Week Ahead: Currency war risks rise as trade conflict widens

How do you combat barriers to trade? With a weaker currency of course. Just such a playbook is being scripted now as the evident escalation in trade skirmishes risks pushing the world headlong not only towards a full-blown trade war, but also a currency war. Trade and currency wars are closely intertwined anyway, but it does appear this trade war is morphing into a wider conflict. It’s a busy week for earnings coming up but it’s trade and currency wars that are likely to dominate for investors.

China’s yuan slipped to a two-year low last week shortly after President Donald Trump laid in Europe and China for manipulating their currencies. China’s currency has been on the slide for a while as investors shy away due to trade war risks and because of widening interest rate differentials. But it’s also the case that the central bank is not acting to support the currency by stepping in as it might have done in the past. The PBOC is more than happy to let its currency weaken, and the belief it won’t step in soon would likely help push the yuan lower still. Clearly Beijing has decided that it cannot go head to head with the US on tariffs, but it can use its currency as a powerful weapon to negate the impact of tariffs.

All this followed Trump’s interview with CNBC, in which he launched wide-ranging attacks on the Federal Reserve as well as US trading partners. Equities sank sharply in the wake of Trump saying is he ready to slap tariffs on all the goods the US imports from China, which total over $500bn. That is versus the current tariffs on $34bn of imports and therefore points to serious escalation.

It’s proof, if it were needed, that the president is prepared to go all the way in the trade war to exact concessions from China, which simply cannot match the US firepower. In light of the EU and others saying they are ready to respond to tariffs on cars, the stakes are rising fast. Whether we get to the point where there is a full-blown trade war – and currency war - remains debatable, but the odds are shortening by the day.

Donald Trump wants a weaker dollar – past comments prove it. But an all-out trade war, by making dollars scarcer, will force up the greenback against its peers. Hence why he’s laying into the Fed for hiking rates.

There’s more than one way to a rig a market, and the US is not carrying out full-scale intervention, but jawboning your currency lower is a favourite. Arguably it’s got only a temporary effect but done enough times it can exert a powerful influence over market expectations. Since January 2017, when Trump warned that the dollar was ‘too strong’, the dollar index has retreated about 6%.

But China is ready. The move to fix the yuan lower in the wake of Trump’s comments was a clear signal from Beijing: ‘We see what you’re doing on trade, but we can shield our economy from tariffs by letting the currency weaken.’

Moreover, Beijing clearly understood that Trump was hoping to get the Fed to back off from hiking in order to cool the dollar’s ascent: ‘We know you want to dictate to the Fed on rates, but you cannot match our control of a currency.’

If Trump is doubling down on the trade rhetoric, it looks likely he may also try harder still to talk down the dollar. The question is whether the Fed feels like it can follow through on more hikes or does it row back a little. That could ultimately result in the dollar’s rally running out of momentum.