FX – The Sting of Protectionism

Currency and equity traders felt the sting of protectionism on Friday as China and the US take fresh steps to restrict trade. Overnight, the Trump Administration announced plans to impose 5% tariff on all Mexican imports starting June 10th and the rate will “gradually increase” “if the crisis” of undocumented migrants persists. Rates would rise to 10% on July 1st if meaningful changes aren’t made and increase an additional 5% each month for 3 months. Trump is resorting to a tariff wall instead of a border wall but politics aside, this broad tariff will hurt not only the Mexican economy but American consumers and businesses.
 
Two things can be assured in a trade war – slower growth and higher prices for all parties involved. The sharp sell-off in stocks on Friday reflects the market’s concern that even though Mexico and China will lose the most from Trump’s trade tantrums, American businesses will be hit hard as well. It is estimated that for a company like GM, each 5% increase in tariffs could cost the company hundreds of millions of dollars. Second half earnings are already at risk because tariffs on China but adding tariffs on Mexico could lead to an earnings recession. The dollar weakened against all of the major currencies on Friday because when President Trump announces fresh tariffs, the first response by investors is panic over US earnings.
 
Unfortunately the rest of the world suffers alongside the US so don’t be lured by the relief rallies in EUR, AUD and other currencies. German retail sales fell -2% in April, which was significantly worse than the market’s forecast for an increase. This tells us that the deterioration in the labor market is more than a statistical fluke. Earlier this week German unemployment rolls rose the most in 4 years and while part of that was due to changes in categorization, the labor department warned that this was the first sign of a weakening economy. The European Central Bank meets next week and it will be an important one. Not only will the details of the TLTRO program be released but economic projections will also be updated. ECB President Draghi will then decide if the economy has weakened enough for them to signal the need for more stimulus.
 
The Eurozone is in a low growth phase and despite some improvements since the last monetary policy meeting, the most important drivers of monetary policy – consumer spending, inflation, manufacturing activity and retail sales weakened. For now, the EU escaped auto tariffs but a simultaneous slowdown in the US and China will hit the economy hard. If the ECB felt that more stimulus was warranted before the US slapped China with another round of tariffs, they will certainly feel that accommodative policy will be needed for the foreseeable future. EUR/USD crashed after their last meeting when they rolled out TLTRO and could fall further if the central bank lowers their growth and inflation forecasts. But that may not be enough. Given how deeply oversold the EUR/USD is, investors may have already discounted ECB dovishness and accounted for lower economic projections. So the nail in the coffin for the euro may have to be changes in their forward guidance or talk of new loan programs beyond the current TLTRO. The ECB meeting is not until Thursday and between now and then, EUR/USD is a sell on rallies and not a buy on dips.
 
For the past week AUD/USD traded in a very tight range and a breakout is on the horizon. Between a Reserve Bank of Australia monetary policy announcement, retail sales, GDP, PMIs and the trade balance, it will be nearly impossible for AUD/USD to remain confined within this past week’s 45 pip trading range. The market is pricing in a 93% chance of a rate cut by the RBA and the only question is whether they’ll follow with another move in July or August. The decision to lower interest rates will be an easy one because US-China trade talks were the only reason why they passed on it in May. But now that the US has proceeded with tariffs on China, Australia needs to preempt a recession by providing stimulus now. Vice President Pence talked about a possible meeting between Trump and Xi but with China announcing plans to release an “unreliable entities” list and the US talking about yet another round of tariffs the outlook for Sino-US trade relations is grim. So while domestic data hasn’t been terrible and the labor market in particular is strong, Australia’s economy could be hit hard in the coming months. If the RBA cuts interest rates and talks about doing more, we could see AUD/USD fall to fresh lows. If they ease and sound noncommittal about future movements, there’s hope for a sustainable relief rally.