Market Brief: Easing US-China Tensions Boost Risk Appetite

Financial markets are back in risk-on mode after US President Donald Trump appeared to suggest that he could avoid putting tariffs on Chinese imports, backing off a campaign pledge to hit the country with a 60-percent levy. In a previously-recorded interview with Fox News that aired in the United States last night, Trump said “We have one very big power over China, and that’s tariffs, and they don’t want them. And I’d rather not have to use it, but it’s a tremendous power over China,” also noting that he had a “great relationship” with Chinese president Xi Jinping prior to the coronavirus pandemic, calling him a “very ambitious man”. The US dollar is down about a third of a percent in trade-weighted terms, and most major currencies are up roughly half a percent against the greenback as traders back off bets on tariffs and reduce hedges against negative downside shocks in trade-sensitive units.

The Bank of Japan raised benchmark interest rates to a 17-year high in a well-telegraphed move, and officials said they remained on a path toward normalising policy, suggesting that at least one more rate hike could come this year. In the statement setting out the decision, policymakers noted that inflation, pay growth, and economic outcomes were evolving in line with their outlook, and warned that “with firms’ behaviour shifting more towards raising wages and prices recently, exchange rate developments are, compared to the past, more likely to affect prices”. The yen strengthened about 0.6 percent after the announcement and held its gains through the press conference, even as Governor Ueda said “We don’t have any preconceived idea. We will make a decision at each policy meeting by examining economic and price developments as well as risks”.

We hope it’s different this time. The Bank of Japan’s last two attempts at ‘normalisation’—between 2000 and 2001, and then again between 2006 and 2008—aligned with major global market downturns.

The euro and pound are outperforming on the crosses after private sector activity gauges in the common currency area and the United Kingdom topped expectations in January. Purchasing manager indices published by S&P showed pain in both economies beginning to ease, suggesting that the cross-Atlantic gap in economic surprise indices—which measure the difference between economist expectations and realised data—could narrow slightly in coming months, helping to relieve pressure on interest rate differentials.

Markets suffered a brief bout of turbulence during yesterday’s session when Trump used a speech and panel discussion at the World Economic Forum to outline his “America First” policy stance in blunt and uncompromising terms. “My message to every business in the world is very simple: Come make your product in America and we will give you among the lowest taxes of any nation on Earth,” he said during a remote appearance. “But if you don't make your product in America, which is your prerogative, then very simply you will have to pay a tariff”.

Crude prices dropped and then regained some altitude after Trump said “I'm also going to ask Saudi Arabia and OPEC to bring down the cost of oil,” noting (quite sensibly) that “If the price came down, the Russia-Ukraine war would end immediately. Right now, the price is high enough that that war will continue. You've got to bring down the oil price. You're going to end that war”. Market participants remain unconvinced that the president's close relationship with Crown Prince Mohammed bin Salman Al Saud will prove sufficient to offset a broader economic backdrop in which weak demand provides a compelling reason for production cuts.

Government bond yields slipped but then recovered after the president said “With oil prices going down, I'll demand that interest rates drop immediately”. Trump can certainly try “jawboning”—or verbally influencing —Fed policy, but the president’s power over the central bank is quite limited under current law. He can try to fire Jerome Powell before the end of his term—the Federal Reserve Act of 1913 allows the president to dismiss a sitting chair “for cause”—but this would undoubtedly face serious legal challenges, making it unlikely to succeed. He can nominate officials who are sympathetic to his views, but the replacement process takes years, confirmation is subject to the same Senate committee approval procedure that blocked Sarah Bloom Raskin during his first administration, and the regional Fed presidents would remain outside his purview.

And the Canadian dollar climbed even after the president reserved his harshest words for Canada. Trump promised to eliminate a “tremendous deficit” with Canada, saying “As you probably know, I say you can always become a state. If you're a state, we won't have a deficit, we won't have to tariff you”. “We don't need them to make our cars, and they make a lot of them. We don't need their lumber, because we have our own forests. We don't need their oil and gas, we have more than anybody”.

Fortunately for Canada, the US does need its oil and gas: as Rory Johnston points out on his excellent blog, “Canada accounts for more than half of total US crude oil imports because (i) Canadian heavy crude is structurally cheaper, (ii) US refineries have spent decades investing in technologies designed to process these grades, and (iii) there is significant physical infrastructure (read: pipelines) that would take time and gobs of money to shift materially”. Perversely, by helping to correct a period of overvaluation in the Canadian dollar, Trump’s threats may ultimately help Canada regain competitiveness in global markets: using purchasing power parity valuations**, the Canadian dollar is now steeply undervalued relative to fundamentals.

Canada may run an oil and gas trade surplus with the US and the world, but export industries outside the energy sector were badly hurt when the exchange rate rallied ahead of the global financial crisis, and again during the China-led commodity rebound that followed. A period of undervaluation could help treat what is often (arguably too simplistically) known as Canada’s Dutch Disease.

*Purchasing power parity valuations have deep flaws, but can help illustrate the extent to which market exchange rates have diverged from long-term economic trends. Other measures—including the Economist’s Big Mac Index—arrive at similar conclusions.

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