Trade policy risks return to centre stage alongside political uncertainty

USD: China-US trade tensions move into new escalation phase

The US dollar has continued to trade at weaker levels during the Asian trading session after the sell-off at the end of last week. The dollar index hit a high of 99.563 on Thursday but has since dropped back below the 99.000-level. The main trigger for the reversal lower for the US dollar was the threat from President Trump on Friday to impose a “massive increase” of tariffs on imports from China. He plans to impose 100% tariffs from 1^st November in response to China’s recent new export restrictions on rare earth minerals which are critical for electronics, defence and EV industries. President Trump also stated that the US will impose export controls on “any and all critical software though did not specify which technologies would be affected.  It marks a new phase of escalation for the trade conflict between China and the US which has triggered a sell-off for risk assets at the end of last week. The S&P500 equity index declined sharply on Friday by -2.7% and the 10-year US Treasury yield fell by around 10bps. In the FX market, the commodity currencies have underperformed amongst G10 (AUD & NOK) and emerging market currencies (BRL, COP & CLP) alongside Asian currencies (KRW).

However, the initial moves have partially retraced overnight after President Trump has attempted to dampen concerns.  He posted “Don’t worry about China, it will all be fine! Highly respected President Xi just had a bad moment. He doesn’t want Depression for his country, and neither do I. the U.S.A wants to help China, not hurt it!!!”. Similarly, Vice President JD Vance has called on Beijing to “choose the path of reason”. He noted that “It’s going to be a delicate dance, and a lot of it is going to depend on how the Chinese respond”. “If they respond in a highly aggressive manner, I guarantee you, the president of  the United States has far more cards than the People’s Republic of China. If however, they’re willing to be reasonable, then the US would, too.” President Trump has also partially backtracked on his initial threat not to meet President Xi at upcoming APEC Summit in South Korea, and might still attend.     

The renewed threat of higher tariffs from President Trump are clearly intended to force China to backdown and reverse recent rare earth minerals. Market participants had been hoping that the worst of the trade conflict between China and the US was in the past. A trade truce reached earlier this year is still in place until 10^th November which had lowered US tariffs on imports from China to 30% down from 145%. As part of that trade truce China lowered tariffs on imports from the US to 10% down from 125%. If President Trump follows through on his new plan to raise tariffs on imports from China by 100% it would lift the overall tariff rate back up closer to the highs from earlier this year at the worst point of the trade conflict. However, we remain hopeful that the 100% tariff won’t be implemented and even if it is then it is unlikely to last long. As we saw earlier this year neither side can tolerate such high tariffs for long and the comments from President trump over the weekend again point towards a path for de-escalation. As a result, the trade threats may just contribute a more volatile FX market in the near-term and trigger some unwind of carry trades.    

FX VOLS PICK-UP FROM RECENT LOWS

Source: Bloomberg, Macrobond & MUFG GMR

EUR: French political uncertainty set to continue in the week ahead

Escalating trade tensions between China and the US have helped to ease downward pressure on the euro from ongoing political uncertainty in France. EUR/USD has climbed back above support at 1.1600-level after hitting a low at 1.1542 last week. However, political uncertainty in France is likely to persist in the week ahead remaining a headwind for euro performance. President Macron decided to reappoint Sebastien Lecornu as Prime Minister after he resigned last week. After the announcement, Prime Minister Lecornu told reporters he will try to pass a budget before the end of this year and that “either the political forces help me and we work together to make it happen, or they don’t”. The new cabinet is expected to meet tomorrow for the first time when Prime Minister is likely to propose a budget.

With the far right and far left vowing to support motions of no confidence in his government this week, Prime Minister Lecornu needs to convince both the Socialists and the Republicans to abstain in the coming votes. Socialist leader Olivier Faure stated over the weekend that the most likely scenario was that Lecornu’s latest efforts would fail. However, he did note that “I am obviously ready not to censure a prime minister who would agree, first, to roll back the pension reform, and then to govern without” bypassing parliament to pass a budget. According to media reports, Prime Minister Lecornu has opened the door to discussions over pausing the increase in the retirement age which has been estimated to cost EUR3 billion by 2027.  

Market participants will be braced for another week of heightened political uncertainty in France. We continue to hold the same views as last week (click here), downside risks for the euro would increase if Prime Minister Lecornu once again proves unsuccessful in reaching an agreement and thereby increases the probability of President Macron calling snap elections before year end. Alternatively, the best outcome for the euro would if a budget agreement can be reached.                     

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com