Will a trade war spill into a currency war?

Global markets will be faced with a myriad of small yet possibly consequential event risks this week – with the US administration’s mercantilist policy rampage at the top of the list of things for investors to keep a watchful eye on. One could argue that President Trump is playing a dangerous trade game after upping the ante on Chinese tariffs to US$100bn last week – and broadly taking the view that such a large threat will force Beijing to ultimately cave in. In a week in which President Xi will make a highly anticipated speech (Tue), the US Treasury may also release its semi-annual FX report (usually mid-month) – which will examine which of the US’s major trading partners may have manipulated their domestic FX markets in an attempt to gain an unfair trade advantage.

Based on the Treasury’s methodical ‘3 criteria’ process, we are not expecting any of the US’s major trading partners to be formally labelled a ‘currency manipulator’. Risks are that US officials make an example out of one of the smaller trading partners (Switzerland or Thailand) – which would keep global trade tensions on a knife-edge. Even worse would be if this mercurial Trump administration gives complete disregard to US trade law and names China a ‘currency manipulator’; this scenario, which we can’t fully rule out, would be a severe escalation in US-China trade tensions – and one that would send stock markets sharply lower.

While we continue to believe that markets will be the voice of reason in any looming trade war, what’s more, unnerving is that Trump’s protectionist push is coming at a time when:

(i) Fed policy is now ‘tight’;

(ii) the US is showing classic late-cycle economy signs, and

(iii) the US fiscal deficit is set to balloon.

All three will be relevant to some degree this week given the events in the US calendar: The minutes to the March FOMC meeting (Wed) will be of interest as we’ll see whether the Fed discussed the ‘elephant in the room’ of the widening Libor-OIS spread. With the real Fed funds rate now close to the neutral rate (‘r-star’), additional Fed hikes going forward are now a de facto tightening of US financial conditions. As such, the Fed may see higher USD Libor rates as a substitute for one or two rate hikes – and we see this as a USD negative.

The Congressional Budget Office (CBO) will release its 10-year economic and budget outlook today. This will be the first official look at how the Trump tax bill has affected the US fiscal deficit. While we expect these to be the worst ever debt-to-GDP projections the CBO has released, it’s worth noting that these will be an understatement of the true debt trajectory (actual debt-to- GDP has on average been 11% higher than the CBO estimates after year 5).