Lack of Dismay

The deadline for tariffs is nigh
And Friday they’ll start to apply
But so far today
The lack of dismay
Has forced pundits all to ask why

Tomorrow is tariff day, as the US is set to impose 25% tariffs on $34 billion of Chinese goods beginning at midnight tonight. The Chinese are prepared to respond in kind, and it seems that the second battle of the emerging trade war (steel and aluminum were the first) is about to begin. Interestingly, financial markets remain extremely calm at the prospect of escalation with equity prices rebounding from Tuesday’s late losses and the dollar ceding some of its recent gains. I question how long this can continue, especially if we move on to stage three of the battle, where President Trump has promised tariffs on an additional $200 billion of Chinese goods. That poses a bigger problem for China as they only import about $135 billion in goods from the US each year (hence the deficit!)

The question at hand, though, is what type of impact this will have on markets going forward. Economic theory tells us that consumers will seek substitutes for those goods but that prices will rise somewhat to offset the effects of either paying the tariffs or accounting for the higher cost of the substitutes. In other words, inflation, which has been steadily moving higher in the US, is destined to continue that trend, if not accelerate somewhat. From there, it is a short hop to higher US interest rates and a stronger dollar. However, if this process continues long enough, it is likely to undermine the US growth story. If that were to happen, weakening data would likely cause the Fed to grow more cautious in their policy normalization drive. In that event, we are likely to see the dollar’s current strengthening trend stall. As is so often the case, one set of stimuli with a particular response leads to another set of stimuli with the opposite impact. The thing is, it will probably be 2019 before there is any indication that US growth is really slowing due to the trade story, and so I see only a limited chance that the Fed adjusts its policy trajectory this year. In other words, I think despite the tariffs, the Fed will still raise rates twice more in 2018.

Perhaps we will get a better idea of the Fed thinking on the subject when the Minutes of June’s FOMC meeting are released this afternoon. And while we have heard from several FOMC members that they are beginning to become concerned about the impact of the trade war, at this point, the data continues to favor policy continuation.

In the meantime, the dollar is a bit softer this morning as Germany finally printed some good data. For the first time this year, Factory Orders rose (+2.6%). While that is encouraging, it still begs the question as to whether this is the outlier number, or whether the previous five months of data were the aberration. But the euro is higher by 0.35% and pushing back toward 1.1700. That said, it has largely been range bound, between 1.1550 and 1.1750, for the past month. It doesn’t strike me that today’s data point is going to change that.

From the UK, Governor Carney was on the tape explaining that the growth picture there has been good enough to warrant higher rates if it continues. Yesterday saw the Services PMI in the UK rise to 55.1, well above expectations of 54.0, and its highest level in 9 months. The futures market has now increased its probability of an August rate hike to 82%, which barring any disastrous announcement on Brexit, seems sufficient to allow the BOE to act. However, nothing I have read has indicated that the UK is going to come up with a workable solution for the current Brexit issues, and I continue to believe that next March, the UK will be leaving the EU with no deal in hand. If that is the case, whatever the BOE was planning will come under renewed scrutiny, and it seems unlikely that rates there will go any higher. In addition, just like in the wake of the actual vote, I would expect the pound to suffer significantly at that time. All of this tells me that GBP receivables hedgers need to be very proactive in managing those risks, especially when we get a bounce in cable.

In the emerging markets, there has been one major move since I last wrote; MXN is higher by nearly 2.5%. While the move was just beginning Tuesday morning, the market has become enamored of the idea that President Trump and President-elect Obrador are going to be great friends and solve many of the problems that exist between the two nations. I don’t mean to be negative, but I find it hard to believe that will be the case. In fact, I expect that based on campaign rhetoric, the US and Mexico will see increased tension, which I am certain will lead to the peso suffering more than the dollar. In the end, Mexico is far more reliant on the US than the other way around, so stress in that relationship will hurt the peso first.

But otherwise, amid a smattering of data and news, the dollar is mildly softer this morning. After the Minutes are released and digested, all eyes will turn toward tomorrow’s payroll report. And in fact, we get a preview this morning with the ADP employment print (exp 190K) and Initial Claims (225K). We also see ISM Non-Manufacturing (58.3), which is likely to continue to show the current strength of the US economy. In the end, we are range bound, but as of now I still see a better case for dollar strength than weakness going forward.

Good luck
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