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SGX: Market Insights with Eurasia Group - Central Banks and Trade-war to Dominate FX Markets Amid Longer Term Politicization of Fed & USD

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Markets continue to watch trade and central bank reaction functions as drivers of foreign exchange, but there are underlying shifts in politics on both sides of the Atlantic. The Fed’s dovish reaction function incorporates USD strength, global growth prospects and the impact of trade war into the rate outlook but gradual cuts will still be too slow for Trump’s taste. While cyclical divergence remains the dominant factor in markets, near-term political trends are showing an improvement in the Eurozone, while the medium-term outlook for Fed independence and US tolerance for USD strength is getting rockier. In a turbulent geopolitical environment driven by both positive and negative headline risk, the distinction between safe-haven DMFX (USD, CHF, EUR and JPY above all) and EMFX will remain a feature of markets. 


With the impact of trade tensions becoming more evident in US manufacturing sentiment, the Fed’s transition to a more dovish policy stance is likely to continue, but it will nevertheless be insufficient to satisfy a President who is increasingly insistent that the Fed cut rates more sharply. Comments by NY Fed President John Williams on September 4th laid out the case for another cut at the September FOMC citing a host of factors—slowing economies in the rest of the world (especially in the Eurozone), further deterioration of pressure on business sentiment as a result of trade war, and the likelihood of further rate cuts by other global central banks. Within the FOMC itself, however, other voices remain unconvinced of the need for further cuts—Regional Presidents Rosengren and George, who dissented against the 25 bps cut in July, are likely to dissent again, which could reduce the space for anything more than 25 bps.


Meanwhile, Trump’s own desire for lower rates is not just to prime the economic pump but also in order to move the USD to levels commensurate with smaller trade deficits.  Trump has been pressing the Fed to be more aggressive in pursuing rate cuts to the extent of tweeting that Jay Powell might be a bigger “enemy” than President Xi. Although uncertainty on the trade outlook and its impact on business confidence is filtering back into Fed policy, it will likely continue to pursue gradual rate cuts rather than the dramatic cuts desired by Trump. The Fed will continue to be attentive to global events, trade-related uncertainty and the impact of the USD on US global financial conditions, but the Fed’s reaction function will not change to directly target USD for competitive purposes, as Trump desires.


But while the Fed remains wedded to these positions now, Trump does have the power to shape Federal Reserve policy through appointments. There are currently two vacancies on the Board of Governors and Trump has nominated Christopher Waller (a relatively orthodox dove) and Judy Shelton, a former enthusiast of the Gold Standard before 2016, who has translated that into a view that the Fed should shadow foreign central banks to prevent excessive FX volatility. There is even speculation that Trump could try to replace Powell before the end of his four-year term as Chair, but the Board could then decide to nominate another Chairman of the FOMC. While some of these more extreme eventualities might never come to pass, the mere discussion of them is a signal of the state of Administration-Trump relations.


Forex markets are likely to continue to be driven more by the interaction of trade tensions that damage growth expectations and the Federal Reserve’s reaction function. Hence, the extent to which the Fed weights the still relatively robust domestic economy versus international spillbacks into the US from slowing growth and USD strength are critical. These remain the dominant drivers of FX narratives but others may also come into view. On the monetary policy front, the extent of Fed vs. ECB easing remain key, but per the latest speech from Williams, it seems as though ECB policies are influencing the Fed more directly. But while a large step (such as QE resumption by the ECB) not matched by the Fed, would likely rekindle broader-based USD bullishness, underlying political narratives in Europe are becoming more positive.  While politics in the UK remain highly fluid, the odds of a no-deal Brexit have fallen as Parliament reclaims the agenda. Similarly, a more Euro-friendly coalition between the center-left PD and the left-populist M5S will likely take office in Italy, exorcising the specter of early elections leading to heightened instability. The market impact has already led to sharp falls in Italian bond yields and a concurrent easing of financial conditions. 


For the moment, markets have treated the politics of the Fed as being unlikely to influence policy settings over the near term, but this could change as US elections come closer into view. In this regard, opposition to USD strength is acquiring an increasingly bipartisan character, as reflected in Elizabeth Warren’s call for a greater Fed role in managing USD. There is also a bill (Hawley/Baldwin) sponsored by Democratic and Republican Senators from the Midwest requiring that the Fed take measures to target the US trade balance potentially including taxes on inflows into US assets. The politics of USD strength opens up other possibilities including intervention to weaken USD if it becomes uncomfortably strong. The willingness of the administration and the broader US political system to consider heterodox measures to target the exchange rate creates near-term headline risk and a possible medium-term reevaluation of the USD’s safe-haven credentials. 


Recent reactions continue to suggest a divergence between EM and DM FX developments. Signs of a more hawkish Fed are USD positive across the board, while signs of heterodox trade policy (and the consequent impact on US equity markets) are treated as USD negative vs. the currencies of the major capital exporters (JPY above all, then CHF, and to some extent EUR). However, both trade war and hints of a less dovish Fed than hoped are likely to increase depreciation pressure in EM currencies and highly cyclical DM currencies (such as AUD). In addition, the FX pressure on EM countries that compete with China is also likely to be highly correlated with movements in USD/CNY and USD/CNH. The interplay of these factors has become evident in intra-Asian JPY crosses such as JPY/KRW, AUD/JPY and CNH/JPY.


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China accommodates gradual CNH weakness as trade-war headline volatility continues


China has responded to the US’s most recent tariff escalation by accommodating more market-driven CNH weakness on the weak side of 7.00. While concerns about diplomacy and financial stability put a limit to Chinese tolerance for FX weakness, limited passthrough from a weaker exchange rate into tighter domestic financial conditions do allow China more degrees of policy freedom than was the case in 2015. Trade-related news will generate lots of headline volatility as Trump’s worries about the impact of trade conflict on the US economy and assets before the 2020 election collide with the deeper structural challenges of increasing strategic, technological and trade rivalry between the US and China.


Global foreign exchange markets continue to be focused on US-China trade tensions and the consequent impact on the USD/CNY exchange rate.  The escalation of the trade war has seen China retaliate against 75 billion USD of imports from the US, which was followed by President Trump not just increasing tariffs on Chinese exports by 5%, but also by “hereby ordering” US companies to leave China. Trump claimed that his power to do such a thing proceeds from the International Economic Emergency Powers Act (but would likely be contested in the courts), but he appears to have backed off from the threat in any event.  The events did lead to a further sharp weakening of CNY beyond the psychologically important 7.00 mark with rather limited efforts by the authorities to counter such weakening via intervention or jawboning.


The countercyclical factor in the fix has been used periodically excessive moves in too short a period, but there has been no attempt to use a squeeze in offshore CNH interest rates in order to squeeze or send a message to speculators. While China is unlikely to use CNY weakness to fully offset tariff increases due to concerns about diplomatic backlash and increasing capital flight pressures, it does appear that the sensitivity of domestic credit conditions to exchange rate moves has diminished since 2015, allowing China more leeway in accommodating market pressures on the currency. The loosening of the link between domestic interest rates and CNY/CNH weakness gives China more degrees of freedom on its overall policy stance, with a greater ability to use countercyclical monetary policy in a fashion more reminiscent of developed markets than of classic emerging markets.


Accordingly, China is taking additional measures to provide targeted stimulus via its policies on interest rates. The PBoC announced a new mechanism to set its benchmark Loan Prime Rate (LPR) by tying it to the PBoC’s Medium-Term Lending Facility (MLF). The MLF injects central bank liquidity via open-market operations against collateral including government and “high-quality” SME debt. The more direct PBoC role in setting the MLF should feed into the LPR and also increases the PBoC’s operational independence, as changes to the benchmark rate previously required State Council approval. While this is consistent with a broader shift towards some policy easing, the authorities are unlikely to use low rates to rekindle a property bubble, and the effect of lower rates is likely to be limited by subdued loan demand and banks’ concerns about credit quality and interest margins.


The most recent messaging from the Chinese government is that it is digging in for a “long struggle,” which suggests that hopes of a speedy and comprehensive resolution to US-China trade conflict are likely to be disappointed. At the same time, the market will also see periodic attempts to pull back from further escalation, driven by Trump’s concerns that the impact of trade conflict on corporate investment sentiment and equity markets could complicate his chances for re-election in 2020.  Indeed, the latest purchasing managers’ data from the US suggests that uncertainty on tariffs and retaliation have had a severe effect on sentiment, with the manufacturing ISM printing 49.1 and new US export orders printing at 43.2.  But the structural strategic tensions beyond trade in US-China relations argue against any easy de-escalation. The proximity of the US election also suggests that Chinese incentives could skew in the direction of “waiting Trump out” rather than offering a comprehensive deal. Between these cross-currents, global risk sentiment as reflected in equities and EMFX is likely to alternate between concerns about trade war and deglobalization and sharp rallies driven by headlines (and hope) that these will be resolved.


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US arms sales to Taiwan highlight political risk ahead of key election


A symptom of the broader US-China strategic rivalry, US sales of offensive aircraft to Taiwan come in the runup to a crucial election in January 2020 pitting incumbent DPP President Tsai against challengers from the KMT and possible independent candidates. The election will be fought on two major campaign issues -- the economy, where Tsai is on the back foot, and relations with China, where her popularity has been boosted by events in Hong Kong. The election will add an element of political risk to an economy already suffering the consequences of a chill in cross-straits relations and the ongoing disruptions to transpacific supply chains, particularly in technology.


The US-China conflict is going well beyond the phase of being a trade war to a broader-based geostrategic conflict marked by multiple red lines on each side. One indication of the broader deterioration in relations comes from a proposed US arms sale of F16 fighter jets to Taiwan to the tune of 8 billion USD, the first fighter jet sale in more than 30 years. The sale is likely to receive the approval of the US Congress, where anger against China is running high in both parties, with sentiment exacerbated by recent events in Hong Kong. The sale also signals the difficulty of an increasingly complicated US-China docket marked by intertwined disagreements on trade, technology, security and political issues, making it more difficult for both sides to compartmentalize an agreement just on the trade issues.


The arms sale is likely to arouse greater anger on the Chinese side as well, potentially leading to countermeasures targeting companies directly involved in the transactions, but the response may be tempered to some degree with an eye to the impact on Taiwanese politics. The sale comes ahead of upcoming elections in Taiwan in January 2020, which could be crucial for the region over the longer-term. The election will pit incumbent President Tsai Ing-Wen of the Democratic Peoples’ Party (DPP) against --Han Kuo-Yu, the nominee of the opposition KMT (currently Mayor of Kaohsiung), and two possible (formally undeclared) independent candidates, Kuo Wen-Je (Mayor of Taipei) and Terry Gou (Chairman of Foxconn). In line with her party’s historic stance, Tsai is a strong proponent of Taiwanese autonomy and national identity as opposed to the KMT’s adherence to the status-quo “one China” policy agreed by China and Taiwan in 1992. The two independent candidates could function as spoilers with Kuo more likely to take votes from Tsai/DPP and Gou from Han/KMT.


The election will likely be fought on a combination of economic and political issues. The Taiwanese economy has been negatively affected not just by a chill in relations with China but also by the broader disruptions to the region’s supply chains as a result of the US-China trade war. Accordingly, the economy is an issue that favors Han, and the KMT candidate will accordingly focus on his plans to dial down tensions with China as a way to boost Taiwan’s economy. In practice, this might prove more difficult in the face of heightened US efforts to decouple US-China technology supply chains, given the role of local firms in intermediating US intellectual property inputs into production facilities in Taiwan and on the mainland. However, Han’s efforts to run a campaign based on economic issues and a China-Taiwan status-quo has been undercut by events in Hong Kong leading to more support for the DPP’s view on China and on cross-straits issues. The most recent polls suggest that escalating protests in Hong Kong in August and China’s response to them have strongly helped Tsai and hurt Han.


In asset markets, TWD and the Taiwan stock exchange have tended to follow the lead of the broader USD, and of regional equity markets. As the crucial election approaches, particularly against the backdrop of more troubled US-China trade and security relations, Taiwanese assets could experience greater volatility. While the scale of Taiwan’s forex reserve holdings suggests an ability to control TWD moves, equities will have greater sensitivity to the combination of local political and economic factors and a troubled international trade environment (particularly affecting technology supply chains).


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Modi faces tough environment on international politics and domestic economics


A 5% pace of growth in Q2 2019, the weakest pace in 5 years, is underscoring the economic and political challenges faced by the Modi government. As a result of Pakistan’s isolation and its financial troubles, recent moves in Kashmir are unlikely to translate into a major diplomatic challenge in India, but the government’s actions raise questions about whether it will use its political capital on economic or socio-cultural issues. Thus far, responses to a growth slowdown that has both cyclical and structural dimensions have been partial and are unlikely to lead to a significant boost in domestic or foreign private sector confidence.


Indian markets are grappling with the host of economic and political issues that raise questions about the political priorities of the Modi government., even as it faces mounting evidence of an economic slowdown.  Q2 data showing growth at 5% annually (the slowest in six years) underscore the multiple pressures on growth, including plummeting auto sales, the troubles of  overleveraged infrastructure developers, and deepening problems in public sector banks and the non-bank financial sector. The financial system remains hobbled by high levels of non-performing loans (c. 10%), 80% of which are in the public sector financial institutions. The non-bank financial sector (NBFCs), a key provider of loans to small enterprises and to households (particularly for vehicle purchases), has also been under stress after a high-profile failure last year.  Despite government efforts to use public sector banks to provide loans to NBFCs or to backstop their borrowings, confidence in the sector has not recovered, contributing to a more generalized credit crunch in the economy.  


Meanwhile, international tensions in the subcontinent have risen as a result of India’s revocation of the state of Jammu and Kashmir’s special status under the Indian constitution. The international consequences of the situation are unlikely to escalate significantly, reflecting the relative isolation of Pakistan on this front. Between its frostier relations with the United States, and its economic and financial problems, which have necessitated IMF support, Pakistan has diplomatic little room to escalate conflict directly. Pakistan’s strongest diplomatic supporter, China, has indulged in more pro-forma criticisms of India’s measures. A portion of Kashmir (Aksai Chin) is also occupied by China, but it is sparsely populated and does not arouse the same passions in domestic Chinese politics as does Kashmir in Pakistan.


However, while the diplomatic fallout from India’s point of view is well contained, the move does raise larger questions about PM Narendra Modi’s broader agenda and the question of whether he will expend the considerable political capital of his landslide electoral victory on socio-cultural issues or economic ones. The election campaign by itself was fought on the basis of nationalism, and other steps of the government, beyond Kashmir, also point in the direction of a greater focus on cultural issues. Another such step involves the compilation of a national citizens’ register, fulfilling a long-standing demand in the Northeastern states in particular where immigration from Bangladesh has long been a subject of political controversy. 


On the economic front meanwhile, steps have been relatively halting. To deal with growing problems in the public-sector banking system, the government has just unveiled plans for mergers in the sector reducing the number of public banks from 27 to 12. The measures are unlikely to boost credit growth in the near-term as management energies are likely to be focused on assessing the scale of troubled loans and the adequacy of provisioning in the takeover targets, labor management and systems integration. And while a public banking sector with fewer but stronger institutions should be positive for the medium-term outlook, it is unclear whether the government will change the incentive structures for public sector banks away from politically-motivated calls for pump-priming and forbearance. 


Despite demands from the private sector, a large-scale fiscal stimulus is also unlikely, with the central government more likely to focus on incremental easing and regulatory reform, rather than blowing out its deficit target of 3.3% (a special dividend from the RBI will help in this regard). Some credit easing for export-oriented industries is a possibility, as is a redefinition of “affordable housing” to target more subsidies to the real estate sector. In terms of encouraging FDI to boost growth, the government is loosening restrictions on sourcing and internet sales for single-brand retailers, which could help foreign investor sentiment somewhat. However, plans to attract FDI into the coal sector are unlikely to be very successful, given a host of issues on labor, profitability and a gauntlet of state and local regulations. Overall, the measures may help at the margin, but are not the big confidence boost the market is seeking.


Meanwhile, the international backdrop is also becoming more challenging as China’s willingness to accommodate market-led currency weakness is leading to a weaker CNY, with spillovers into other Asian currencies. Although India is less negatively affected by US-China trade conflict than commodity or capital goods exporters hit by slowing Chinese growth and uncertainty on supply chains, the combination of domestic slowdown and broader USD strength is likely to increase depreciation pressure and volatility in INR. INR weakness could also raise further questions on two other fronts that spill into Indian equity markets—one is the extent to which domestic corporates and financials are exposed to INR weakness via the external commercial borrowings channel. In this regard, the RBI recently backtracked on its efforts from earlier this year to limit the use of external borrowings to repay INR loans, a position that might backfire now. In addition, sharp INR weakness could also cause the market to second-guess the extent of the RBI’s easing this year, and curtail further rate cuts thus depressing growth sentiment.


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Contagion from Argentina likely to be limited outside Latin America


The disastrous showing by Argentine markets (down 50% in USD terms in a single-day) in the aftermath of incumbent President Macri’s performance in a primary election suggests monitoring possible channels of contagion to other EM. The scale of Argentina’s external imbalances and the politicization of a 57 billion USD IMF program makes some of these problems sui generis, but there could be limited contagion into major trading partners in South America. Asian sovereign balance sheets are largely in better shape, but one possible contagion channel could be via the extent of foreign ownership in local currency debt markets, where Malaysia and Indonesia could experience some turbulence in a more difficult global environment.


Emerging markets facing a more challenging international environment as a result of slowing global growth, heightened risks to trade and USD strength could face some additional pressure on sentiment as a result of contagion, but the extent is likely to be limited compared to past shocks. The proximate source in this case is Argentina, where the shockingly poor political showing of market favorite President Mauricio Macri in a primary ahead of the October elections led equity markets to fall almost 50% in USD terms in a single day. The scale of Macri’s loss in the primary (a 15% margin) is a poor omen for his performance in the elections, and could endanger Argentina’s massive IMF package of 57 billion USD concluded last year, of which 44 billion USD have already been disbursed. Although less austere than previous IMF packages, the conditions are still highly unpopular.  Fear that the opposition will attempt to renegotiate the package have led to accelerated capital flight, forcing the government to seek a reprofiling of its sovereign debt, and to impose harsh capital controls.


The question for the markets is to what extent there is likely to be contagion into other countries, and via what channels. Large stocks of public external debt with a short maturity schedule forced Argentina to seek the IMF package last year, but this was insufficient to assuage market concerns about persistent balance of payments shortfalls and a high dependence on external public and private borrowing. The key problem in the case of Argentina was the relatively small tradeable sector that made it difficult for the country to benefit from exchange rate weakness. Argentina’s difficulties last year (which led it to the IMF) saw it twinned with Turkey, another country suffering from a low level of reserves relative to short-term external debt.  However, the contagion of sentiment into Turkey has been relatively limited this year. On the economic front, key differences include a much larger tradeable sector in the Turkish case that permitted both import compression and some gains in exports, as well as foreign banks continuing to roll over maturing FX debt. But the political differences are even more striking. For all its political and economic difficulties, for reasons of political prestige, Turkey did not approach the IMF last year, despite ample speculation that it would need to. However, it is precisely this recourse to the Fund, and the sizeable political backlash to it this year that have exacerbated the scale of capital outflows and market panic in Argentina this year.


Among broader EM, contagion has been more pronounced into Brazil, where BRL is feeling the pressure, notwithstanding the relatively more optimistic views that markets have taken towards President Bolsonaro. In view of their trading links with each other, and their competition in third markets (for agriculture and livestock, markets are rationally projecting weakness in ARS as negative for BRL. Beyond real contagion, diagnostic contagion is another possibility, with the focus in Asia being in countries that have sizeable levels of short-term external debt versus insufficient reserves. While Asia has increased domestic leverage substantially in recent years, a larger portion has been in local currency. Another contagion channel that may be more applicable in the case of Asia is via extensive ownership of local currency domestic debt in pooled vehicles (ETFs or mutual funds) that face redemption pressure, thus forcing broader liquidation of other EM assets. The Asian countries (and hence currencies) most likely to be affected by this route are Malaysia and Indonesia. However, thus far, the scale of contagion has been relatively limited, reflecting the low weight of Argentina in pooled vehicles.  Thus, the combination of global factors (trade and US Fed policy) and idiosyncratic domestic issues appear to be playing a larger part (disappointment with Modi e.g.) seem to be playing a larger role in Asian markets. However, the sheer scale of the distress in Argentina still argues for close monitoring of possible contagion channels.


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A version of this article was previously published on 27 Sep 2019 at