riskier assets across the world, this isn’t the unwinding of defensive Dollar demand that caused a USD surge in the early phases of the trade war. With equity prices struggling to make gains across Asian, European and US markets, the move is far more indicative of the monetary policy shift across the Atlantic. The move therefore reveals very little about markets’ expectations for the pivotal meeting between the Chinese Premier Xi and President Trump.

 

What happens in the event of a trade breakthrough at this meeting? The dispute on trade has so far led to a heightened demand for defensive assets. With the US Dollar as the currency of global commerce (consider the denomination of the world’s oil prices or nations’ ‘hard’ debt issuance), a threat to trade also leads to demand for the asset that underwrites it as a form of protection. Consider fuel or food crises that we’ve all lived through, what happens? People stockpile the asset at risk. In a fuel crisis, people queue up for days at petrol stations and in food crises, all you’ll find in the isles of your local supermarket are cupcake tins and newspapers. The same is true with trade crises – a threat to commerce leads economic agents to stockpile the only guaranteed assets behind their global trading activities; and that’s the Dollar. Combine this with the status of the Dollar as a safe haven and reserve currency and trade threats inevitably lead to a stronger Dollar. A breakthrough on trade this weekend would therefore unwind the stockpiling of USD that has already occurred in order to survive the conflict, creating pressure for it to weaken further.

 

However, there’s been a major change in US economic dynamics since the start of the trade war. When tariffs first started to be raised and the rhetoric between the US and China first started to sour, the Dollar looked like a good bet. Growth was incredibly strong, the Fed was raising rates and expected to continue thereby deepening the demand the greenback commanded as a result of higher interest rates and yields, and the market remained optimistic with respect to inflation expectations. As 2018 progressed, the perception of an infallible US economy has changed and instead of expecting rates to keep rising the market now prices a 40% chance of two rate cuts in 2019 – far from the expectation of 3 hikes that money markets priced for this year within the US only six months ago.

 

A restoration of trade relationships this week would reverse the cuts to global and domestic growth expectations that have suffered as a result of the trade war. As expectations for economic activity rise the expectation that the Federal Reserve will have to cut rates in order to foster domestic economic growth evaporates. As a result, bond yields would rise once again as the market prices out their expectations for a looser monetary policy, restoring the reward for holding the Dollar and US assets. The Dollar would receive support from this dynamic and as a result, determining its net move in the event that the US and China signal their willingness to make a deal is challenging. Whatever the case, the move is likely to be limited by the conflicting dynamics.

 

Instead, look towards a weakening of defensive instruments including Gold, the Japanese Yen and the Swiss franc. The Pound Sterling too should receive a bid given the elevated risk profile currently assigned to it.

 

Big news over the weekend that the European Commission will at least delay its formal procedures under the Excessive Deficit Procedure against Italy have supported the Euro. The spread of Italian bond yields over German or average European yields have narrowed considerably since the announcement on Sunday evening showing that investors perceive the risk associated with the Italian political economy to be lower than before. Italy’s Prime Minister Giuseppe Conte is likely to meet with Commission President Jean-Claude Juncker at the summit to progress the negotiations surrounding Italy’s fiscal outlook. A hint towards concessions from both parties will lead to further Euro strength as the spread between Italian and European risk assets would tighten further. A fallout between the two could unwind the rallying Euro we’ve seen so far this week.

 

 

 

Discussion and Analysis by Charles Porter

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