Geopolitics Becomes More Salient as Monetary Policy Plays for Time

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  • BOE meeting this week rounds out the major central bank spring meetings. No change is expected, but the market pushed out the hike until Q3 and has given up on two moves this year.
  • Geopolitics–trade tensions, resumption of NAFTA talks, and the Iran decision by the US are providing the main talking points.
  • Emerging markets remain on the defensive.

The US dollar is on a firm note to start the week. However, it is technically stretched and some consolidation seems likely. Disappointing German factory orders softened the euro but could not drive it through the pre-weekend low just above $1.19. Japanese markets re-open for the first time since the middle of last week and after initially taking the dollar lower, snapped it back and lifted it toward JPY109.35. Emerging market currencies are lower, led by the Russian ruble (-0.5%) and the Turkish lira (-0.4%). Equities are stable, with the MSCI Asia Pacific Index snapping a four-day fall by edging less than 0.1% higher. European shares are firmer and the Dow Jones Stoxx 600 is up 0.2% in late morning turnover in Europe. European benchmark 10-year yields are little changed but mostly softer, while the US 10-year yield is stable at 2.95%.

 Say what one will, US President Trump is vigorously projecting what he believes are American interests.  There is virtually no sign of the isolationism that many observers had anticipated.  Indeed, as we have argued, the America First rejection of the League of Nations that Trump harkens back to was not isolationist as much as unilateralist.  And the same is true of the Trump Administration.

He is trying to get North Korea to give up the nuclear weapon capability it has sought for a generation.  Stopping Iran from acquiring nuclear weapons is not sufficient, he wants to reduce its ability to be a regional power.

It wants China, the world’s second-largest economy at around $11.2 trillion to remake its economy and abandon one of President Xi’s major initiatives, Made in China 2025.  The US is seeking a $200 bln reduction (~2/3 by the US accounting) of China’s bilateral surplus in two years, which is the equivalent of 1.7% of the PRC’s GDP.  The US has continued to ratchet up sanctions on Russian companies and individuals to express disapproval of Putin’s foreign policy.

The Trump Administration is not content with aggressively pursuing America’s traditional rivals. The re-assertion of US power has been directed at American allies, such as Europe, Japan, and Canada.  Europe has been given another one-month exemption to the steel and aluminum tariffs, but this seems to be simply playing for time,   Japan was not even given a temporary exemption in the first place.

Each disagreement is expressed in superlative terms, and few have been resolved.  The US and South Korea reformed an existing free-trade agreement but the pressure the US was able to bring to bear may be not duplicated elsewhere.  Some other countries have done the calculations and may be willing to accept quotas instead of tariffs on their steel and aluminum exports to the US.

The priorities of the Trump Administration are not clear.  It seems to exaggerate its ability to dictate the outcome of events.  Since it sees international relations as a dog-eat-dog world, there are no real allies.  Transactional diplomacy yields more results than strategic posturing.

In the week ahead, three geopolitical and trade issues are high on the agenda.  The post-mortem on the Sino-American trade talks will be provided.  The US next steps will likely be clarified.  Some are linking China’s decision to cancel import commitments for soybeans for three consecutive weeks in April to the trend tensions.  It might, though, at the same time, it may also be linked to China’s decision announced at the end of last year,  to tighten the quality standards of US soybean imports by reducing the amount of foreign materials in the shipments.  Reports identify that the Chinese concern was over weed seeds.

Similarly, China’s gradual decline of waste imports from the US, the UK, EU, and Japan also is also a source of tension.  China announced last July as part of its efforts to reform its own environmental practices phase in a ban on imported garbage, scrap, and waste.   China’s solid waste imports (plastics, paper, and metal) fell 54% in Q1 18, in the immediate aftermath of the ban that went into effect at the start of the year.  More items will be banned starting next year and the year after.  It is not an unalloyed benefit for the Chinese environment as some producers will not be able to rely on foreign scrap, but in general, the motivation seems environmental and not trade per se.

The NAFTA negotiations are set to resume.  While there has been progress,  many are skeptical that it will be sufficient to reach an agreement in the coming weeks.  This may lead to the talks being postponed until after the July election in Mexico.  At the same time, the legislative requirements in the US, including an economic impact study, means that if an agreement is not reached soon, it will not be approved by this Congress.

The Mexican peso fallen as the US dollar has surged against nearly all currencies.  The peso has fallen for three consecutive weeks and four of the past five.  The US dollar’s 3.5% gain against the peso last week was the largest since immediately after the November 2016 US election.  Since the dollar dipped below MXN18.00 on April 17, it has appreciated by 7.5%.

The market is stretched, but like the euro, the speculative community (judging from the futures market) is still sitting with a substantial long position.  The gross longs have been cut by 25k contracts over the past two weeks (through May 1) but at nearly 130k, they are the still above the 52-week average and around  50% higher than at the end of last year.   Gross speculative have been trimmed by 10k contracts over the past couple of weeks and at 43.8k contracts is 15% smaller than the year-end position.

Mexico’s recent economic data, including the April PMIs, show economic momentum continues to stall.  Improvement is being made on inflation, and that will continue to be evident in this week’s CPI report.  Mexico’s inflation peaked at the end of last year just shy of 6.8%.  In March, it stood a little above 5.0%.  In April it is expected to have fallen to 4.6%.

The market is discounting a bit more than a 50% chance the central bank hikes rates when it meets on May 17.  June is seen as a more likely timeframe by the market, though a hike on the eve (less than a fortnight) of the election may not make for great optics but also underscores market confidence in the central bank’s independence.

The third major event is the US decision about the agreement with Iran.  The Trump Administration’s modus operandi has been to make bold demands/claims and then backpedal, but many expect Trump to begin the process that leads to the US exit.  This possibility or likelihood is thought to be a factor supporting oil prices.

We argued that a yuan-denominated oil futures contract does not challenge the role of the dollar in the world economy one iota.  The dollar’s role in the world economy is a function of its military might and depth and breadth of its capital markets.  It will not be a significant boost to the internationalization of the yuan, especially to the extent it is used by domestic producers and consumers to manage risk.  However, an unintended consequence of the futures contract may be that it is easier for Iran to minimize the impact of sanctions on its oil sales, an important source of revenue.

Unilaterally pulling out of the agreement with Iran would also complicate US relations with Europe.  It is not clear that European companies could be held liable is new US sanctions would be violated.  US foreign economic policy is also exposing Europe.  Some European officials have been trying to get the US to lighten up on sanctions against the Russian oligarchs.

Perhaps what is perceived as a more aggressive and unilateral stance by the US is a catalyst for clarifying a vision for future of Europe that the Great Financial Crisis and Brexit in themselves have apparently been insufficient.  Indeed, it is the sense of being at an inflection point that we suspect Merkel may compromise about the next ECB President in exchange for a more important position in setting the agenda for the coming years.

Prime Minister May seemed to be barely holding on to the reins of power.  It is not that there is an immediate challenger, but rather her inner cabinet rejected her compromise on the customs union.  The House of Lords passed another amendment to the Withdrawal Bill that would prevent a hard border with Ireland to the dismay of 10 Downing Street.

A rump of Tories in the House of Commons could ally with the opposition and not reject all of the amendments, including the requirement to stay in the customs union.  It seems impossible to find an agreement that will satisfy both Parliament and the Tory government.  The best news for May came in the way of the local elections, where the Tory loss was not as bad as had been feared.

The Bank of England meets May 10.  A rate hike that seemed like a done deal a month ago seems unlikely now.  The odds interpolated from OIS is about a 10% chance.  The market is not so much giving up on a hike, but pushing it into the second half of the year.  It has though nearly unwound the expectation for a second hike.  It is tempting to expect a hawkish hold like we anticipated for the Fed.  However, what tempers this is our suspicion that the BOE will shave its forecasts for growth and inflation.

The Reserve Bank of New Zealand meets on May 9.  Policy is widely expected to be on hold. On a trade-weighted basis, the New Zealand dollar has depreciated by about 3% since the middle of April.  This is the direction the central bank wanted.  The report covering inflation expectations for Q2 is out a couple days before the RBNZ meeting.  Expectations have been trending higher, and a continued depreciation would likely fuel further gains.

We suspect that economic data in the coming days will not be a major focus, given these geopolitical developments and the BOE meeting.  Over a two week period, the major central banks would have met, and Q1 data is history, and early Q2 data suggests little pickup in what appears to be a synchronized soft patch in Q1.

Among the data highlights, we would include a small tick up in US April CPI, led by a rise in energy.  The core rate may tick up to 2.2%, last seen in February 2017.  Europe reports March industrial production.  Contractions are expected in Italy and Spain, while France may have been flat.  A 0.3% rise in expected from Germany.  To the extent that order data is forward-looking,  a gain in Germany’s March factory orders, it may help support the ECB’s confidence over caution.

The UK is expected to eke out a 0.1%-0.2% gain, though manufacturing output probably fell for a second month, after being flat in January. The trade shortfall is expected to widen sharply.  Switzerland reports March CPI, and the EU harmonized measure is expected to be unchanged at 0.7%.  In comparison, headline Japanese inflation stood at 1.1% in March.   Meanwhile, headline and underlying inflation may soften in Sweden while tick up in Norway.