US-China trade tensions show little sign of ending

Increasing tensions at the APEC summit between the US and China, which resulted in the failure to issue a joint communique (for the first time in APEC’s 29 year history) highlight the risks to any agreement at the G20 summit at the end of this month.   Consequently the chances of US tariffs on $250bn of Chinese goods rising from 10% to 25% in the new year remain  high as does the risks of tariffs on the remaining $267bn of goods exported to the US from China.  Contentious issues such as forced technology transfers remain a key stumbling block.

As the Trump-Xi meeting at the G20 leaders summit approaches, hopes of an agreement will grow, but as the APEC summit showed, there are still plenty of issues to negotiate.  US officials feel that China has not gone far enough to alleviate their concerns, especially on the topic of technology, with the hawks in the US administration likely to continue to maintain pressure on China to do more.  As it stands, prospects of a deal do not look good, suggesting that the trade war will intensify in the months ahead.

Despite all of this, the CNY CFETS trade weighted index has been remarkably stable and China’s focus on financial stability may continue as China avoids provoking the US and tries to limit the risks of intensifying capital outflows.  China may be wary of allowing a repeat of the drop in CNY that took place in June and July this year, for fear of fuelling an increase in domestic capital outflows.  However, if the USD strengthens further in broad terms, a break of USDCNY 7.00 is inevitable soon, even with a stable trade weighted currency.

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US data this week

Despite a softer tone to US equity markets at the end of last week market tensions appear to be easing, with news over the weekend of the ousting of Ukraine’s President helping in this respect. Although US equities ended the week slightly lower the overall tone to risk appetite was firm.

The G20 meeting proved to be a non event in terms of immediate market impact although the aim to lift GDP by more than $2 trillion over the next five years appears to be ambitious to say the least. However, at least focus has shifted from austerity to growth in terms of G20 thinking.

Last week’s release of the February Markit US PMI manufacturing survey which revealed a stronger than expected reading helped to allay some concerns afflicting markets over the pace of US growth giving markets reason for optimism. Indeed, in general markets have attributed recent weakness in US economic data to adverse weather conditions rather than a shift in growth trajectory.

Unfortunately this week’s US data releases are unlikely to be particularly helpful in shaking off growth worries. Although February consumer confidence is likely to be unchanged at a relatively high reading (tomorrow) declines in new homes sales (Wednesday) and durable goods orders (Thursday) in January will not bode well while a revision lower to US Q4 GDP (Friday) will highlight a slower pace of growth momentum at the end of last year than previously recorded.

The US data is likely to be bond friendly helping to cap gains in Treasury yields as well as restraining the USD. Nonetheless, the message from a plethora of Fed speakers on tap this week will likely be one of continued willingness to maintain the current pace of tapering, with recent and current weakness in economic data being shaken off as bad weather related.

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JPY selling momentum slows

Markets have few leads to trade off following yesterday’s President’s Day holiday in the US. Nonetheless, caution appears to be settling in ahead of this weekend’s Italian elections, especially in Europe.

European Central Bank President Draghi’s address to the EU parliament did little to stir markets as he didn’t elaborate much on his post ECB press conference in February. The most notable comment was that he urged the G20 to have very “strong verbal discipline” on talking about currency movements.

Despite the Italian election caution most risk measures appear to be well behaved. Equity volatility has continued to drop and gold prices have stabilised following the recent sharp decline. The highlight of the data calendar today is a likely gain in the February German ZEW survey.

Currency markets are rangebound but it is notable that USD/JPY has struggled to sustain gains above the 94.00 level, with upward momentum in the currency pair appearing to fade. Comments by Japan’s Finance Minister Aso that the government was not considering changing the central bank law at present or buying foreign bonds helped to dampen USD/JPY.

Although the G20 meeting effectively gave the green light for further JPY declines, a lot is in the price in terms of policy expectations and any further JPY weakness is likely to be much more gradual. USD/JPY 94.46 will offer strong resistance to further upside.

Asian currencies continue to deliver a mixed performance, with JPY sensitive currencies including SGD, KRW and TWD remaining on the back foot. The SGD is the most highly correlated Asian currency with JPY, with a high and significant correlation between the two. Any further drop in JPY will clearly bode badly for SGD but the inability of the JPY to weaken further may help to moderate pressure on the SGD in the near term.

Although the KRW has rebounded over recent days one risk to the currency is continued outflows of equity portfolio capital. South Korea is one of the only countries in Asia to have recorded outflows (around USD 1.2 billion year to date). However, this month the outflow appears to have reversed, with around USD 500 million in inflows registered month to date. In part the outflows of equity capital from South Korea in January reflected concerns about North Korea. Such concerns have receded but the risks remain of more sabre rattling and/or more nuclear tests from the North.

Political events move into focus

The start of the week will be relatively muted due to the US President’s Day holiday although Chinese markets will reopen following the New Year holidays giving a little more impetus to Asian markets.

The main event over the weekend was the G20 meeting. Ultimately it did not target Japanese FX policy, but instead the statement pledged not to “target our exchange rates for competitive purposes”. European Central Bank President Draghi may utter no more than this sentiment on the EUR exchange rate during his dialogue with the European Parliament today.

The lack of specificity will mean that the G20 statement will allow further unobstructed JPY weakness in the months ahead. In the near term markets will probe further downside in the JPY although we suspect that profit taking on long USD/JPY and EUR/JPY positions will restrict further downside potential. Expect plenty of resistance on any break above USD/JPY 94.00.

Attention will now turn to political events, in particular the looming elections in Italy (24th) and the formulation of a bailout for Cyprus in the wake of elections there. In the US the looming sequester may prompt some nervousness for markets over the coming days given the approaching deadline.

Data releases this week will be a little more encouraging following the recent plethora of data revealing a global softening in activity towards the end to 2012. In Europe gains in the German ZEW and IFO investor and business sentiment surveys will bode well for the region although the rest of the Eurozone will not look as upbeat as Germany. Despite the likely firmer German data expected over coming days EUR/USD is likely to remain restrained ahead of Italian elections, with strong resistance seen around 1.3462.

In the US there will likely be little new in the Fed’s FOMC minutes, with no new signal that the Fed is about to shift its policy stance despite a few nervous FOMC members. US Housing indicators will look a little softer but will not detract from the improving trend in housing activity currently underway. Meanwhile, relatively well behaved CPI and PPI inflation releases will pass reasonably quietly, provoking little nervousness in interest rate markets.

Finally in the UK the Bank of England MPC minutes will show a unanimous decision on policy settings. Unfortunately this will give little to help to GBP although it increasingly looks as though EUR/GBP is topping out even if GBP/USD looks vulnerable to further slippage.

Euro on the front foot

The G20 meeting of leaders in Mexico over the weekend did not make much progress in terms of increasing the size of the International Monetary Fund (IMF) or increasing support for the Eurozone. A decision on this has been delayed until the next meeting on 19-20 April. Instead attention has turned to the various bailout votes across Eurozone countries and discussions over increasing the firewall (by boosting the size of the bailout fund) around the Eurozone periphery. Germany continues to oppose any increase in the firewall. Sentiment will hinge this week on the outcome of these events rather than data releases.

The USD has come under growing pressure but this is as reflection of a stronger EUR rather than inherent USD weakness. Data releases in the US have continued on a positive track yet the USD has failed to benefit as higher US bond yields have been matched elsewhere. Business and consumer confidence measures over coming days are also likely to reveal some encouraging outcomes while the Beige Book will report improvement in economic activity but the USD will continue to be restrained.

The EUR is looking increasingly stretched from a fundamental perspective yet technical indicators show it to be on a stronger footing. EUR/USD will find strong resistance around the 1.3550 level and the currency could still stumble over coming days depending on the outcome of Wednesday’s ECB Longer term refinancinf operation (LTRO).

Various policy events will also help dictate EUR direction including national parliamentary votes on the Greek bailout and the EU Summit. Theoretically a large uptake by banks at the LTRO could result in more EUR liquidity and a weaker EUR but the reality is quite different. Improved sentiment in peripheral bond markets as LTRO funds are used to buy local debt are helping the EUR to push higher, with its short covering rally gaining more traction.

GPB has come under pressure in the wake of a stronger EUR, but we still expect EUR/GBP’s charge to falter. My quantitative models show that the currency pair is overbought and we will likely struggle to break above 0.85. If it does, EUR/GBP 0.8562 will prove to be a strong resistance level. UK data this week will likely give some support to GBP, with the manufacturing purchasing managers index (PMI) set to strengthen further. However, the release of a relatively dovish set of Bank of England (BoE) Monetary Policy Committee (MPC) minutes has helped to undermine GBP for the time being, meaning that any recovery will be limited in the near term.

Sell Risk Currencies on Rallies

The Federal Reserve FOMC outcome and Greece’s travails failed to dampen the recovery in risk appetite overnight. The Fed highlighted downside risks to growth and revised lower its forecasts. However, positively for risk appetite the Fed left open further policy easing options, hinting at more quantitative easing if needed.

Meanwhile European leaders tightened the noose around Greece by cutting off EUR 8 billion in aid payments and threatening to cut of all aid if the country’s referendum now scheduled for December 4 fails to endorse the EU rescue package announced last week.

At the emergency meeting of European leaders yesterday Greece’s Prime Minister also admitted that the referendum will not only decide the fate of the rescue package but also whether Greece wants to remain in the eurozone. Greece was not only the eurozone country in focus as Italy continues to be racked by political uncertainties, with Prime Minister Berlusconi failing push through legislation on structural reforms ahead of the G20 meeting beginning today.

The risk rally is highly unlikely to last, with the EUR, commodity and high beta emerging market currencies to face further pressure. Although the immediate market focus will be on the G20 meeting beginning today the fact that leaders are now seriously beginning to consider the prospects of a Greek exit from the eurozone while taking a tougher stance on the country highlights how important the December 4 referendum will be.

Ahead of the vote markets will remain highly nervous and risk aversion will remain elevated. Consequently risk assets are set to face further pressure. Moreover, the fact that China has downplayed the prospects of further bond purchases from the EFSF bailout fund suggests there will be no help from this quarter any time soon.

Aside from the G20 meeting markets will pay attention to Draghi and Co. at the European Central Bank (ECB) today as well as bond auctions in France and Spain but we do not look for much excitement from the ECB despite the increased uncertainty within the eurozone. While an interest rate cut today cannot be ruled out given the increased market uncertainty the ECB is likely to wait until December before cutting policy rates.

Euphoria fades, risk currencies weaker

The euphoria emanating from last week’s eurozone agreement will likely fade into this week as renewed doubts creep in. Details of how the EFSF bailout fund will be leveraged or how the special purpose vehicle will be utilised have yet to emerge while the firewall to protect countries such as Italy and Spain may still be insufficient given that the use of the European Central Bank (ECB) to provide unlimited support has been ruled out.

With more questions than answers markets will be hungry for further details over coming weeks and until then it is difficult to see risk appetite stretching too far. One indication of such concern was the fact that Italy’s borrowing costs climbed to euro-era highs the day after the European Union (EU) plan was agreed. The G20 meeting on 3-4 November will be eyed for further developments as well as further reaction to the EU agreement.

There are plenty of events to digest this week that could add to any market nervousness. In terms of central banks we do not expect to see any change in policy stance from the ECB, Federal Reserve or Reserve Bank of Australia (RBA) this week but the decisions may be close calls. The ECB under the helm of new President Draghi will be under pressure to ease policy as growth momentum has clearly weakened but the Bank will likely hold off for the December meeting when new growth and inflation forecasts will be released.

The RBA may also take some solace from a better global economic and market climate but the market disagrees having priced in a cut this week. The Fed will look to see how ‘Operation Twist” is faring before moving again but recent indications from some Fed officials suggest growing support for purchases of mortgage backed securities.

On the data front eurozone inflation today will be the key number in Europe while the US jobs report at the end of the week will be the main release in the US. Ahead of the payrolls data, clues will be garnered from the ISM manufacturing data and ADP jobs report. The consensus is for a 95k increase in non-farm payrolls and the unemployment to remain at 9.1% maintaining the trend of only gradual improvement in the US jobs market.

Recent data releases have turned less negative, however, and at the least have helped to alleviate renewed recessionary concerns. Overall, I suspect that markets will come back down to the reality of slow growth and unanswered questions this week, with risk assets likely to lose steam over coming days.

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